ST5 PC 16

ST5 – P C – 16
Combined Materials Pack
ActEd Study Materials: 2016 Examinations
Subject ST5
Contents
Study Guide for the 2016 exams

Course Notes
Question and Answer Bank
Series X Assignments*
*Note: The Series X Assignment Solutions should also be supplied

with this pack unless you chose not to receive them with your study material.
If you think that any pages are missing from this pack, please contact ActEd’s admin team
by email at ActEd@bpp.com.
How to use the Combined Materials Pack
Guidance on how and when to use the Combined Materials Pack is set out
in the Study Guide for the 2016 exams.
Important: Copyright Agreement
This study material is copyright and is sold for the exclusive use of the purchaser. You
may not hire out, lend, give out, sell, store or transmit electronically or photocopy any
part of it. You must take care of your material to ensure that it is not used or
copied by anybody else. By opening this pack you agree to these conditions.
ISBN 178-1-4727-0274-4
The Actuarial Education Company

1HILERM*hachee+ © IFE: 2016 Examinations
All study material produced by ActEd is copyright and is sold
for the exclusive use of the purchaser. The copyright is owned
by Institute and Faculty Education Limited, a subsidiary of
the Institute and Faculty of Actuaries.
Unless prior authority is granted by ActEd, you may not hire

out, lend, give out, sell, store or transmit electronically or
photocopy any part of the study material.
You must take care of your study material to ensure that it is

not used or copied by anybody else.
Legal action will be taken if these terms are infringed. In

addition, we may seek to take disciplinary action through the
profession or through your employer.
These conditions remain in force after you have finished using

the course.
© IFE: 2016 Examinations The Actuarial Education Company

ST5: Study Guide Page 1
2016 Study Guide
Subject ST5
Introduction
This Study Guide contains all the information that you will need before starting to study
Subject ST5 for the 2016 exams. Please read this Study Guide carefully before
reading the Course Notes, even if you have studied for some actuarial exams before.
When studying for the UK actuarial exams, you will need:
 a copy of the Formulae and Tables for Examinations of the Faculty of

Actuaries and the Institute of Actuaries, 2nd Edition (2002) – these are often
referred to as simply the “Yellow Tables”
 a “permitted” scientific calculator – you will find the list of permitted

calculators on the profession’s website. Please check the list carefully, since it is
reviewed each year.
These are both available from the Institute and Faculty of Actuaries’ eShop. Please visit
www.actuaries.org.uk.
Contents
Section 1 The Subject ST5 course structure Page 2

Section 2 ActEd study support Page 3
Section 3 How to study to pass the exams Page 14
Section 4 Frequently asked questions Page 18
Section 5 Core Reading and the Syllabus Page 19
Section 6 Syllabus Page 22
The Actuarial Education Company © IFE: 2016 Examinations

Page 2 ST5: Study Guide
1 The Subject ST5 course structure

There are six parts to the Subject ST5 course. The parts cover related topics and have
broadly equal lengths. The parts are broken down into chapters.
The following table shows how the parts, the chapters and the syllabus items relate to
each other. The end columns show how the chapters relate to the days of the regular
tutorials. This table should help you plan your progress across the study session.
Syllabus 3 full
Part Chapter Title No. of pages
objectives days
0 Introduction to Subject ST5 9
1 Derivatives (1) (j) (part) 22
1 2 Derivatives (2) (j) (part) 21
3 Specialist asset classes (1) (i) (part) 41
4 Specialist asset classes (2) (i) (part) 72
5 Environmental influences (c) 25 1
6 The theory of finance (h) 37
7 Regulation of financial services (g) (i)-(ii) 15
Applications of the legislative and
2 8 (g) (ii)-(iii) 23
regulatory framework (1)
Applications of the legislative and
9 (g) (ii)-(iii) 29
regulatory framework (2)
10 Fundamental share analysis (d) 31
3 11 Valuation of investments (1) (e) (part) 49
12 Valuation of investments (2) (e) (part) 40
13 Industry classification (m) (part) 16 2
14 Investment indices (m) (part) 46
4
15 Performance measurement (1) (n) 45
16 Performance measurement (2) (l) 19
17 Overall risk control (a) & (f) 25
18 Actuarial techniques (1) (k) (part) 18
5
19 Actuarial techniques (2) (k) (part) 19
20 Portfolio management (1) (o) (i)-(iii) 42
(o) (vii), 3
21 Portfolio management (2) 34
(x)-(xii)
(o) (iv)-(vi),
6 22 Portfolio management (3) 49
(viii), (ix)
23 Taxation (b) 14
24 Glossary – 17

2 ActEd study support

Successful students tend to undertake three main study activities:
1. Learning – initial study and understanding of subject material
2. Revision – learning subject material and preparing to tackle exam-style questions
3. Rehearsal – answering exam-style questions, culminating in answering
questions at exam speed without notes.
Different approaches suit different people. For example, you may like to learn material
gradually over the months running up to the exams or you may do your revision in a
shorter period just before the exams. Also, these three activities will almost certainly
overlap.
We offer a flexible range of products to suit you and let you control your own learning
and exam preparation. The following table shows the products that we produce. Note
that not all products are available for all subjects.
LEARNING LEARNING & REVISION REVISION & REHEARSAL

REVISION REHEARSAL
Course Notes Q&A Bank Flashcards Revision Notes Mock Exam A
X Assignments Sound ASET Additional

Revision Mock Pack
Combined Revision (AMP)
Materials Pack MyTest Tutorials
(CMP) Mock / AMP
Marking
X Assignment
Marking
Tutorials
Online
Classroom

The products and services available for Subject ST5 are described below.

“Learning” products
Course Notes
The Course Notes will help you develop the basic knowledge and understanding of
principles needed to pass the exam. They incorporate the complete Core Reading and
include full explanation of all the syllabus objectives, with worked examples and short
questions to test your understanding.
Each chapter includes the relevant syllabus objectives, a chapter summary and, where
appropriate, a page of important formulae or definitions.
“Learning & revision” products
Question and Answer Bank
The Question and Answer Bank provides a comprehensive bank of questions (including
some past exam questions) with full solutions and comments.
The Question and Answer Bank is divided into seven parts. The first six parts include a
range of short and long questions to test your understanding of the corresponding part of
the Course Notes. Part seven consists of 100 marks of exam-style questions.
X Assignments
The six Series X Assignments (X1 to X6) cover the material in Parts 1 to 6 respectively.
Assignments X1, X2 and X3 are 80-mark tests and should take you two and a half hours
to complete. Assignments X4, X5 and X6 are 100-mark tests and should take you three
hours to complete. The actual Subject ST5 examination will have a total of 100 marks.
Combined Materials Pack (CMP)
The Combined Materials Pack (CMP) comprises the Course Notes, the Question and
Answer Bank and the Series X Assignments.
The CMP is available in eBook format for viewing on a range of electronic devices.
eBooks can be ordered separately or as an addition to paper products. Visit
www.ActEd.co.uk for full details about the eBooks that are available, compatibility
with different devices, software requirements and printing restrictions.


CMP Upgrade
The purpose of the CMP Upgrade is to enable you to amend last year’s study material to
make it suitable for study for this year. In most cases, it lists all significant changes to
the Core Reading and ActEd material so that you can manually amend your notes. The
upgrade includes replacement pages and additional pages where appropriate.
However, if a large proportion of the material has changed significantly, making it

inappropriate to include all changes, the upgrade will only outline what has changed. In
this case, we recommend that you purchase a replacement CMP (printed copy or eBook)
or Course Notes at a significantly reduced price.
The CMP Upgrade can be downloaded free of charge from our website at
www.ActEd.co.uk. Alternatively, if the upgrade contains a large number of pages, you
may prefer to purchase a hard copy from us at a minimal price to cover production and
handling costs.
A separate upgrade for eBooks is not produced but a significant discount is available for
retakers wishing to re-purchase the latest eBook.
X Assignment Marking
We are happy to mark your attempts at the X assignments. Marking is not included with
the Assignments or the CMP and you need to order it separately. You can submit your
scripts by email, fax or post. We recommend that you submit your script by email.
Your script will be marked electronically and you will be able to download your marked
script via a secure link on the internet.
Don’t underestimate the benefits of doing and submitting assignments:

 Question practice during this phase of your study gives an early focus on the end
goal of answering exam-style questions.
 You’re incentivised to keep up with your study plan and get a regular, realistic
assessment of progress.
 Objective, personalised feedback from a high quality marker will highlight areas
on which to work and help with exam technique.
In a recent study, it was found that students who attempt more than half the assignments
have significantly higher pass rates.

Series Marking
Series Marking applies to a specified subject, session and student. If you purchase
Series Marking, you will not be able to defer the marking to a future exam sitting or
transfer it to a different subject or student.
We typically send out full solutions with the Series X Assignments. However, if you
order Series Marking at the same time as you order the Series X Assignments, you can
choose whether or not to receive a copy of the solutions in advance. If you choose not
to receive them with the study material, you will be able to download the solutions via a
secure link on the internet when your marked script is returned (or following the final
deadline date if you do not submit a script).
If you are having your attempts at the assignments marked by ActEd, you should submit
your scripts regularly throughout the session, in accordance with the schedule of
recommended dates set out in information provided with the assignments. This will help
you to pace your study throughout the session and leave an adequate amount of time for
revision and question practice.
The recommended submission dates are realistic targets for the majority of students.
Your scripts will be returned more quickly if you submit them well before the final
deadline dates.
Any script submitted after the relevant final deadline date will not be marked. It is your
responsibility to ensure that scripts are received by us in good time.
Marking Vouchers
Marking Vouchers give the holder the right to submit a script for marking at any time,
irrespective of the individual assignment deadlines, study session, subject or person.
Marking Vouchers can be used for any assignment. They are valid for four years from
the date of purchase and can be refunded at any time up to the expiry date.
Although you may submit your script with a Marking Voucher at any time, you will need
to adhere to the explicit Marking Voucher deadline dates to ensure that your script is
returned before the date of the exam. The deadline dates are provided with the
assignments.

Tutorials
Our tutorials are specifically designed to develop the knowledge that you will acquire
from the course material into the higher-level understanding that is needed to pass the
exam.
We run a range of different tutorials including face-to-face tutorials at various locations,

and Live Online tutorials. Full details are set out in our Tuition Bulletin, which is
available from our website at www.ActEd.co.uk.
Regular and Block Tutorials
In preparation for these tutorials, we expect you to have read the relevant part(s) of the
Course Notes before attending the tutorial so that the group can spend time on exam
questions and discussion to develop understanding rather than basic bookwork.
You can choose one of the following types of tutorial:

 Regular Tutorials (three full days) spread over the session.
 A Block Tutorial (three full consecutive days) held two to eight weeks before
the exam.
Online Classroom
The Online Classroom acts as either a valuable add-on or a great alternative to a face-to-
face or Live Online tutorial.
At the heart of the Online Classroom in each subject is a comprehensive,

easily-searched collection of over 50 tutorial units. These are a mix of:
 teaching units, helping you to really get to grips with the course material, and
 guided questions, enabling you to learn the most efficient ways to answer
questions and avoid common exam pitfalls.
The best way to discover the Online Classroom is to see it in action. You can watch a
sample of the Online Classroom tutorial units on our website at www.ActEd.co.uk.

“Revision” products
For most subjects, there is a lot of material to revise. Finding a way to fit revision into
your routine as painlessly as possible has got to be a good strategy! Flashcards, Sound
Revision and MyTest are inexpensive options that can provide a massive boost. They
can also provide a variation in activities during a study day, and so help you to maintain
concentration and effectiveness.
Flashcards
Flashcards are a set of A6-sized cards that cover the key points of the subject that most
students want to commit to memory. Each flashcard has questions on one side and the
answers on the reverse. We recommend that you use the cards actively and test yourself
as you go.
Flashcards are available in eBook format for viewing on a range of electronic devices.
eBooks can be ordered separately or as an addition to paper products. Visit
www.ActEd.co.uk for full details about the eBooks that are available, compatibility
with different devices, software requirements and printing restrictions.
Sound Revision
It is reported that only 30% of information that is read is retained but this rises to 50% if
the information is also heard.
Sound Revision is an audio product, designed to help you remember the most important
aspects of the Core Reading.
The tracks cover the majority of the course, split into a number of manageable topics
based on the chapters in the Course Notes. Each track lasts no longer than a few
minutes so it’s perfect for the train, tube, or car journey on the way to work, or where
taking folders and course notes is not practical.
MyTest
MyTest is a revision product containing over 450 questions specially written for
actuarial students. There are some multiple-choice questions and some requiring a
longer answer. The more you use it, the more it learns about the gaps in your
knowledge and understanding. Questions become ever more focused onto these gaps,
until they are filled. In a recent study, it was found that students who focus on questions
testing the areas of the course they find most difficult have significantly higher pass
rates.

MyTest is only available online. Registration runs for one exam session and will
automatically expire after the exam. Visit our website at www.ActEd.co.uk for
information on how the programme works and details of how to place an order for
MyTest.
Choice of revision product
For most students, using one or two of these products will be more effective than using
all three and different students will have preferences for different products.
So, what might influence your choice between these three study aids? The following
questions and comments might help you to choose the revision products that are most
suitable for you:

Different students will have preferences for different revision products.
So, what might influence your choice between these study aids? The following
questions and comments might help you to choose the revision products that are most
suitable for you:
Flashcards
 Do you have a regular train or bus journey?

Flashcards are ideal for regular bursts of revision on the move.
 Do you want to fit more study into your routine?

Flashcards are a good option for “dead time”, eg using flashcards on your
phone or sticking them on the wall in your study.
 Do you find yourself cramming for exams (even if that’s not your original
plan!)?
Flashcards are an extremely efficient way to do your pre-exam memorising.
Sound Revision

 Do you have some regular time where carrying other materials isn’t practical,
eg commuting, at the gym, walking the dog?
Sound Revision is an ideal “hands-free” revision tool.

 Do you have a preference for auditory learning, eg do you remember

conversations more easily than emails?
Sound Revision will suit your preferred style and be especially effective for you.
MyTest
 Do you tend to avoid studying topics you find difficult?

MyTest tracks your progress and tailors future tests to reflect this.
 Do you want to fit in some study at work?

MyTest is ideal for regular bursts of revision at the start of the day or at
lunchtime.
 Do you like being at your computer?

If you’re not tired of looking at a screen after a day at work, then MyTest may be
for you.
Choosing more than one revision product

In general, we recommend using just one or two of these products rather than all three,
however, retakers might consider using a different selection of products than on a
previous attempt to keep revision fresh and effective.
“Revision & rehearsal” products
Revision Notes
Our Revision Notes have been designed with input from students to help you revise
efficiently. They are suitable for first-time sitters who have worked through the ActEd
Course Notes or for retakers (who should find them much more useful and challenging
than simply reading through the course again).

The Revision Notes are a set of six A5 booklets – perfect for revising on the train or
tube to work. Each booklet covers one main theme or a set of related topics from the
course and includes:
 Core Reading with a set of integrated short questions to develop your bookwork
knowledge
 relevant past exam questions with concise solutions from the last ten years
 detailed analysis of key past exam questions (selected for their difficulty), and
 other useful revision aids.
ActEd Solutions with Exam Technique (ASET)
The ActEd Solutions with Exam Technique (ASET) contains our solutions to the
previous four years’ exam papers, ie eight papers, plus comment and explanation. In
particular it will highlight how questions might have been analysed and interpreted so as
to produce a good solution with a wide range of relevant points. This will be valuable
in approaching questions in subsequent examinations.
From the April 2014 exam session, we have also indicated a balanced solution that we
believe would have scored fully in the exam. Alternative (equally valid) points are then
covered in a section below this model solution. This should give a valuable insight into
the breadth, depth and number of points required in an excellent answer.
A “Mini-ASET” will also be available in the summer session covering the April Exam
only.
Revision Tutorials
Revision Tutorials are intensive one-day face-to-face or Live Online tutorials in the
final run-up to the exam.
They give you the opportunity to practise interpreting and answering past exam
questions and to raise any outstanding queries with an ActEd tutor. These courses are
most suitable if you have previously attended Regular Tutorials or a Block Tutorial in
the same subject.
Details of how to apply for our tutorials are set out in our Tuition Bulletin, which is
available from our website at www.ActEd.co.uk.

“Rehearsal” products
Mock Exam A
Mock Exam A is a 100-mark mock exam paper and is a realistic test of your exam
preparation. It is based on Mock Exam A from last year but it has been updated to
reflect any changes to the Syllabus and Core Reading.
Additional Mock Pack (AMP)
The Additional Mock Pack (AMP) consists of two further 100-mark mock exam papers
– Mock Exam B and Mock Exam C. This is ideal if you are retaking and have already
sat Mock Exam A, or if you just want some extra question practice.
Mock / AMP Marking
We are happy to mark your attempts at Mock Exam A or the mock exams included within
the AMP. The same general principles apply as for the X Assignment Marking. In
particular:
 Mock Exam Marking is available for Mock Exam A and it applies to a specified
subject, session and student
 Marking Vouchers can be used for Mock Exam A or the mock exams contained
within the AMP; please note that attempts at the AMP can only be marked using
Marking Vouchers.
Recall that:
 marking is not included with the products themselves and you need to order it
separately
 we recommend that you submit your script by email
 your script will be marked electronically and you will be able to download your
marked script via a secure link on the internet.
Queries and feedback
From time to time you may come across something in the study material that is unclear
to you. The easiest way to solve such problems is often through discussion with friends,
colleagues and peers – they will probably have had similar experiences whilst studying.
If there’s no-one at work to talk to then use our discussion forum at
www.ActEd.co.uk/forums (or use the link from our home page at www.ActEd.co.uk).

Our online forum is dedicated to actuarial students so that you can get help from fellow
students on any aspect of your studies from technical issues to study advice. You could
also use it to get ideas for revision or for further reading around the subject that you are
studying. ActEd tutors will visit the site from time to time to ensure that you are not
being led astray and we also post other frequently asked questions from students on the
forum as they arise.
If you are still stuck, then you can send queries by email to ST5@bpp.com (but we
recommend that you try the forum first). We will endeavour to contact you as soon as
possible after receiving your query but you should be aware that it may take some time
to reply to queries, particularly when tutors are away from the office running tutorials.
At the busiest teaching times of year, it may take us more than a week to get back to
you.
If you have many queries on the course material, you should raise them at a tutorial or
book a personal tuition session with an ActEd tutor. Information about personal tuition
is set out in our current brochure. Please email ActEd@bpp.com for more details.
If you find an error in the course, please check the corrections page of our website
(www.ActEd.co.uk/Html/paper_corrections.htm) to see if the correction has already
been dealt with. Otherwise please send details via email to ST5@bpp.com or send a
fax to 01235 550085.
Each year ActEd tutors work hard to improve the quality of the study material and to
ensure that the courses are as clear as possible and free from errors. We are always
happy to receive feedback from students, particularly details concerning any errors,
contradictions or unclear statements in the courses. If you have any comments on this
course please email them to ST5@bpp.com or fax them to 01235 550085.
The ActEd tutors also work with the profession to suggest developments and
improvements to the Syllabus and Core Reading. If you have any comments or
concerns about the Syllabus or Core Reading, these can be passed on via ActEd.
Alternatively, you can send them directly to the Institute and Faculty of Actuaries’
Examination Team by email to education.services@actuaries.org.uk.

3 How to study to pass the exams
The ST Subject exams
It is important to recognise that the ST subject exams are very different from the
CT Subject exams in both the nature of the material covered and the skills being
examined.
Both the Core Reading and the exam papers themselves are generally much less
numerical and more “wordy” than the typical CT subject. The exam will primarily
require you to explain a particular point in words and sentences, rather than to
manipulate formulae. Numerical questions typically account for only a small part of
each exam paper. If you haven’t sat this type of exam for some time, you need to start
practising again now. Many students find that it takes time to adjust to the different
style of the ST subject exam questions. As ever, practice is the key to success.
The aim of the exams is to test your ability to apply your knowledge and understanding
of the key principles described in the Core Reading to specific situations presented to
you in the form of exam questions. Therefore your aim should be to identify and
understand the key principles, and then to practise applying them. You will also need a
good knowledge of the Core Reading to score well and quickly on any bookwork
questions.
We recommend that you prepare for the exam by practising a large number of
exam-style questions under exam conditions. This will:
 help you to develop the necessary knowledge and understanding of the key
principles described in the Core Reading
 highlight exactly which are the key principles that crop up time and time again
in many different contexts and questions
 help you to practise the specific skills that you will need to pass the exam.
There are many sources of exam-style questions. You can use past exam papers, the
Question and Answer Bank (which includes many past exam questions), assignments,
mock exams, the Revision Notes and ASET.

Overall study plan
We suggest that you develop a realistic study plan, building in time for relaxation and
allowing some time for contingencies. Be aware of busy times at work, when you may
not be able to take as much study leave as you would like. Once you have set your plan,
be determined to stick to it. You don’t have to be too prescriptive at this stage about
what precisely you do on each study day. The main thing is to be clear that you will
cover all the important activities in an appropriate manner and leave plenty of time for
revision and question practice.
Aim to manage your study so as to allow plenty of time for the concepts you meet in
this course to “bed down” in your mind. Most successful students will probably aim to
complete the course at least a month before the exam, thereby leaving a sufficient
amount of time for revision. By finishing the course as quickly as possible, you will
have a much clearer view of the big picture. It will also allow you to structure your
revision so that you can concentrate on the important and difficult areas of the course.
A sample ST subject study plan is available on our website at:
www.ActEd.co.uk/Html/help_and_advice_study_plans.htm
It includes details of useful dates, including assignment deadlines and tutorial

finalisation dates.
Study sessions
Only do activities that will increase your chance of passing. Try to avoid including
activities for the sake of it and don’t spend time reviewing material that you already
understand. You will only improve your chances of passing the exam by getting on top
of the material that you currently find difficult.
Ideally, each study session should have a specific purpose and be based on a specific
task, eg “Finish reading Chapter 3 and attempt Questions 1.4, 1.7 and 1.12 from the
Question and Answer Bank”, as opposed to a specific amount of time, eg “Three hours
studying the material in Chapter 3”.
Try to study somewhere quiet and free from distractions (eg a library or a desk at home
dedicated to study). Find out when you operate at your peak, and endeavour to study at
those times of the day. This might be between 8am and 10am or could be in the
evening. Take short breaks during your study to remain focused – it’s definitely time
for a short break if you find that your brain is tired and that your concentration has
started to drift from the information in front of you.

Order of study
We suggest that you work through each of the chapters in turn. To get the maximum
benefit from each chapter you should proceed in the following order:
1. Read the Syllabus Objectives. These are set out in the box on page 1 of each
chapter.
2. Read the Chapter Summary at the end of each chapter. This will give you a useful
overview of the material that you are about to study and help you to appreciate the
context of the ideas that you meet.
3. Study the Course Notes in detail, annotating them and possibly making your own
notes. Try the self-assessment questions as you come to them. Our suggested
solutions are at the end of each chapter. As you study, pay particular attention to
the listing of the Syllabus Objectives and to the Core Reading.
4. Read the Chapter Summary again carefully. If there are any ideas that you can’t
remember covering in the Course Notes, read the relevant section of the notes
again to refresh your memory.
It’s a fact that people are more likely to remember something if they review it several
times. So, do look over the chapters you have studied so far from time to time. It is
useful to re-read the Chapter Summaries or to try the self-assessment questions again a
few days after reading the chapter itself.
You may like to attempt some questions from the Question and Answer Bank when you
have completed a part of the course. It’s a good idea to annotate the questions with
details of when you attempted each one. This makes it easier to ensure that you try all of
the questions as part of your revision without repeating any that you got right first time.
Once you’ve read the relevant part of the notes and tried a selection of questions from
the Question and Answer Bank (and attended a tutorial, if appropriate), you should
attempt the corresponding assignment. If you submit your assignment for marking,
spend some time looking through it carefully when it is returned. It can seem a bit
depressing to analyse the errors you made, but you will increase your chances of
passing the exam by learning from your mistakes. The markers will try their best to
provide practical comments to help you to improve.
To be really prepared for the exam, you should not only know and understand the Core
Reading but also be aware of what the examiners will expect. Your revision programme
should include plenty of question practice so that you are aware of the typical style,
content and marking structure of exam questions. You should attempt as many questions
as you can from the Question and Answer Bank and past exam papers.

Active study
Here are some techniques that may help you to study actively.
1. Don’t believe everything you read! Good students tend to question everything
that they read. They will ask “why, how, what for, when?” when confronted
with a new concept, and they will apply their own judgement. This contrasts
with those who unquestioningly believe what they are told, learn it thoroughly,
and reproduce it (unquestioningly?) in response to exam questions.
2. Another useful technique as you read the Course Notes is to think of possible
questions that the examiners could ask. This will help you to understand the
examiners’ point of view and should mean that there are fewer nasty surprises in
the exam room! Use the Syllabus to help you make up questions.
3. Annotate your notes with your own ideas and questions. This will make you
study more actively and will help when you come to review and revise the
material. Do not simply copy out the notes without thinking about the issues.
4. Attempt the questions in the notes as you work through the course. Write down
your answer before you refer to the solution.
5. Attempt other questions and assignments on a similar basis, ie write down your
answer before looking at the solution provided. Attempting the assignments
under exam conditions has some particular benefits:
 It forces you to think and act in a way that is similar to how you will
behave in the exam.
 When you have your assignments marked it is much more useful if the
marker’s comments can show you how to improve your performance
under exam conditions than your performance when you have access to the
notes and are under no time pressure.
 The knowledge that you are going to do an assignment under exam
conditions and then submit it (however good or bad) for marking can act as
a powerful incentive to make you study each part as well as possible.
 It is also quicker than trying to write perfect answers.
6. Sit a mock exam four to six weeks before the real exam to identify your
weaknesses and work to improve them. You could use a mock exam written by
ActEd or a past exam paper.

4 Frequently asked questions

Q: What knowledge of earlier subjects should I have?
A: This is answered thoroughly in Chapter 0, Section 1 of the Course Notes.
Q: How technical is the ST5 course?
A: Although largely a discursive course, ST5 does contain some technical material
relating to the valuation of interest rate derivatives (in Chapters 11 and 12). This
material is similar to the derivatives material in Subject CT8, but is less
theoretical as you are not required to know the derivations of the results used.
Instead, you may be required simply to apply the formula to value various types
of derivative, whose payoffs depend on bond prices or interest rates. In addition,
there are a number of other less technical areas that offer some scope for
numerical questions, eg indices and performance measurement.
Q: What calculators am I allowed to use in the exam?
A: Please refer to www.actuaries.org.uk for the latest advice.
Q: What should I do if I discover an error in the course?
A: If you find an error in the course, please check our website at:
www.ActEd.co.uk/Html/paper_corrections.htm
to see if the correction has already been dealt with. Otherwise please send
details via email to ST5@bpp.com or send a fax to 01235 550085.

5 Core Reading and the Syllabus
Core Reading
The Syllabus for Subject ST5, and the Core Reading that supplements it, has been
produced by the Institute and Faculty of Actuaries. The relevant individual Syllabus
Objectives are included at the start of each course chapter and a complete copy of the
Syllabus is included in Section 6 of this Study Guide. We recommend that you use the
Syllabus as an important part of your study. The purpose of the Core Reading is to
assist in ensuring that tutors, students and examiners have a clear, shared appreciation of
the requirements of the Syllabus. The Core Reading supports coverage of the Syllabus
in helping to ensure that both depth and breadth are re-enforced. It is therefore
important that students have a good understanding of the concepts covered by the Core
Reading.
Core Reading deals with each syllabus objective. Core Reading covers what is needed to
pass the exam but the tuition material that has been written by ActEd enhances it by
giving examples and further explanation of key points. The Subject ST5 Course Notes
include the Core Reading in full, integrated throughout the course. Here is an excerpt
from some ActEd Course Notes to show you how to identify Core Reading and the
ActEd material. Core Reading is shown in this bold font.
Note that in the example given above, the index will fall if the actual share price goes
below the theoretical ex-rights share price. Again, this is consistent with what would
happen to an underlying portfolio.
This is
After allowing for chain-linking, the formula for the investment index then ActEd
becomes: text
This is Core
 Ni ,t Pi ,t Reading
I (t )  i
B(t )
where Ni ,t is the number of shares issued for the ith constituent at time t;
B(t ) is the base value, or divisor, at time t.

Core Reading accreditation
The Institute and Faculty of Actuaries would like to thank the numerous people who
have helped in the development of this material and in the previous versions of Core
Reading.
The following sources have been consulted in developing the Core Reading:
 Asset pricing. Cochrane, J. H. Rev. ed. and earlier Princeton University Press,
2005. ISBN: 0691121370
 Principles of corporate finance. Brealey, R. A.; Myers, S. C.; Allen, F. 10th
ed. and earlier McGraw-Hill, 2010. ISBN: 0071314172
 The monetary and financial system. Goacher, D. 4th ed. Chartered Institute
of Banking, 1999. ISBN: 0852975406
 Options, futures and other derivatives. Hull, J. C. 8th ed. and earlier Pearson
Education, 2011. ISBN: 0273759078
The Institute and Faculty of Actuaries would like to thank the numerous people who have
helped in the development of this material and in the previous versions of Core Reading.
Changes to the Syllabus and Core Reading
The Syllabus and Core Reading are updated as at 31 May each year. The exams in
April and September 2016 will be based on the Syllabus and Core Reading as at
31 May 2015.
We recommend that you always use the up-to-date Core Reading to prepare for the
exams.

The Institute and Faculty of Actuaries’ Copyright
All study material produced by ActEd is copyright and is sold for the exclusive use of
the purchaser. The copyright is owned by Institute and Faculty Education Limited, a
subsidiary of the Institute and Faculty of Actuaries. Unless prior authority is granted
by ActEd, you may not hire out, lend, give out, sell, store or transmit electronically or
photocopy any part of the study material. You must take care of your study material
to ensure that it is not used or copied by anybody else.
Legal action will be taken if these terms are infringed. In addition, we may seek to
take disciplinary action through the Institute and Faculty of Actuaries or through
your employer.
These conditions remain in force after you have finished using the course.
Past exam papers
You can download some past exam papers and Examiners’ Reports from the
profession’s website at www.actuaries.org.uk.
Recommended reading
The exam will be based on the relevant Syllabus and Core Reading and the ActEd
course material will be the main source of tuition for students.
However, some students may find it useful to obtain a different viewpoint on a

particular topic covered in Subject ST5. Although there is no list of further reading for
Subject ST5, the sources consulted in developing the Core Reading and listed in the
Core Reading accreditation section above may be useful.
Occasional references to other reading and websites that you may find interesting or
useful are also given in the Course Notes.

6 Syllabus
The full Syllabus for Subject ST5 is given here. To the right of each objective are the
chapter numbers in which the objective is covered in the ActEd course.”
Aim
The aim of this Finance and Investment Technical subject is to instil in successful
candidates the ability to apply, in simple situations, the principles of actuarial planning
and control to the appraisal of investments, and to the selection and management of
investments appropriate to the needs of investors.
Links to other subjects
This subject draws on the issues introduced in Subjects:

 CT2 – Finance and Financial Reporting
 CT7 – Business Economics
 CT8 – Financial Economics.
Subject CA1 – Actuarial Risk Management: covers the general underlying principles
affecting all specialisms.
Subjects SA5 – Finance Specialist Applications and SA6 – Investment Specialist

Applications: use the principles in this subject to solve complex problems, to produce
coherent advice and recommendations within a specifically United Kingdom context.

Objectives
On completion of this subject the candidate will be able to:
(a) State what is meant by a risk-free rate of return, and describe assets that may be
assumed to be risk-free in practical work. (Chapter 17)
(b) Describe the typical ways in which investment returns are taxed and the effect of
the taxation basis on investor behaviour. (Chapter 23)
(c) Demonstrate knowledge of the influences over the commercial and economic
environment from: (Chapter 5)
 central banks
 main investor classes
 government policy
(d) Demonstrate a knowledge of the principles of fundamental analysis of equities

and bonds. (Chapter 10)
(e) Apply appropriate methods for the valuation of individual investments and
demonstrate an understanding of their appropriateness in different situations.
(Chapters 11 and 12)
 fixed income analytics and valuation (including interest rate swaps and
futures)
 arbitrage pricing and the concept of hedging
 empirical characteristics of asset prices
 introduction into fixed income option pricing
 evaluating a securitisation (including CBOs and MBSs)
 evaluation of a credit derivative

(f) Describe methods by which an institution can monitor and control its exposure
to the following types of risk: (Chapter 17)
 asset / liability mismatching risk
 market risk
 credit risk (including counterparty risk)
 operational risk
 liquidity risk
 relative performance risk
and explain in the context of mean-variance portfolio theory what is meant by:
 opportunity set
 efficient frontier
 indifference curves
 the optimum portfolio.
(g) (i) Describe the principles and aims of market conduct regulatory regimes.
(Chapter 7)
(ii) Demonstrate a knowledge of the principles underlying the legislative and
regulatory framework for investment management and the securities
industry. (Chapter 7)
(iii) Demonstrate how these principles can be applied in the areas of:
 trust law
 corporate governance
 role of the listings authority
 environmental and ethical issues
 competition and fair trading controls
 monopolies regulators
 investment restrictions in investment agreements
 provision of financial services
 institutional investment practices
 EU legislation
 role and responsibilities of directors
 development of international accounting standards
(Chapters 8 and 9)

(h) Demonstrate a knowledge and understanding of the theory of finance.

(Chapter 6)
(i) Discuss the relationship between financial management and acting as an
entrepreneur.
(ii) Outline the possible motives for mergers and divestitures.
(iii) Discuss the key findings in behavioural finance.
(iv) Outline the main steps involved in financial planning.
(i) Demonstrate a knowledge and understanding of the characteristics of specialist

financial instruments: (Chapters 3 and 4)
 financial instruments available for short-term lending and borrowing
 corporate debt and credit derivatives
 swaps and swaptions
 private debt
 asset-backed securities, securitisation
 venture capital
 hedge funds
 currency
 infrastructure
 commodities
 structured products
 new ways of investing in old asset classes
(j) Describe the main types of derivative contract, how they are traded, and define
their payoffs. (Chapters 1 and 2)
(k) Show how actuarial techniques may be used to develop an appropriate

investment strategy. (Chapters 18 and 19)
 asset pricing models
 asset / liability modelling
 asset / liability mismatch reserving
 credit rating an entity
 liability hedging
 dynamic liability benchmarks

(l) Analyse the performance of an investment and discuss the limitations of such
measurement techniques. (Chapter 16)
 portfolio risk and return analysis
 equity price
 net present value
 net asset value
 return on capital
(m) Describe the construction of investment indices and the principal features of
major investment indices. (Chapter 14)
(i) Discuss the uses of investment indices.
(ii) Describe the principal indices in the United Kingdom, United States,
Japanese, German and French stock markets.
(iii) Explain the problems encountered in constructing property indices.
(n) Analyse the performance of an investment portfolio and discuss the limitations
of such portfolio measurement. (Chapter 15)
(i) Assess the performance of a portfolio relative to a published market
index.
(ii) Assess the performance of a portfolio relative to a predetermined bench-
mark portfolio.
(iii) Analyse the performance of a portfolio into components relating to
investment sector selection and individual stock selection.
(iv) Discuss the relative merits of assessing portfolio performance relative to
published indices, other portfolios or a predetermined benchmark
portfolio.
(v) Discuss the uses of risk-adjusted performance measures.
(vi) Discuss the value of portfolio performance measurement and its
limitations.

(o) Demonstrate a knowledge and understanding of the principal techniques in

portfolio management including risk control techniques.
(i) Describe and discuss the principal active management “styles” (value,
growth, momentum, rotational). (Chapter 20)
(ii) Discuss the principal equity portfolio management techniques.
(Chapter 20)
(iii) Discuss the principal bond portfolio management techniques.(Chapter 20)
(iv) Discuss the uses which an institutional investor might make of financial
futures and options, including over the counter contracts. (Chapter 22)
(v) Discuss the uses which an institutional investor might make of interest
rate, currency and inflation swaps. (Chapter 22)
(vi) Discuss the uses which an institutional investor might make of forward
foreign exchange contracts for currency hedging. (Chapter 22)
(vii) Discuss the usefulness of multifactor models in practical investment
management and risk control. (Chapter 21)
(viii) Discuss the problems of making significant changes to the investment
allocation of a substantial portfolio. (Chapter 22)
(ix) Transition management and asset allocation techniques (including
overlay strategies) (Chapter 22)
(x) Role of the custodian. (Chapter 21)
(xi) Portfolio construction with attention to: (Chapter 21)
 value at risk
 tracking error
 risk budgets
(xii) Measurement, comparison and attribution of risk. (Chapter 21)





the course.

ST5: Index Page 1
ST5 Index
Absolute NPV ........................................................................................ Ch16 p7
Absolute pricing ..................................................................................... Ch18 p3
Acquisitions ........................................................................................... Ch6 p9
Active management ............................................................................... Ch20 p12
................................................................................................. Ch21 p6
................................................................................................. Ch20 p3
Active return ......................................................................................... Ch21 p4
Active risk .............................................................................................. Ch21 p4
Actual default loss.................................................................................. Ch3 p12
Agency theory ........................................................................................ Ch6 p7
Anchoring and adjustment ..................................................................... Ch6 p13
Anomaly switching ................................................................................ Ch20 p15
Arbitrage ................................................................................................ Ch22 p16
................................................................................................. Ch22 p26
Arbitrage pricing ................................................................................... Ch11 p23
Asset / liability mismatching risk ........................................................... Ch18 p13
Asset liability modelling ........................................................................ Ch18 p5
Asset pricing models .............................................................................. Ch18 p2
Asset-backed securities .......................................................................... Ch4 p7
Balance of payments .............................................................................. Ch5 p18

Bank time deposits ................................................................................. Ch3 p7
Bankers’ acceptances ............................................................................. Ch3 p7
Banking sector liquidity ......................................................................... Ch5 p3
Barometer indices .................................................................................. Ch14 p30
Basic materials ....................................................................................... Ch13 p5
Basis risk ................................................................................................ Ch22 p14
Behavioural finance ............................................................................... Ch6 p12
Benchmarks ........................................................................................... Ch9 p11
................................................................................................. Ch15 p13
Black’s model ........................................................................................ Ch12 p2
Bond indices .......................................................................................... Ch14 p24
Bond options .......................................................................................... Ch12 p6
Bond portfolio management................................................................... Ch20 p15
Bond price .............................................................................................. Ch11 p2
Bond yields ............................................................................................ Ch11 p4
Bootstrapping ......................................................................................... Ch11 p5
Bottom-up approach............................................................................... Ch20 p7
CAC ................................................................................................. Ch14 p20

Capital budgeting decision ..................................................................... Ch6 p4
Capital gains tax ..................................................................................... Ch23 p4
CAPM ................................................................................................. Ch16 p10
CAPM ................................................................................................. Ch18 p2
Carbon markets ...................................................................................... Ch4 p40
Cash markets .......................................................................................... Ch22 p34
CDX ................................................................................................. Ch14 p27
Central banks ......................................................................................... Ch5 p2
Chain linking.......................................................................................... Ch14 p3
Chartism ................................................................................................. Ch21 p9

Page 2 ST5: Index
Classical tax system ............................................................................... Ch1 p5

Clearing house ....................................................................................... Ch23 p9
................................................................................................. Ch1 p10
Commercial paper .................................................................................. Ch3 p5
Commodities .......................................................................................... Ch4 p34
Commodity derivatives .......................................................................... Ch4 p35
Commodity indices ................................................................................ Ch4 p36
Competition ........................................................................................... Ch8 p14
................................................................................................. Ch5 p13
Conflicts of interest ................................................................................ Ch9 p5
Conglomerate mergers ........................................................................... Ch6 p10
Constant parameters ............................................................................... Ch11 p30
Construction of indices .......................................................................... Ch14 p2
Consumer goods .................................................................................... Ch13 p6
Consumer services ................................................................................. Ch13 p7
Contracts for differences ........................................................................ Ch4 p50
Corporate debt........................................................................................ Ch3 p10
Corporate finance ................................................................................... Ch6 p3
Corporate governance ............................................................................ Ch8 p7
Corporate taxation.................................................................................. Ch23 p8
Covered call ........................................................................................... Ch22 p23
Credit crunch ......................................................................................... Ch20 p23
Credit default swaps............................................................................... Ch3 p13
Credit derivative indices ........................................................................ Ch3 p10
................................................................................................. Ch12 p21
................................................................................................. Ch14 p27
Credit derivatives ................................................................................... Ch3 p12
Credit exposure ...................................................................................... Ch17 p12
Credit rating ........................................................................................... Ch1 p6
Credit risk .............................................................................................. Ch4 p4
................................................................................................. Ch17 p12
Creditworthiness .................................................................................... Ch17 p12
Cross hedging ........................................................................................ Ch22 p14
Currency ................................................................................................ Ch4 p24
Currency hedging ................................................................................... Ch3 p21
Currency swaps ...................................................................................... Ch22 p27
................................................................................................. Ch22 p6
Custodians.............................................................................................. Ch21 p23
DAX ................................................................................................. Ch14 p20

Derivative reporting ............................................................................... Ch22 p32
Derivatives ............................................................................................. Ch1 p14
Deterministic modelling......................................................................... Ch18 p13
Directors ................................................................................................ Ch9 p18
Dividend policy...................................................................................... Ch23 p8
Dow Jones .............................................................................................. Ch14 p17
Duration ................................................................................................. Ch20 p19
Duration analysis ................................................................................... Ch17 p15
Dynamic liability benchmarks ............................................................... Ch19 p13
Effect of options..................................................................................... Ch6 p22

Eligible bills ........................................................................................... Ch3 p7
Environmental and ethical issues ........................................................... Ch8 p12

ST5: Index Page 3
Equity-linked notes ................................................................................ Ch4 p43

Estimating probabilities ......................................................................... Ch6 p19
EU Legislation ....................................................................................... Ch9 p14
Event-driven funds ................................................................................. Ch4 p18
Exchange Traded Funds ......................................................................... Ch4 p48
Expected default loss ............................................................................. Ch3 p10
Financial analysis ................................................................................... Ch6 p6

Financial intermediaries ......................................................................... Ch5 p7
Financial planning .................................................................................. Ch6 p24
Financial services ................................................................................... Ch9 p3
Financial Services Action Plan .............................................................. Ch9 p15
Financials ............................................................................................... Ch13 p8
Financing decision ................................................................................. Ch6 p4
Foreign investors.................................................................................... Ch5 p9
Forward exchange rates ......................................................................... Ch2 p2
Forward rate agreements ........................................................................ Ch11 p7
Forward rates ......................................................................................... Ch11 p11
................................................................................................. Ch20 p21
Forward-looking tracking error .............................................................. Ch21 p13
Forwards ................................................................................................ Ch2 p2
................................................................................................. Ch21 p16
................................................................................................. Ch3 p26
Framing ................................................................................................. Ch6 p17
Freedom of action .................................................................................. Ch7 p6
FTSE 100 Index ..................................................................................... Ch14 p16
FTSE 250 Index ..................................................................................... Ch14 p16
FTSE 350 Supersectors Index ................................................................ Ch14 p16
FTSE Aim Index Series ......................................................................... Ch14 p17
FTSE All-Share Index............................................................................ Ch14 p17
FTSE Fledgling Index ............................................................................ Ch14 p17
FTSE Gilts Index Series......................................................................... Ch14 p24
FTSE global bond index series .............................................................. Ch14 p25
FTSE Global Equity Index Series .......................................................... Ch14 p22
FTSE industry classification system ...................................................... Ch13 p4
FTSE SmallCap Index ........................................................................... Ch14 p16
FTSE UK Index Series........................................................................... Ch14 p15
Full replication ....................................................................................... Ch20 p10
Fundamental analysis ............................................................................. Ch2 p6
Futures ................................................................................................. Ch10 p4
................................................................................................. Ch22 p11
................................................................................................. Ch1 p3
Gap analysis ........................................................................................... Ch17 p14

Geometric indices .................................................................................. Ch14 p11
Global custodians ................................................................................... Ch21 p24
Global tactical asset allocation funds ..................................................... Ch4 p17
Government agency securities ............................................................... Ch3 p6
Government policy................................................................................. Ch5 p11
Governments .......................................................................................... Ch5 p10
Growth style ........................................................................................... Ch20 p3
Guaranteed equity products ................................................................... Ch1 p14

Page 4 ST5: Index
Healthcare .............................................................................................. Ch13 p7

Hedge funds ........................................................................................... Ch2 p3
Hedging ................................................................................................. Ch4 p16
................................................................................................. Ch11 p26
................................................................................................. Ch22 p11
................................................................................................. Ch22 p21
Historical tracking error ......................................................................... Ch21 p16
Horizontal mergers ................................................................................ Ch6 p9
Households ............................................................................................ Ch5 p6
Immunisation ......................................................................................... Ch22 p19

Imputation tax system ............................................................................ Ch23 p9
Incentives for investment ....................................................................... Ch5 p14
Income enhancement ............................................................................. Ch22 p23
Independent custodians .......................................................................... Ch21 p24
Independent increments ......................................................................... Ch11 p30
Index Funds ........................................................................................... Ch4 p47
Index tracking ........................................................................................ Ch20 p9
Industrials .............................................................................................. Ch13 p5
Inflation swaps ....................................................................................... Ch22 p8
Information ratio .................................................................................... Ch21 p18
Infrastructure.......................................................................................... Ch4 p27
Institutional investment.......................................................................... Ch9 p8
Interest rate caps .................................................................................... Ch12 p8
Interest rate collars ................................................................................. Ch12 p13
Interest rate effects ................................................................................. Ch5 p16
Interest rate floors .................................................................................. Ch12 p13
Interest rate futures ................................................................................ Ch11 p13
Interest rate risk ..................................................................................... Ch3 p16
Interest rate swaps .................................................................................. Ch11 p17
................................................................................................. Ch22 p4
................................................................................................. Ch22 p5
Interest rate-linked notes ........................................................................ Ch4 p43
International Accounting Standards ....................................................... Ch9 p20
International bond indices ...................................................................... Ch14 p25
Intertemporal CAPM ............................................................................. Ch8 p16
Investment Mandates ............................................................................. Ch9 p11
Investment restrictions ........................................................................... Ch8 p16
iTraxx ................................................................................................. Ch14 p27
Jensen measure ...................................................................................... Ch15 p26
Labour policy ......................................................................................... Ch5 p13

LDI ................................................................................................. Ch19 p8
Liability hedging .................................................................................... Ch19 p2
Limitations of performance measurement ............................................. Ch15 p30
Linked internal rate of return ................................................................. Ch15 p6
Liquidity risk ......................................................................................... Ch17 p14
Listings authority ................................................................................... Ch8 p10
Load differences .................................................................................... Ch17 p11
Load ratios ............................................................................................. Ch17 p11
Long-term financial planning ................................................................ Ch6 p24

ST5: Index Page 5
Margin ................................................................................................. Ch1 p6

Market practice ...................................................................................... Ch9 p4
Market risk ............................................................................................. Ch17 p9
Market-neutral funds .............................................................................. Ch4 p19
Markit iBoxx fixed income indices ........................................................ Ch14 p26
Matching ................................................................................................ Ch20 p15
Mechanical trading rules ........................................................................ Ch21 p11
Mental accounting .................................................................................. Ch6 p21
Mergers ................................................................................................. Ch6 p9
Mixed regimes ....................................................................................... Ch7 p10
Money markets....................................................................................... Ch3 p2
Money-weighted rate of return............................................................... Ch15 p3
Morgan Stanley Capital International Indices ........................................ Ch14 p23
Multifactor models ................................................................................. Ch18 p2
................................................................................................. Ch21 p6
Myopic loss aversion ............................................................................. Ch6 p18
Naked call .............................................................................................. Ch22 p24

Naked put ............................................................................................... Ch22 p24
NASDAQ ............................................................................................... Ch14 p18
Net asset value ....................................................................................... Ch16 p8
Nikkei ................................................................................................. Ch14 p19
Non-executive directors ......................................................................... Ch8 p8
Normality ............................................................................................... Ch11 p30
Oil and gas ............................................................................................. Ch13 p4

Operating performance .......................................................................... Ch19 p6
Operational risk ...................................................................................... Ch17 p13
Option payoff diagrams ......................................................................... Ch2 p8
Options ................................................................................................. Ch1 p11
................................................................................................. Ch2 p7
................................................................................................. Ch3 p25
................................................................................................. Ch22 p21
OTC markets .......................................................................................... Ch1 p13
Outcome-based regulation ..................................................................... Ch7 p6
Overconfidence ...................................................................................... Ch6 p20
Par yields................................................................................................ Ch11 p4

Passive management .............................................................................. Ch21 p7
Performance attribution.......................................................................... Ch15 p14
Performance measurement ..................................................................... Ch9 p12
Policy switching ..................................................................................... Ch20 p18
Portfolio-based indices........................................................................... Ch14 p29
Prepayment risk ..................................................................................... Ch4 p4
Prescriptive regulation ........................................................................... Ch7 p6
Pre-specified standard deviation ............................................................ Ch15 p27
Price limits ............................................................................................. Ch1 p9
Price models ........................................................................................... Ch20 p17
Price ratios ............................................................................................. Ch20 p17
Private debt ............................................................................................ Ch3 p29
Private equity ......................................................................................... Ch4 p9
Property indices ..................................................................................... Ch14 p28
Prospect theory....................................................................................... Ch6 p15

Page 6 ST5: Index
Put-call parity......................................................................................... Ch12 p13
Quantitative analysis .............................................................................. Ch10 p15

Quantitative easing ................................................................................ Ch5 p4
Real rate swaps ...................................................................................... Ch7 p3

Regulation .............................................................................................. Ch8 p15
................................................................................................. Ch8 p17
................................................................................................. Ch22 p9
................................................................................................. Ch9 p6
Regulatory regimes ................................................................................ Ch7 p6
Reinvestment rates ................................................................................. Ch20 p20
Relative performance risk ...................................................................... Ch17 p15
Relative pricing ...................................................................................... Ch18 p3
Relative strength analysis ...................................................................... Ch21 p11
Repos ................................................................................................. Ch3 p6
Retail financial services ......................................................................... Ch9 p15
Risk budgeting ....................................................................................... Ch21 p13
Risk-adjusted performance measures..................................................... Ch15 p25
Risk-adjusted return on capital .............................................................. Ch16 p10
Risk-free return ...................................................................................... Ch17 p3
Sector selection ...................................................................................... Ch4 p3
Securitisation ......................................................................................... Ch12 p19
................................................................................................. Ch15 p15
Self-regulation ....................................................................................... Ch7 p7
Sharpe measure ...................................................................................... Ch15 p26
Short selling ........................................................................................... Ch4 p20
Short-term financial planning ................................................................ Ch6 p26
Special purpose vehicle.......................................................................... Ch4 p5
Speculation ............................................................................................ Ch22 p16
Split-rate tax system............................................................................... Ch23 p9
Spot FX ................................................................................................. Ch4 p24
Spot rate volatilities ............................................................................... Ch12 p12
Spot rates ............................................................................................... Ch20 p21
................................................................................................. Ch11 p4
Spreads ................................................................................................. Ch22 p25
Standard & Poor’s .................................................................................. Ch14 p18
Statutory regulation................................................................................ Ch7 p9
Stochastic modelling .............................................................................. Ch18 p14
Stock selection ....................................................................................... Ch15 p15
Straddles ................................................................................................ Ch22 p25
Stress testing .......................................................................................... Ch21 p21
Structural risk......................................................................................... Ch21 p4
Structured notes ..................................................................................... Ch1 p15
Structured products ................................................................................ Ch4 p41
Swap rates .............................................................................................. Ch1 p14
Swaps ................................................................................................. Ch3 p16
................................................................................................. Ch3 p23
................................................................................................. Ch12 p16
Swaptions ............................................................................................... Ch11 p20
................................................................................................. Ch12 p15
Switching ............................................................................................... Ch20 p15

ST5: Index Page 7
Synthetic index-linked bonds ................................................................. Ch22 p9

Synthetic portfolio management ............................................................ Ch19 p5
Taxation ................................................................................................. Ch5 p12

Technical analysis .................................................................................. Ch21 p8
Technology ............................................................................................ Ch13 p9
Telecommunications .............................................................................. Ch13 p7
Time-weighted rate of return ................................................................. Ch15 p4
Top-down approach ............................................................................... Ch20 p6
Topix ................................................................................................. Ch14 p19
Total return indices ................................................................................ Ch14 p6
Trade cycle ............................................................................................. Ch10 p13
Trading systems ..................................................................................... Ch1 p4
Treasury bills ......................................................................................... Ch3 p4
Treynor measure .................................................................................... Ch15 p26
Trust law ................................................................................................ Ch8 p3
Trustees ................................................................................................. Ch8 p5
UK yield indices .................................................................................... Ch14 p24

Unregulated markets .............................................................................. Ch7 p7
Unweighted arithmetic indices............................................................... Ch14 p11
Utilities ................................................................................................. Ch13 p7
Value at Risk .......................................................................................... Ch21 p20

Value style ............................................................................................. Ch20 p3
Vertical mergers ..................................................................................... Ch6 p10
Volatility ................................................................................................ Ch20 p19
Volatility indices .................................................................................... Ch14 p21
Voluntary codes of conduct ................................................................... Ch7 p7
Weighted arithmetic indices................................................................... Ch14 p2

Wholesale............................................................................................... Ch9 p14
XD adjustment ....................................................................................... Ch14 p6
Yield differences .................................................................................... Ch20 p16

Yield models .......................................................................................... Ch20 p18
Yield volatilities ..................................................................................... Ch12 p7





the course.

ST5-00: Introduction Page 1
Chapter 0
Introduction to Subject ST5
0 Introduction
This introductory chapter contains some Core Reading that is intended to give an
introduction to the ST5 course. We also provide an overview of the ST5 course
structure. We recommend that you read this chapter both before and after reading the
rest of the course.
1 Structure of professional examinations

Earlier parts of the actuarial qualification have covered accounting, discount
rates, economics and financial economics in the CT subjects. CA1 — Actuarial
Risk Management brings all the core technical skills together and shows how
actuaries use them in risk management, which is the fundamental skill of an
actuary. All of these form an important background to this subject and you are
encouraged to refresh your knowledge of them before embarking on the study of
this subject.

Page 2 ST5-00: Introduction
2 Prerequisite knowledge
You may find the following material (from subjects CT1, CT2, CT7, CT8 and CA1)
useful background and refer to it if you need to refresh your memory.
2.1 CT1
 the summary for the chapter on investments.

 the summary for the chapter on arbitrage and forward contracts.
 the chapter on the term structure of interest rates
2.2 CT2
 the chapter on agency theory

 the summary for the chapter on financial instruments.
 the chapter on derivatives
 the chapter on interpretation of accounts
 the summary for the chapter on limitations of account.
 the summary for the chapter on financial institutions.
2.3 CT7
 the summary for the chapter on the balance of payments and exchange rates.
 the summary for the chapter on government intervention in markets.
 the summary for the chapter on growth strategy and globalisation.

2.4 CT8
 the summary for the chapter on the efficient markets hypothesis.

 the summary for the chapter on measures of investment risk.
 the summary on portfolio theory.
 the summary for the chapter on asset pricing models.
 the continuous-time lognormal model and, in particular, the criticisms of its
assumptions. This is in the early part of the chapter on stochastic models of
security prices.
 the chapter on introduction to derivatives.
 the chapter on the Greeks.
 the summary for the chapter on credit risk.
2.5 CA1
 the summary for the chapter on external environment.

 the summary for the chapter on regulation.
 the summary for the chapter on money markets.
 the summary for the chapter on bond markets.
 the summary for the chapter on equity markets.
 the summary for the chapter on property markets.
 the summary for the chapter on futures and options.
 the summary for the chapter on collective investment schemes.
 the chapter on sources of risk
Examination questions may include sections based on this prior knowledge in

the formation of an answer.

3 The scope of ST5
3.1 Background knowledge
Some sections of the ST5 course provide a useful background to the other sections of
the course:
 The first four chapters cover various asset classes. Chapters 1 and 2 cover the
more basic derivatives, futures, forwards and options. Chapters 3 and 4 cover
credit derivatives and other more specialised investments. It is important that
you have a good grasp of the mechanics of all the assets covered in the first four
chapters.
 Chapter 6 looks at how businesses are run and considers conflicts of interest that
exist between stakeholders of any firm.
 Chapters 7 to 9 consider the regulatory and legislative environment within which
firms operate.
 Chapter 13 explains how industries can be classified into sub-groups. It is
important that you understand the common characteristics of firms within each
sub-group.
 Chapter 14 gives us an idea of how indices may be constructed before
explaining all the major world indices in equities and other assets..
 Chapter 23 discusses tax.
Now is an interesting time to be studying ST5, with recent years having thrown up a
wealth of ST5-relevant material. World economies have experienced a global financial
crisis and there has been much in the news:
 “Credit crunch” – a banking liquidity crisis with its roots in the US sub-prime
mortgage market. We discuss this in Chapter 20.
 The devaluation of securitised loans that followed due to “credit crunch”.
Securitisations are covered in Chapter 4.
 Hedge funds have been the subject of fierce debate as they have sought to take
advantage of firms going bust and have destabilised bank shares by shorting
them. We look into hedge funds in Chapter 4.
 Private equity has also been scrutinised more in recent times for its treatment of
employees and pensioners. Private equity is also covered in Chapter 4.
 In 2007 the UK bank, Northern Rock was saved at the last minute by the Bank
of England’s decision to provide liquidity support. Chapter 5 considers central
banks and their role within the banking system. QE, the process of buying
government bonds using new money, is also described in this chapter.

 Worldwide, budget deficits have been a serious concern recent years. In the UK,
the 2015 general election was fought, arguably over the issue of the UK’s high
budget deficit and large outstanding stock of government bonds. Greece has had
numerous bail-outs in the Eurozone sovereign debt crisis and is currently
negotiating its financial position with respect to austerity. Government policy is
also discussed in Chapter 5.
To keep up to date with ST5-relevant events, we strongly recommend that you read the
financial press, namely:
 The Financial Times.

 The Economist.
 the business section of any broadsheet newspaper – these are excellent for
providing a high-level view of events and their consequences in the financial
world.
 Google – if in doubt, you can Google any of the key words in the index to find
more resources.
 BBC business news – television and internet.
 City AM
 YouTube – there have been some good documentaries in recent times about a
wide range of events happening in the financial world. This website gives you a
chance to watch them.
3.2 Risk versus return
The course is broken down into a number of component parts. You will have
learned in earlier courses about the use of risk free rates in discounting income
streams. The risk-free rate is defined at the beginning of Chapter 17.
This course focuses on how these returns can be achieved and what other
returns may be available dependent upon the level of risk that one is prepared to
accept. The course looks into the factors that affect the returns including
political and regulatory aspects.
The idea of risk versus return is critical in choosing whether to invest in any asset.
Chapter 10 looks at how to value equities fairly by considering all the factors that will
contribute to each firm’s future profits. Chapter 11 looks into the valuation of bonds

3.3 Portfolio analysis
The Course gives an appreciation of the different forms that investments may
take, their key characteristics, how they should be assessed, including analysis
of securities, and how they can be used to build portfolios for different
investment mandates.
Evaluating securitisations and credit derivatives now receives more emphasis.

This is covered in Chapter 11.
A key outcome from the course is the ability to develop appropriate portfolios for
different types of investor with individual financial planning being as important
as that for institutional mandates.
3.4 Risk management
Risk management is a feature of the course emphasising both actuarial and

investment aspects. Liquidity risk, counter-party risk, operational risk and credit
risk also feature.
Chapter 17 provides the central focus for types of financial risk and how to control
them. Chapter 22 looks in particular at how derivatives can be used to control risk.
In the wake of the 2007-08 financial crisis these have taken on more significance
than has previously been the case. Value at risk and risk budgets are important
aspects of the actuarial approach as are asset liability modelling (ALM) and
liability hedging.
Value at Risk and Risk budgeting are both covered in Chapter 21. ALM is first covered
in Chapter 17. Chapters 18 and 19 focus in more detail on it and, in particular,
liability-driven investment (LDI). Choosing assets with a particular focus on liabilities
has become a very important factor in fund management in recent years.

3.5 Performance measurement
A key component of this course is performance measurement. This covers not

only the analysis of returns for securities and portfolios but also performance
attribution.
There is a strong emphasis on risk adjusted returns and on the interpretation of

the results from such analysis.
Benchmarking and the construction and use of indices form important parts of
this section.
3.6 Regulatory and legislative environment
Although not covered by many guidance notes or actuarial standards, it is

important to understand the regulatory and legislative environment which
applies to the investment management and securities industry. It is key that
actuaries understand this because more and more we will find ourselves working
with other professions.
In particular, although they only apply to actuaries working in the UK, or for UK
regulated entities, the Financial Reporting Council’s Generic Technical Actuarial
Standards TAS R, TAS D, and TAS M (to be replaced by a single TAS 100 in due
course) are a good foundation for all actuarial work and are covered in the CA
subjects, particularly CA2.
3.7 Behavioural finance
Behavioural finance has become important in assessing investment outcomes.

Although in most cases it cannot be quantified it is an input that has to be
understood in evaluating market activity or, for example, the actions of trustees.
It tends to explain why an alternative outcome happens to the one that looks
most sensible in valuation terms.
The theory relates to the psychology that underlies and drives financial decision-making
behaviour. Behavioural finance is covered explicitly in Chapter 6.

4 Further reading
Although there is no list of further reading for Subject ST5, the sources consulted in
developing the Core Reading below may be useful:
 Principles of corporate finance. Brealey, R. A.; Myers, S. C.; Allen, F. 10th

ed. and earlier McGraw-Hill, 2010. ISBN: 0071314172
 Options, futures and other derivatives. Hull, J. C. 8th ed. and earlier
Pearson Education, 2011. ISBN: 0273759078
Occasional references to other reading and websites that you may find interesting or
useful are also given in the Course Notes.

ST5-01: Derivatives (1) Page 1
Chapter 1
Derivatives (1)
Syllabus objectives
their payoffs.
0 Introduction
A derivative is a financial instrument whose value is dependent on (or derived from) the
value of another, underlying asset.
Derivative instruments were discussed in Subjects CT1 and CT2. The valuation
of derivative securities was considered in Subject CT8. In particular, the earlier
subjects considered the valuation of forwards and options based on shares.
Derivatives can be used to:

 control credit risk
 reduce market risk (a process known as “hedging”)
 increase risk in order to enhance returns
 switch asset allocations between different asset classes without disturbing the
underlying assets, as part of transition management.
The derivatives market can be divided into two distinct marketplaces, exchange-
traded derivatives and over-the-counter derivatives. In recent years regulators
have been encouraging derivative market participants either to transact deals on
exchanges or to centrally clear transactions. The aim is to improve transparency
and reduce counterparty risks. Additionally, regulators have required banks to
hold additional capital in respect of over-the-counter derivative transactions.
Exchanges have, over time, increased the number of derivative products offered.
In general they focus on standardised derivatives where there are high levels of
supply and demand, and hence high levels of liquidity.

Page 2 ST5-01: Derivatives (1)
Historically most derivatives exchanges can trace their origins to futures

exchanges, where they focussed on futures contracts and options on futures
contracts. Major exchanges include Euronext.liffe, the Chicago Mercantile
Exchange, Eurex and Intercontinental Exchange (ICE).
This and the following chapter review some of the basic features of derivatives, many of
which will be familiar to you from the earlier actuarial subjects and a knowledge of
which is required to understand how they may be applied in portfolio management.
These chapters describe:
 the markets in which derivatives are traded
 the basic features of forward, futures and options, and the payoffs that they
provide.

1 Futures markets
1.1 Nature of futures
A futures contract is a standardised, exchange-tradable contract between two parties to

trade a specified asset on a set date in the future at a specified price.
The price that you agree for a future is closely related to the price of the underlying
asset. To distinguish between the futures market itself and the market in the underlying
asset the terms cash market and spot market are often used when referring to the
underlying market.
Range of futures
Financial futures are based on an underlying financial instrument. Examples include:

 bond futures
 currency futures
 short interest rate futures
 equity index futures.
Commodity futures are based upon a physical commodity, eg gold or pork bellies.
1.2 Operation of futures exchanges
A contract
To make futures easily tradable, derivative exchanges specify a standard “contract” for
each type of future, the details of which are set by the exchange.
The contract will typically specify:

 the unit of trading
 how the settlement price is to be determined
 exact details of the underlying asset (ie type and quality)
 the delivery date.
All that the individual buyers and sellers of the contract have to agree is the price, and
how many “contracts” to buy or sell. It is not possible to deal in fractions of a contract.

Example
A futures contract on a particular share might be specified as follows:

Contract size: 1,000 shares
Currency: US dollars
Delivery date: Any date in December chosen by the seller
Minimum price movement: Prices can only be agreed in $0.01 steps
So, if two people want to agree a futures contract, they must do so in terms of a contract
for 1,000 shares. If the share price is $20, then each contract will be for about $20,000.
The exact price that a buyer and seller agree might be, say, $19,990 or $20,000 or
$20,010 etc (ie it varies in steps of $10).
Note that the “price” of the future is the notional amount of money that changes hands
on the delivery date. It is agreed at the start of the contract although no money passes
from buyer to seller at the start.
To ease administration, the exchanges normally specify a minimum price movement for
a contract. This minimum price movement is known as the contract’s tick size. In the
share futures example above, prices are quoted to the nearest $0.01 per individual share
– ie $1.99, $2.00, $2.01 etc. Given that the notional size of the contract is 1,000 shares,
the tick value would be 1, 000 ¥ $0.01 = $10 per contract.
Only members of the exchange are allowed to deal on the exchange. Other investors
need to use a member firm as a broker.
Question 1.1
Define precisely what is meant by a financial future.
Trading process
When a buyer and a seller agree to deal an exchange-traded derivative, opposing

contracts are created between each party and the clearing house of the
exchange.
The clearing house checks that the buy and sell orders match each other. The clearing
house then acts as “a party to every trade”. In other words it simultaneously acts as if it
had sold to the buyer, and bought from the seller.

In effect the clearing house becomes the counterparty to both of the parties to
the transaction. As such the clearing house guarantees each side of the original
transaction, subject to its capital resources.
The clearing house stands between the buyer and seller so that the link between the two
is broken. This gives two key advantages:
1. Through this guarantee the clearing house largely removes counterparty

credit risk between the buyer and the seller. Exchanges have
standardised legal documentation that is applied to buyers and sellers
entering into an exchange traded derivative.
Neither the buyer nor the seller needs to worry about whether the other party
will honour the agreement. Their contract is with the clearing house, not with
the person with whom they agreed the trade.
2. Each contract is indistinguishable from all others. Thus, if a buyer or seller

wants to “close out” their position they can do so without having to find the
original partner to the trade or without trying to link a new partner to the old
partner.
The clearing house keeps each trader informed of all the contracts which the trader has
outstanding (or “open”) with the clearing house.
Margin
Margin is the collateral that each party to an exchange-traded derivative must

deposit with the clearing house. It acts as a cushion against potential losses,
which the parties may suffer from future adverse price movements.
The potential losses referred to here, are those which would arise if one party to the
trade defaults on the agreement. The risk that you default on the agreement to trade
may increase if the market moves against you. In practice, each derivative broker
deposits margin with the clearing house, whilst at the same time, each investor will
deposit margin with their broker. The margin essentially acts as a good faith deposit.
When a transaction is first struck, initial margin is deposited by the broker with
the clearing house. It is changed on a daily basis through additional payments
of variation margin. This variation margin ensures that the clearing house’s
exposure to counterparty risk is controlled. The exposure can increase after the
contract is struck through subsequent adverse price movements.

The investor's margin account balance with his broker goes up and down each day by
the amount of his profit or loss. However, he needs only to top it back up to the initial
margin level if it falls below a specified level – the maintenance margin. Any such
payments are sometimes also referred to as variation margin and any margin in excess
of the initial margin can again be withdrawn.
So, at the start of an agreement, both parties to the future deposit a returnable initial
margin in the form of cash (on which the clearing house will pay interest) or in the form
of acceptable securities (eg the underlying asset or Treasury bills). Minimum initial
margin is generally set by the clearing house to be between 5% and 20% of the
contract’s value. This amount is based on the likely maximum overnight movement in
the contract’s price.
As time progresses, the underlying asset price is likely to change. For example, suppose
that the price of the underlying asset goes up. This is good news for the buyer of the
future because he has agreed to buy the (now more valuable) asset at a specified fixed
price. The seller of the future is in the opposite position and is facing a loss. So, the
contract is marked to market at the end of each day to reflect these profits and losses.
Example
Let’s say that we buy 20 FTSE 100 Index Futures for June delivery next year. The
delivery price is 6,523 and the contracts are valued by the exchange at £10 per index
point. The initial margin is set at £3,000 per futures contract and so we deposit £60,000
with our broker.
At any time prior to delivery we could sell similar contracts (ie 20 FTSE 100 Index
Futures for June delivery). If we do this then the clearing house will note that we have
two equal and opposite positions in this contract, net them off and record that we have a
net position of nil.
At the end of the day of purchase the futures price has risen to 6,535 (ie if we were now
to buy June delivery FTSE 100 Index futures then this would be the delivery price on
these contracts). Our position, marking to market, has accrued 12 points multiplied by
20 contracts. Our margin account balance is therefore credited with our profit of
£2,400, ie 12 points  £10 per point  20 futures contracts.
At the same time, the seller of the futures will be looking at an equal and opposite loss
and so her margin account balance will be debited with a loss of £2,400.

The process of daily margin requirement changes is known as marking to

market. Through this process of daily calculation of the market value of a
trader’s position, any fall in value will need to be topped up with additional
payments of cash (or other acceptable margin) to enable the clearing house to
continue to give its guarantee. Increases in the value of a contract are paid out
to the investor, also on a daily basis.
Here we are referring to the margin deposited by the broker with the clearing house.
Recall that an investor need only pay in additional margin if the margin account balance
with the broker falls below the maintenance margin level.
Delivery and open interest
The settlement process in futures markets is known as delivery. Most positions

in futures markets are closed out before delivery by taking an opposite position.
For example, a buyer of a contract can later close out his position by selling an
equivalent contract. His net position is then nil.
Example (continued)
Recall that we originally bought 20 FTSE 100 Index Futures for June delivery next
year. The delivery price was 6,523 and the contracts are valued by the exchange at £10
per index point. The initial margin was set at £3,000 per futures contract and so we
deposited £60,000 with the clearing house.
On the second trading day the price starts slipping and we decide to take our profits
when the futures price stands at 6,531. It is at this point that we sell 20 contracts to
close our position. As the price is now 4 points lower than the previous day’s
settlement price of 6,535, our margin account balance is reduced by £800. This leaves
£61,600 available to us in our account, ie our initial margin of £60,000, plus a profit of
£1,600. The clearing house notes that we have two equal and opposite positions in this
contract and thus records our position as closed.
Note that this profit is simply 20 ¥ £10 ¥ (6,531 - 6,523) = £1, 600 . It is in this way that
over time that profit or loss on futures positions is realised or incurred via the marking
to market process.
This ability to close out a position by entering into an equal and opposite trade is why
contracts are standardised. As a result, only a relatively small proportion of
contracts reaches physical delivery.
In practice, even those futures contracts that reach delivery are normally settled “for
cash”, rather than by delivery of the physical asset. This is because it is often costly and
difficult to physically deliver the underlying asset.

The overall cash settlement is based on the difference between the market price of the
asset at the delivery date and the futures price agreed at the start of the contract. (Of
course, the profit or loss up to the close of play on the day prior to the delivery date will
already have been reflected in the margin account balance via the marking to market
process. This profit or loss is then added to the profit or loss on the settlement day itself
to give the overall profit or loss.)
The market price of the asset needs to be precisely defined and the exchange does this
for futures that can be cash settled by publishing an exchange delivery settlement price
(EDSP) – the final settlement price, against which all outstanding cash settled futures
are settled.
Example
Joe agrees to buy one gold futures contract based on 100 ounces of gold and at an initial
futures price of $1,480 per ounce. Suppose that at the delivery date the settlement price
is $1,490 per ounce, then he has made a profit of $10 per ounce, or $1,000 in total.
If the future is settled for cash, then he will receive his total margin account balance
back from the clearing house, which will be equal to his initial margin deposit plus his
$1,000 profit. If delivery actually takes place, he again receives his initial margin and
his $1,000 profit from the clearing house. In addition, he will pay $149,000 (ie $1,490
per ounce  100 ounces) in return for the gold. This means that the net cost of the gold
to Joe is equal to $148,000, or $1,480 per ounce, as agreed at the outset of the future.
The number of contracts outstanding at any one time is known as the open
interest. Given that most contracts don’t reach physical delivery, the open interest over
the lifetime of a particular futures contract will, most likely, reduce towards zero as
delivery approaches.
Question 1.2
Why do you think that a graph of the open interest of a futures contract will be
negatively skewed and the volume of trading at its greatest near delivery?
Question 1.3
State the maximum profit, and the maximum loss, that can be made by:
1. buying a future (taking a long futures position)
2. selling a future (taking a short futures position)

Price limits
Margin is one method by which the clearing house addresses default or credit risk. To
ensure orderly markets, futures markets may also have price limits. On any one
trading day, if the price of a futures contract moves up or down, from the day’s opening
price, by more than the price limit then the exchange will halt trading in that contract.
Trading may recommence on the next trading day or restart that day, after a pause for
traders to reflect on their positions and to allow variation margin to be collected. These
price limits are another means by which to protect the clearing house from
excessive credit risk.
1.3 Role of the clearing house
Summarising the above, the clearing house fulfils the following roles:
 counterparty to all trades
 guarantor of all deals (removing credit risk)
 registrar of deals
 holder of deposited margin
 facilitator of the marking to market process.
Question 1.4
Outline the role of margin and the clearing house in reducing “counterparty” credit risk.

2 Options markets
2.1 Definition
Like futures, options are contracts agreed between investors to trade in an underlying
security at a given date at a set price. The difference is that the holder of the option is
not obliged to trade – hence the name “option”. The other party, the writer, is obliged
to trade if the holder of the option wants to.
As with futures, options are usually short-term (usually the maximum term to expiry is
less than a year for a traded option).
Question 1.5
Define the following terms used in connection with options:

 call option
 put option
 exercise or strike price
 writer
 premium.
From the two types of option, there are four basic positions that an investor could hold:
1. buying a call option
2. buying a put option
3. “writing” (ie selling) a call option
4. “writing” (ie selling) a put option
Question 1.6
Explain why buying a put is not the same as selling a call.
Question 1.7
What are the key differences between an option and a future?

2.2 Option trading
Unlike futures, when options are traded, margin is only required from only one of the
parties to an options contract. As with futures, a clearing house acts as “a party to every
trade”, thus severing the link between buyer and seller.
Question 1.8
Why aren’t the buyers of options required to deposit margin?
Writers are required to pay initial margin, and will be required to pay variation margin if
the underlying asset price moves against them (ie up for a call writer, down for a put
writer).
As with futures, most options contracts are typically closed out with an opposite
transaction, rather than being exercised.

3 Over-the-counter markets
3.1 Introduction
Like futures and options, forwards and swaps are both “derivative instruments”.
However, they are “over-the-counter” instruments, ie they are individually arranged on
a non-standardised basis over the telephone with banks rather than being traded on a
recognised exchange.
As well as derivatives that are traded on exchanges, derivatives are also traded
over-the- counter (OTC) by investment banks. The interest rate swaps market
and the market in forward currency contracts are two very important OTC
markets, although many transactions are now taking place on exchanges or are
migrated to a clearing house (“cleared”) immediately after the transaction has
taken place.
Investment banks are able to tailor a wide variety of derivatives to suit the needs
of corporate clients and investors. OTC markets are generally less liquid and
transparent than the markets in exchange-traded derivatives and counterparty
credit risk is greater.
OTC derivatives are typically transacted under documentation maintained by the

International Swaps and Derivatives Association (ISDA). ISDA documents are
often bespoke, and can contain provisions for collateralisation and other legal
terms that can be used to manage counterparty risk.
Example
Tailored derivatives that are available OTC include:

 Bermudian options, which are exercisable only on specified days, and
 Asian options, where the payoff is based on the average value of the underlying
asset over a period rather than the value at the point it is exercised.
Question 1.9
What are the main advantages and disadvantages of the OTC market compared to
exchange trading?

3.2 Forwards
A forward contract is a non-standardised and privately negotiated contract between two

parties to trade a specified asset on a set date in the future at a specified price.
We discuss the nature of forwards in more detail in Chapter 2.
3.3 Swaps
A swap is a contract between two parties under which they agree to exchange a series of
payments according to a prearranged formula.
Swaps, like forwards, are deals arranged with banks as the main market makers in an
“over-the-counter” market. In a swap the two parties agree to swap a series of payments
with each other. The two most common types of swaps are:
1. interest rate swaps– whereby two different sets of interest payments are swapped
2. currency swaps – payments in two different currencies are swapped.
Question 1.10
What are the two types of risk associated with the use of swaps?

3.4 Other derivative products
There is an high level of activity involving other types of derivative products providing
returns linked to a wide variety of underlying assets.
Guaranteed equity products
Guaranteed equity products (GEPs) offer a return that is linked to an equity index, but
with a minimum guaranteed return, often of zero. For example, a particular GEP might
offer a return equal to the increase in the value of the FTSE 100 index over a 5-year
period, together with a guarantee to return your initial investment should the index fall
over the 5-year period.
Structured notes
Structured notes are non-standard securities that are structured so as to meet the
particular risk and return requirements of investors. As such they often contain
embedded options and/or provide payments that vary in some pre-specified way.
Examples include:
 bonds that include an option for the lender to extend or reduce the term of the
bond in accordance with pre-specified terms
 bonds whose coupon payments vary in line with a property index or an exchange
rate index. The former enables the purchaser to gain some indirect exposure to
property, whilst the latter might be used for hedging currency risk, without any
direct derivative exposure – which may not be permitted for the investor in
question.
 bonds whose coupon payments are denominated in a different currency to the
capital payments.

Chapter 1 Summary
The derivatives market can be divided into two distinct marketplaces, exchange-traded
derivatives and over-the-counter derivatives
Futures markets
A futures contract is an exchange-traded, standardised, and thus marketable, obligation

to trade an underlying asset on a set date a few months later at a set price. Futures exist
on a range of financial assets including bonds, short interest rates, currencies and stock
market indices, and also commodities.
The clearing house to an exchange fulfils the following roles:

 counterparty to all trades
 guarantor of all deals (removing credit risk)
 registrar of deals
 holder of deposited margin
 facilitator of the marking to market process.
The exposure of the clearing house to credit risk is controlled by the marking to market
process (ie initial margin and variation margin) and, sometimes, by the adoption of
price limits by the exchange.
The process of settlement in the futures market is known as delivery. The

(standardised) timing of delivery may be a specific time on a set trading day or a period
of time. If it is the latter then the party selling the asset (the short party) has the choice
as to the exact timing of delivery.
Most futures and options contracts are closed out (by entering an equal and opposite
trade) prior to delivery. This is made possible by the standardisation of contracts by the
exchange. The number of contracts that have not been closed out at any one time is
referred to as the open interest in that contract.

Options markets
A traded option is a standardised and thus marketable agreement giving the holder the
right but not the obligation to trade an underlying asset on a set date a few months later
at a set price. Call options give the right to buy. Put options give the right to sell.
Most traded options are “American”, which means that they can be exercised at any
time up to expiry.
Options are usually traded in a similar way to futures. A clearing house is party to
every trade and will require margin to be deposited by writers of options. Buyers of
options do not need to deposit margin as they have a choice and not an obligation to
trade.
The party buying the option is said to be taking a long position in the option. The seller
(or writer) of the option is said to be taking a short position in the option.
Over-the-counter (OTC) markets
Investment banks and other financial institutions and corporations facilitate the OTC
market in derivatives, which is separate from any formal exchange.
The main advantage of the OTC market is the ability to tailor contracts to the buyers’
precise requirements.
The main disadvantages of the OTC market are:

 low marketability
 high dealing costs
 lack of market values
 greater credit risk.
Derivatives products
There is also an increasing level of activity involving derivative products, such as:
 guaranteed equity products
 structured notes

Chapter 1 Solutions
Solution 1.1
A financial futures contract is a standardised and exchange-tradable, legally binding

agreement to trade a specified quantity of an underlying financial security or instrument
on a specified date and at a specified price
Solution 1.2
Most traders in the futures market favour contracts with shorter durations. This is
especially true of speculators. Thus as a contract approaches delivery the number of
traders interested increases.
There are two main reasons why trading volumes increase close to delivery:
1. speculation increases as to the likely settlement price
2. traders not wanting to reach settlement close out their positions.
Solution 1.3
1. The maximum profit is unlimited. The worst possibility from the buyer’s point
of view is that the price of the underlying asset drops to zero. Therefore the
maximum loss is the price agreed for the future.
2. The seller is in the opposite position. The maximum profit is the price agreed
for the future. The maximum loss is unlimited. (Although note that if the seller
owns the underlying asset, then the unlimited loss on the future will be matched
by an unlimited profit from the underlying asset. )

Solution 1.4
Once a contract is matched, the clearing house becomes the “party to every trade”. So,
each trader’s obligation is subsequently with the clearing house, and not the original
counterparty, thereby removing the exposure of each trader to the possibility of default
by the other trader.
Initial margin is paid by the trader to the clearing house at the outset of each open
position. This is subsequently varied each day to reflect the profit or loss on the open
position. In particular, if the margin account balance falls below a specified level, then
the trader will need to deposit additional margin with the clearing house. In this way,
the margining system provides the clearing house itself with some protection against
either of the two traders defaulting.
Solution 1.5
1. A call option gives its holder the right, but not the obligation, to buy a specified
asset on a set date in the future for a specified price.
2. A put option gives its holder the right, but not the obligation, to sell a specified
asset on a set date in the future for a specified price.
3. The exercise price is the price at which an underlying security can be sold to (for
a put) or purchased from (for a call) the writer or issuer of an option (or option
feature on a security). Also known as the strike price.
4. The writer of an option is the seller of that option.
5. To buy either a call or a put option you pay a small amount of money up front to
the writer of the option. This money, the option premium, is non-returnable.
Note that if you exercise a call option you then have to pay the writer the exercise price.
So in total you will have paid the option premium plus the exercise price to buy the
asset.
If you exercise a put option the writer pays you the exercise price for the specified asset.
So in total you will have received the exercise price less the premium in return for the
asset.
If you choose not to exercise an option, there are no further cash flows, so only the
premium will have changed hands.

Solution 1.6
The difference is between right and obligation. Buying a put costs you money and
allows you to choose whether or not to sell the underlying asset. Selling a call means
that you receive money and must sell the underlying asset if, and only if, the holder of
the option wants to.
If you buy a put you are likely to choose to sell the underlying asset if the market price
is less than the exercise price. If you sell a call you are likely to be forced to sell the
underlying asset if the market price exceeds the exercise price.
Solution 1.7
The key differences between an option and a future are that:
1. An option gives the holder an option. With a future both parties have an
obligation.
2. The buyer of an option will pay a small premium to the writer. With a future no
money changes hands up-front (ignoring margin requirements).
Solution 1.8
Buyers of options are not obliged to trade, unlike the sellers of such contracts. Buyers
do not face any loss, beyond that of the initial costs (such as commission) and thus do
not pose any default risk to the clearing house. As there is no credit risk, no margin is
required to protect the clearing house.
Solution 1.9
The main advantage of the OTC market is the ability to tailor contracts to the buyer’s
precise requirements eg with a delivery date which is different to that of the similar
exchange tradable contract.
The main disadvantages of the OTC market are:

 non-standard contracts reduce or eliminate marketability
 high dealing costs
 no quoted market values
 greater credit risk as you are not dealing with a clearing house as guarantor.

Solution 1.10
Two types of risk associated with swaps
Market risk is the risk that market conditions will change so that the present value of the
net outgo under the agreement increases. The market maker will often attempt to hedge
market risk by entering into an offsetting agreement.
Credit risk is the risk that the other counterparty will default on its payments. This will
only occur if the swap has a negative value to the defaulting party so the risk is not the
same as the risk that the counterparty would default on a loan of comparable maturity.
It is “not the same” because:
 credit risk is only a problem when the swap has a positive value to you (a loan
will always have a positive value, whereas the value of a swap could be positive
or negative)
 even if the swap has a positive value the problem may be quite small because:
– the principal is not at stake with an interest rate swap
– the loss of future interest income will largely be offset by the fact that
you will no longer need to make the interest outgo payments if your
counterparty defaults; ie you lose the net present value of the swap, not
the gross value of your payments.

Chapter 2
Derivatives (2)
Syllabus objectives
their payoffs.
0 Introduction
This chapter describes:
 the basic features of forwards, futures and options
 the payoffs that they provide.
In doing so, we draw diagrams to illustrate how the payoff from a particular derivative
varies with the price of the underlying asset at the maturity of the derivative.

1 Types of contract and their payoffs
1.1 Forward contracts
A forward contract is an agreement between two parties to trade an asset at a

certain future time for a certain price.
Question 2.1
List the fundamental differences between forward contracts and futures contracts.
This type of contract is normally traded in the over-the-counter market. The

party that agrees to buy the underlying asset is said to assume a long position
and the party that agrees to sell the asset assumes a short position.
Forward exchange rates
Forward contracts on the foreign exchange are very popular. They can be used
by investors to hedge foreign currency risk. Most large banks have a “forward
desk” within their foreign exchange trading room that is devoted to the trading of
forward contracts.
Example
Imagine that a UK company knows that it will have to pay $1m to one of its US
suppliers in two months’ time. It faces the exchange rate risk that the pound might
weaken against the dollar. It could hedge by entering a long forward contract to buy
$1m in two months’ time. This would effectively guarantee the exchange rate and
remove the exchange rate risk. Of course if the US Dollar weakens then no gain will be
made either!
Rates for forward currency deals are based on spot rates but with an adjustment for the
difference in interest rates between the two currencies.

Example
 The current £/$ spot rate is £1 = $1.50.

 One year £ spot interest rate is 7% pa and one year $ spot interest rate is 4% pa.
A bank should quote a one-year forward based on a £/$ rate of:
.  104
150 .
 14579
.
1  107
.
This fall reflects the expected decline in the value of Sterling against the Dollar
indicated by the lower Dollar spot interest rate. (The expected depreciation of Sterling
offsets the higher interest rate paid in Sterling, so that the expected return is the same in
both currencies. )
The market is efficient in the sense that the cost of buying one currency directly with
another is the same as the cost of buying that currency indirectly via a third (ignoring
dealing costs).
Using forwards to hedge
If you are expecting proceeds from a foreign currency investment you may want to sell
the foreign currency forward. By doing this you remove the possibility that a
depreciation of the foreign currency will reduce the domestic currency value of the
expected proceeds. You can lock in to a rate agreed today. The costs of this are:
 you also remove the possibility that an appreciation of the foreign currency will
increase the domestic currency value of the expected proceeds
 the bid/offer spread on forward deals is normally a little more than the spread on
spot market transactions, so there is a small additional cost for using forwards.

1.2 Payoffs from forward contracts
The holder of the contract promises to buy at time T one share from the issuer of the
contract at a price K, which is fixed at the time of issue. The payment time T is usually
called the expiry date or maturity date. The forward price, K, is usually set in such a
way that the value of the contract at time 0 is equal to zero. In other words, at the outset
of the contract, the expected present value of the profit to both the buyer and the seller
of the forward contract can be considered to be approximately zero. In addition, neither
the buyer nor the seller of the forward contract hands over any payment or premium to
the other party.
The forward price is also known as the delivery price.
Question 2.2
List the main factors that will influence the agreed delivery price.
It is the movement in market conditions over the period until the expiry date that
determines the profit or loss that each party to the trade ultimately makes – eg if the
market price of the security increases, then the buyer of the forward will benefit.
Also, under a forward contract, both parties are obliged to trade once the contract has
been agreed. So, the holder of the contract is obliged to buy the share at price K even if
the market price of the share, ST , is less than K: in which case the holder will lose an
amount K – ST . If, on the other hand, ST > K, the holder makes a profit of ST – K at
time T.
Thus, the payoff from a long position in a forward contract per unit of asset is:
ST - K
and the payoff from a short position is:
K - ST
where:
 K is the delivery price
 ST the spot price of the asset at maturity of the contract.

The payoffs can be shown graphically in Figures 2.1 and 2.2 as follows:
Payoff
0
K ST
Figure 2.1: Forward contract, short position
Payoff
0
K ST
Figure 2.2: Forward contract, long position
It can been seen that the payoff is equal to the trader’s total gain or loss from the
contract. This is because the holder is obliged to trade the underlying asset and it
costs nothing to enter into a forward contract, as no premium is payable when the
contract is first agreed. We are also ignoring taxes and transaction costs here.
Note that the above payoff diagrams and those that follow:
 all form part of the Core Reading
 are typically drawn ignoring:
– any taxes and transactions costs payable
– any income payable by the underlying asset and any margin payments
– the effect of discounting on the value of the cashflows exchanged.

1.3 Futures contracts
As for forward contracts, futures contracts are agreements between two parties
to trade an asset at a certain future time for a certain price. However, they differ
in that they are normally traded on an exchange. The exchange specifies certain
standard features of the contract and provides a mechanism whereby both
parties have a guarantee that the contract will be honoured. Details of this were
covered in Section 1 of Chapter 1.
Question 2.3
What are the typical standard features specified by the exchange in a financial futures
contract?
Another difference from forward contracts is that often the actual date of delivery
is not specified. Instead, the contract is generally referred to by the month of
delivery and the exchange specifies the period during the month in which
delivery must be made which, for commodities in particular, can often be the entire
month. Where delivery is not a specific date and time, the holder of the short
position has the right to choose the actual delivery date. Remember the holder of
the short position is the party obliged to sell (deliver) the underlying asset.
Note that we can draw payoff diagrams for futures that are similar to those for forwards.

1.4 Options
The nature of options
Options are traded on exchanges and the over-the-counter market.
Traded options, like futures, are contracts specified by an exchange that are
standardised and marketable. We are mainly interested in traded options.
As traded option contracts are fully standardised, all that buyers and sellers need to
negotiate is the premium for the contract. Note that this standardisation extends to the
exercise price. (This is different to futures where there is no premium, and it is the
strike price that is negotiated. )
An over-the-counter (OTC) derivative is one that is not traded on a recognised

exchange. Note that the expression over-the-counter can be used to describe any
security dealings outside of a recognised exchange. Most OTC derivatives are sold by
investment banks and may be European or American in nature.
Question 2.4
What are the differences between a traded call option and an OTC put option?
Traded options are available on individual equities and also financial futures contracts,
as well as commodities, foreign currencies, short-term interest rates and stock market
indices.
Call options and put options
The two types of option are:
 call option: gives the holder the right to buy the underlying asset
– by a certain date
– for a certain price
 put option: gives the holder the right to sell the underlying asset
– by a certain date
– for a certain price.
Recall that options covey the right but not the obligation to trade the underlying asset.
However, in each case, the writer of the option is obliged to trade if the holder chooses
to do so.

The buyer of the option pays a premium to the writer for this choice. It is this option
premium or option price that is quoted in the marketplace and that can be estimated
using pricing formulae such as that developed by Black and Scholes.
The agreed price in the contract is known as the exercise price or strike price
and the date is known as the expiration date or maturity date. It is sometimes also
referred to as the exercise date or the strike date!
There are two different types of option which differ according to when they can
be exercised. American options can be exercised at any time up to the
expiration date and European options can only be exercised on the expiration
date. These terms do not refer to the location of the option or the exchange, for
example European options are traded on North American exchanges.
In practice:
 most options traded on exchanges are American options, regardless of the
location of the exchange
 there is a large number of other more complex options available beyond the
standard or “vanilla” options discussed here. For example, options are available
that have a series of pre-specified strike dates or in which the payoff depends on
the average share price over the period to expiry (and not just the share price at
the expiry date).
1.5 Payoffs from call options (long position)
The investor who purchases an option is said to have taken the long position and
has the option to buy one share from the issuer of the contract at time T at the strike
price K.
If at time T the share price ST is less than the strike price then the option will not be
exercised. This is because the holder of the option would be silly to pay K for the share
when he could just as easily go and buy the share for ST (< K) in the open market. He
therefore simply walks away and “loses” the premium that he originally paid for the
option itself. Conversely, the seller or writer of the option gets to keep the premium
that he received at the outset and therefore makes an overall profit on the deal equal in
value to that premium.
If ST > K then the holder should buy the share at the strike price and can sell
immediately at the market price, ST , making a profit at expiry of ST - K . It is
important to note that the profit here ignores the premium paid for the option – we are
really talking about the payoff at time T rather than the overall profit made.

Thus, after also allowing for the premium paid at outset, the payoff for an investor
who purchases a call option and exercises the option can be expressed as:
ST - K - O
where: K is the exercise (strike) price

ST is the price of the underlying stock at expiry (maturity)
O is the price of the call option – the option premium
This assumes that the option is actually exercised. Clearly if the stock price, ST , is
less than the exercise price, the investor will not exercise the option, therefore
the payoff in practice will be:
where ST > K : ST - K - O
where ST < K : -O
Question 2.5
Explain where these payoffs come from.
Figure 2.3 below shows how the payoff varies with the final stock price for a call
option purchased for £5 at an exercise price of £50:
Profit (£)
30
20
10
Terminal Stock
Price (£ ST )
0
30 40 50 60 70 80
5
Figure 2.3: Call option, long position

1.6 Payoffs from call options (short position)
The investor who has sold the option is said to have taken the short position.
The payoff for an investor who sells (or writes) a call option can be expressed
as:
O - ST + K
This is because the writer receives cashflows of O and K and effectively pays out ST
(by handing over the share worth ST ). As before, this assumes that the option is
actually exercised.
Again, if the stock price, ST , is less than the exercise price, the investor who has
purchased the option will not exercise it, therefore the payoff in practice will be:
where ST > K : O - ST + K
where ST < K : O
Figure 2.4 below shows how the payoff varies with the final stock price for a call
option sold for £5 at an exercise price of £50:
Profit (£)
0
30 40 50 60 70 80
Terminal
Stock Price (£ ST )
10
20
30
Figure 2.4: Call option, short position

Question 2.6
In the example illustrated in Figure 2.4, what terminal stock price results in zero profit?
Question 2.7
What is the total combined profit of the purchaser and the writer of the call option?
1.7 Payoffs from put options (long position)
As for call options the investor who purchases an option is said to have taken
the long position.
The payoff for an investor who purchases a put option can be expressed as:
K - ST - O
Assuming the option to sell is exercised by the purchaser of the put.
This time the investor will not exercise the option if the stock price, ST , is
greater than the exercise price, therefore the payoff in practice will be:
where ST > K : -O
where ST < K : K - ST - O 
Question 2.8
Explain where these expressions come from.

Figure 2.5 below shows how the payoff varies with the final stock price for a put
option purchased for £5 at an exercise price of £50:
Profit (£)
30
20
10
Terminal
0
20 30 40 50 60 70
5
Figure 2.5: Put option, long position
1.8 Payoffs from put options (short position)
The investor who writes the option is said to have taken the short position.
The payoff for an investor who writes a put option can be expressed as:
O - K + ST
Once more, this assumes that the exercise actually occurs.
Again, if the stock price, ST , is greater than the exercise price, the investor who
has purchased the option will not exercise it, therefore the payoff in practice will
be:
where ST > K : O
where ST < K : O - K + ST

Figure 2.6 below shows how the payoff varies with the final stock price for a put
option sold for £5 at an exercise price of £50:
Profit (£)
5 Terminal
0
20 30 40 50 60 70
10
20
30
Figure 2.6: Put option, short position
Question 2.9
A straddle is a speculative options strategy where both put and call options are
purchased simultaneously with the same strike price and date.
Combining the above expressions for the expected payoffs from each option, draw a
payoff diagram for a simple straddle (one put plus one call option) where:
 K is the exercise (strike) price for both types of option
 ST is the price of the underlying stock at expiry (maturity)
 P is the price of each of the options.
State the range of prices (for ST ) over which the straddle generates a profit.
Terminal value of payoff
European options are often characterised in terms of the terminal value of the
payoff, that is the payoff at maturity thus ignoring the initial outlay, or the option
price.

So the payoffs are exactly the same as before except that they exclude the option
premium O .
In general terms the payoff diagrams can be represented in Figure 2.7 as follows:
Payoff Payoff
ST ST
K K
(a) Payoff = max (ST  K, 0) (b) Payoff = min (K  ST, 0)
Payoff Payoff
ST ST
K K
(c) Payoff = max (K  ST, 0) (d) Payoff = min (ST  K, 0)
Figure 2.7: Terminal value of payoffs from options –

(a) long call, (b) short call, (c) long put, (d) short put
The diagrams in this chapter, which are often referred to as payoff diagrams or position
diagrams, are usually drawn also ignoring a small number of other factors that will
affect the value of the profit realised in practice.
Question 2.10
What other factors do the diagrams ignore?

Chapter 2 Summary
Forward contracts
A forward contract is a non-standardised contract between two parties to trade a

specified asset on a set date in the future at a specified price.
Forward contracts on the foreign exchange are very popular. They can be used by
investors to hedge foreign currency risk.
The long party in a forward or futures contract is the one who has agreed to purchase
the underlying asset. The short party in a forward or futures contract is the one who has
agreed to deliver the underlying asset. These phrases are also used to describe the
positions of the respective parties.
Payoff diagrams
These show how the payoffs from futures, forwards or option contracts vary according
to the price of the underlying asset at maturity.
The payoff simply nets off all the relevant cashflows (ignoring their timing, taxes,
transaction costs, income from the underlying asset and any margin payments). The
cashflows considered are the asset value at maturity, the delivery or exercise price and,
for options, the premium. Note that for futures, the margin payments made under the
marking to market process are ignored.
For options contracts, terminal value payoff diagrams ignore any option premium paid
at the outset and only compare the underlying asset value at expiry/maturity with the
exercise price.
Payoffs from forward and futures contracts
The payoff from a long position in a forward contract per unit of asset is ST - K .
The payoff from a short forward position is K - ST , ie the opposite of that for the long
position.
The payoffs from a futures contract are closely related to those from a similar forward
contract.

Payoffs from a call option
The payoff from a long position in a call option will be:
Where ST > K : ST - K - O
Where ST < K : -O
Payoffs from a put option
The payoff from a long position in a put option will be:
Where ST > K : -O
Where ST < K : K - ST - O
As with forwards and futures, the payoff from a short option position is always the
opposite of that to the corresponding long position.

Chapter 2 Solutions
Solution 2.1
Futures contract Forward contract

exchange-traded normally over-the-counter or OTC
standardised tailored
highly marketable non-marketable
liquid illiquid
delivery price determined openly by delivery price negotiated privately
buyers and sellers in the marketplace between buyer and writer
index futures readily available contracts normally based on specified
underlying security
can be closed out prior to maturity and difficult to close out and so usually settled
most are! at maturity
Solution 2.2
The agreed delivery price will reflect:

 the current share price
 the current risk-free rate over the period to maturity
 the dividends that the share is expected to pay between now and maturity
 the term to maturity.
In Chapter 11 you will see that the theoretical forward price F0 is given by:
F0 = S0e(
r - q )T
where:
 S0 is the current share price
 r is the risk-free force of interest

 q is the constant and continuous force of dividends
 T is the term to maturity.

Solution 2.3
The typical standard features specified by the exchange for a financial futures contract
are:
 underlying financial security or index
 specific delivery date and time or period during which delivery must take place
 trading hours
 unit of trading (eg £10 per index point)
 form of quotation (eg pence per share)
 minimum price movement (tick size)
 method of calculating the EDSP (exchange delivery settlement price) ie the
monetary value that can be paid at delivery rather than providing physical
delivery of the underlying asset.
Solution 2.4
Traded call option OTC put option
 right to buy  right to sell
 traded on an exchange  purchased from an investment bank
 standardised  can be “tailor-made”
 can easily close out  would need to negotiate terms to end contract
 limited credit risk  possibly material counterparty credit risk
 price quoted in market  valuation more subjective
Note that all but the first point apply equally to a discussion of the difference between
futures and forwards.

Solution 2.5
If ST > K at expiry, then the call option will be exercised leading to an immediate
profit at exercise of ST - K . So allowing for the premium paid at outset, the total profit
to the buyer of the call option will be ST - K - O .
Conversely, if ST < K at expiry, then the call option will not be exercised, but will
instead expire worthless. The loss will then be simply the premium paid at outset,
giving an overall profit of -O .
Solution 2.6
From Figure 2.4, we see that the short position leads to a zero profit when ST > K , in
which case the profit is given by:
O - ST + K
Thus, zero profit arises when:
O - ST + K = 0
 5 - ST + 50 = 0
ie ST = 55
This is because the seller has received a premium of 5 at outset and the strike price of 50
at expiry date in return for a share which is then worth 55.
Solution 2.7
For any option, the total combined profit of the purchaser and the writer of the option is
simply zero (ignoring taxes and transactions costs). This is because the gain to one
party is always equal to the loss incurred by the opposite party.
We can show this by considering the combined payoffs received. These are given by:
If ST > K : combined payoff = ST - K - O + O - ST + K = 0
If ST < K : combined payoff = -O + O = 0

Solution 2.8
Here the put will not be exercised if ST > K , as the share would then be sold for less
than its market price, and so the long party simply loses the premium paid at outset.
If instead ST < K , then the put will be exercised. The long party selling the share will
then receive the strike price of K in return for a share worth ST and the initial premium
of O , giving a net profit equal to K - ST - O .
Solution 2.9
Payoff
K
ST
–2P
ST < K ST > K
call -P ST - K - P
put K - ST - P -P
straddle K - ST - 2 P ST - K - 2 P
Thus the straddle generates a profit if either:
ST < K - 2 P or ST > K + 2 P

Solution 2.10
The diagrams ignore:

 taxes
 transactions costs
 any income payable by the underlying asset in the period between now and the
strike date
 any margin payments
 discounting – ie the fact that the premium is paid/received at the outset, whereas
the remainder of the profit or loss arises at the strike date, typically several
months later.





the course.

ST5-03: Specialist asset classes (1) Page 1
Chapter 3
Specialist asset classes (1)
Syllabus objectives

financial instruments:
 financial instruments available for short-term lending and borrowing
 corporate debt and credit derivatives
 swaps and swaptions
 private debt
0 Introduction
In this chapter we begin our look at a number of specialist asset classes and markets,
which are often viewed as complementary to the bonds, equities and property
traditionally held by institutional investors such as insurance companies and pension
funds. Some of these assets (eg commercial paper) will be familiar from earlier
subjects, whereas others (eg credit derivatives, private debt and equity and asset-backed
securities) are introduced for the first time.
Amongst the more specialist derivatives described are credit derivatives, swaps and
swaptions. In this chapter we describe the main features of each of these and in
Chapters 11 and 12 we consider how to value them.
The main asset classes (equities, bonds, property and cash) were introduced in
earlier subjects (CT1, CT2, and CA1).

Page 2 ST5-03: Specialist asset classes (1)
1 Financial instruments available for short-term lending

and borrowing
1.1 Money markets
The nature of the money market and money market instruments was introduced in
Subject CA1.
Question 3.1
List the money market instruments introduced in Subjects CT1 and CT2.
The money market is not a physical location; instead it is a virtual market place
made up of electronic communications between banks, dealers and major
corporations.
It operates on a “wholesale” level, with individual transactions of tens or

hundreds of million pounds sterling. There are also collective investment
vehicles (“money market funds”) offering access to the money market for
individuals and small companies.
There are three basic ways for investors to access the money markets:
1. directly on their own account – most suitable for large financial firms
2. hire a professional investment management firm – suitable for investors who
will make transactions of large amounts but who don’t have the expertise to deal
in the market themselves
3. via a money market fund – these provide a diversified holding of money market
instruments and are most suitable for smaller investors.
Distinction is often made between domestic and international money markets.

The latter consists of funds in a particular currency deposited in banks that are
located outside that currency’s domestic market (and are therefore not subject to
the regulation and taxation that governs the domestic market).
For example, we distinguish between Yen deposits in the Tokyo money market and Yen
deposits at a London bank.
In the UK, money market interest rates are often quoted relative to LIBOR (the
London Inter Bank Offered Rate).
This is true of currencies other than just sterling, eg a US bank may be prepared to lend
to a US company at “1.5% over LIBOR”.

Factors influencing the spreads of money market rates will include default risk
and market liquidity.
Question 3.2
Give 2 reasons why the risk of default is generally less for money market instruments
issued by a company than for corporate bonds issued by the same company.
Most money market securities operate on a discount basis; that is, they do not
pay explicit interest but rather generate returns by the difference between the
purchase price and the maturity proceeds.
Example
A 3-month Treasury bill is being issued at an annual (simple) discount rate of 4%.
Therefore, an investor would pay $99 at issue for each $100 nominal.
Strictly the return is in the form of a capital gain and there is no explicit income
payment.
However, taxation authorities will generally regard the returns as income, and tax
it accordingly.

1.2 Money market instruments – lending
The money markets provide a means for institutions (or individuals) with excess short-
term cash to make a return on that cash. The institutions involved include banks,
companies and national and local governments and government agencies.
The available investments that we will look at are:

 Treasury bills
 commercial paper
 repos
 government agency securities
 bank time deposits and certificates of deposit
 bankers’ acceptances and eligible bills.
At least some of these should be familiar to you from earlier subjects.
In most markets Treasury bills, commercial paper and repo agreements are the
major forms of money market investment.
Treasury bills
In most economies the major issuer of money market instruments is the national
government. Bills issued by the government are usually known as Treasury bills
and are typically issued in 3-month (91-day), 6-month (182-day) and one-year
forms.
Usually, issue is by auction, where competitive and non-competitive bids may be

entered – the latter are then filled at the average price of the successful
competitive bids.
In a UK Treasury bill auction, all bids must be on a competitive basis. In a US Treasury

bill auction, investors must choose whether to bid competitively or non-competitively;
they cannot do both in the same auction.
If bidding competitively, the investor submits a tender specifying the discount rate he
requires (eg 0.51%). If the specified discount rate is too high, the investor may not
receive any bills or may not receive their full allocation bid.

With a non-competitive bid, the investor is guaranteed to receive the full amount of bills
requested. The price the investor pays will be the average price determined from the
successful competitive bids. The upper limits on how much each investor can bid for
are lower for non-competitive bids than for competitive ones.
There is also a deep and liquid secondary market for Treasury bills.
Commercial paper
Short-term unsecured notes issued directly by a company (overriding the need

for financial intermediation) are known as commercial paper. Such notes are
issued at a discount, usually for a term of a few months, but can typically be
presented to the issuer (or to a dealer) for repurchase.
The main features of commercial paper may be familiar from earlier subjects:
 It is a bearer document.
 Terms at issue vary from a few days up to several months with terms up to two
months being the most common.
 It is a single-name instrument, the security is provided only by the company
issuing the paper, ie borrowing the money.
 Companies who wish to raise finance by issuing commercial paper have to meet
certain minimum standards.
 The effective rate of interest paid will be slightly higher than the equivalent rate
on a risk-free investment (such as a Treasury bill). The size of the “margin”
over the risk-free rate of interest will depend on the company’s credit rating.
 Rating agencies such as Moody’s and Standard and Poor’s publish ratings for
commercial paper.

Repos
A repo is an agreement whereby one party sells stock to another with a

simultaneous agreement to repurchase it at a later date at an agreed price.
Holders of government bonds and other high quality assets can use repos as a
short-term financing tool, whilst maintaining their underlying economic exposure
to these assets.
The “stock” involved is usually either Government bonds or Treasury bills. The
difference between the repurchase price and the selling price is quoted as the repo
interest rate.
Overnight repos are very common and so they are a very liquid instrument. As well as
the range of available fixed terms, open repos are also available. These have no fixed
maturity date and either side can withdraw after giving the specified notice, usually
1 day. For example, the investor can give notice and get the return on his cash (ie the
agreed price for the Treasury bill) in return for handing back the bill.
A “reverse repo” is the opposite side of the agreement. This is a form of secured
lending as cash is being lent for the duration of the repo by the party buying the
stock, with the security as collateral.
Other money market instruments include:

 government agency securities
 interbank deposits
 bankers’ acceptances and eligible bills.
Government agency securities
In most countries a near-government sector of the market exists which issues

and trades securities that are almost as risk-free and liquid as Treasury bills.
Typical examples are nationalised industries and local authorities (in the UK) or
Federal Mortgage Associations, states and counties and school boards (in the
US). The securities (“notes”) issued are similar to Treasury bills, and a liquid
secondary market typically exists in such bills and notes.

Although there is a liquid secondary market in these instruments, they are not quite as
marketable as Treasury bills. This is one reason for the slightly higher interest rate on
government agency securities. The second reason relates to a slightly higher level of
risk – the risk is that the national government would allow the agency to default.
Investors may decide that this is extremely unlikely to happen, particularly for certain
government agencies, in which case the risk margin over Treasury bills will be very
small. Like Treasury bills, government agency bills are issued at a discount and
redeemed at par.
Bank time deposits
Question 3.3
What is a bank time deposit?
The banks are major providers of funds to the markets as well as being
borrowers (when faced with a shortage of funds due to clearing activities).
Interest-bearing inter-bank overnight borrowing and Certificates of Deposit (1 to

3 months) are the typical securities involved, the latter being negotiable.
It can be helpful to think of a Certificate of Deposit (CD) as a negotiable term deposit.

If the investor wants to realise his investment before the maturity date, he can sell the
CD to another investor. The main features of CDs are:
 They are bearer documents – the bank pays the time deposit payment to whoever
presents the CD at maturity.
 A secondary market exists but it is far less liquid than that for Treasury bills and
government agency securities.
 Typical maturity terms range from 1 to 3 months.
 Domestic and international CDs exist in many currencies.
Bankers’ acceptances and eligible bills
These are a form of tradable IOUs, whereby a company that has supplied goods
or services to a client will have the invoice “accepted” by a bank (who thereby
guarantees payment at the due date). The bill can then be traded in a secondary
market to raise immediate cash, at a discount.
These were referred to as bills of exchange in Subject CT2.

1.3 Money market instruments – borrowing
For every lender there is a borrower. We have discussed the purchase of commercial
paper and bills as a form of lending. From the other side of the fence, issuance of
commercial paper and bills represents a form of short-term borrowing by
companies.
There are other ways in which companies can borrow short-term. These other forms
of borrowing, mainly involving the banks, include:
 term loans
 evergreen credit (permission to borrow up to a specified limit, with no

fixed maturity)
So this is just like an overdraft facility, although it does involve the potential
borrower paying a commitment fee to the bank for the option to borrow when it
wants to.
Even with such an agreed line of evergreen credit, the bank may require the
borrower to repay all outstanding amounts periodically to prevent what is
intended to be a short-term form of borrowing becoming a long-term (or
permanent) fixture.
 revolving credit (similar to evergreen credit, but with a fixed maturity of up

to 3 years)
It is normal to have to pay a commitment fee on the full agreed amount of
borrowing, whether or not it is all used. Interest is only payable on the amount
actually borrowed.
 bridging loans (advances to be repaid from specified income)

A bridging loan is used to pay for a specific item (eg new machinery, investment
in a new project) in the interim period before long-term finance is obtained.
 international bank loans

As an alternative to borrowing from a domestic bank, a company may choose to
borrow international currency from a bank overseas. This may be from a single
bank or possibly, especially if large amounts are to be borrowed, from a
syndicate.
Note also the discussion of factoring in Subject CT2.

Question 3.4
Describe factoring.
Issues that differentiate between different types of loan include:
 Commitment – whether there is prior commitment by the lender to

advance funds when required (often requiring payment of a commitment
fee to the lender).
Companies may just approach a bank for a loan “as and when” they need the
cash. It is more usual, however, to pre-arrange a line of credit, ie to get a
commitment from the bank on an amount up to which it will lend. This can be
on an evergreen or a revolving basis. A commitment fee is usually payable to
the bank.
 Maturity – the term for which the lending is made.
 Rate of interest – this may be either fixed or floating.

Very short-term loans may be at a fixed rate of interest. Most loans are at a
floating rate, ie linked to the general level of interest rates, eg a fixed margin
above LIBOR.
 Security – whether the loan is to be secured against assets (either fixed or

liquid assets).
Question 3.5
What are liquid assets?

2 Corporate debt and credit derivatives
2.1 Introduction
In Subjects CT1 and CT2 the various categories of corporate debt were
introduced – debentures, loan stock, preference shares.
In analysing corporate debt the key issue to be considered is, generally, the
security of the debt and the risk of default. In recent times, the use of credit
derivatives has significantly deepened the market for corporate debt.
Associated with this have been the study of credit risk and the allowance for risk
of default in pricing.
Investors are able to use credit derivatives to reduce their exposure to the risk of default.
We will describe both credit derivatives and the use of credit derivatives to reduce
credit risk in Section 2.4 below. In Chapter 12 we also describe one method of pricing
corporate debt and assessing credit risk based on the information about the credit risk of
the debt contained within the company’s equity.
2.2 Calculating expected default losses from bond prices
In broad terms, a credit rating gives an indication of the creditworthiness of a bond. A

typical categorisation system – such as that used by Standard & Poor’s – assigns a grade
of AAA to the most creditworthy bonds, which are deemed to have almost no chance of
defaulting. AA is then the next best rating, then A, then BBB, then BB and so on. The
process of credit rating is discussed in Chapter 10.
Zero-coupon yield curves are derived by a process called bootstrapping – more on this
in Chapter 11 of the course. The curves so derived can then be used to value other
bonds. The diagram below shows a typical pattern of zero-coupon yield margins, where
AAA, AA and A are progressively less secure rating categories.
Example
Historical evidence suggests that the average probability of default within the next 5
years by a corporate bond currently rated AAA by Standard & Poor’s is about 0.1%,
whereas for a bond rated BBB the corresponding probability is over 2%.

margin over
risk-free
rate
(% pa) A
AA
AAA
0 term (years)
Figure 3.1: Margin over risk-free rate
The higher yield on corporate bonds is entirely due to compensation for the
additional risk from investing in these instruments. It is generally accepted that
there are two primary additional risks:
1. Default risk – which is the risk that the issuer will not be in a position to
make payment of the interest or redemption payments, either on the due
dates or at all.
2. Liquidity risk (strictly marketability risk) – which is the risk that a holder of
the bond will not be able to realise value for it in certain market
conditions. This might be because the bond has certain unusual terms or
covenants, or because the issue is small and unlikely to be attractive to
major investors.
These two risks are not necessarily independent. For example if a company is in
financial difficulties, not only may it be more likely to default on debt interest
payments, but the debt may also be less marketable. Also market liquidity tends
to be less at times of economic distress when overall defaults will tend to be
higher.
Corporate bonds typically yield more than comparable Treasury bonds.

Bond traders construct zero-coupon yield curves for bonds of different credit
rating categories and by comparing these to comparable Treasury curves we can
see the magnitude of this excess credit spread for different maturities. The
credit spread typically is significantly in excess of historic default losses, so that
an investor could expect significantly higher returns from investing in corporate
bonds than from investing in Treasury bonds.
2.3 Actual default losses based on historical data
Actual default losses can be calculated using historical data.
The excess of the yield on corporate bonds over Treasury bonds is typically
decomposed into four components:
1. Compensation for expected defaults.
2. Investors may expect future defaults to exceed historic levels.
3. Compensation for the risk of higher defaults, ie a credit risk premium.
4. A residual that includes the compensation for the liquidity risk — typically
referred to as an illiquidity premium.
Question 3.6
Why is part of the higher yield on corporate bonds compensation for the risk of higher
defaults over and above that indicated from historical data?
Quantifying this decomposition is a major area of current research. Techniques

being considered include the use of option pricing models using equity volatility
to estimate the risk of default (see Chapter 12), and the use of credit default
swaps (see Section 2.4 below) to estimate the market premium for credit risk.
2.4 Credit derivatives
One way of managing credit risk is by the use of credit derivatives – contracts
where the payoff depends partly upon the creditworthiness of one (or more)
commercial (or sovereign) bond issuers. The two most common types of credit
derivative are:
1. credit default swaps
2. credit spread options.
We also touch on credit-linked notes in the discussion that follows.

Credit default swaps
A credit default swap is a contract that provides a payment if a particular event

occurs. For example, it may give Bank X the right to sell a bond issued by utility
Company Y to Bank Z for the face value of the bond should Company Y default on the
bond. The bond involved is sometimes referred to as the reference bond.
Events that trigger payments under credit derivatives are known as credit events.
Examples of credit events include:
 bankruptcy (insolvency, winding-up, appointment of a receiver)
 a rating downgrade
 repudiation – when the debt issuer simply chooses to cancel all of the
outstanding interest payments and the capital repayment of the debt
 failure to pay a particular coupon
 cross-default. A cross-default clause on a bond means that a credit event on
another security of the issuing firm will also be considered as a credit event on
the bond in question.
In addition, it is important to note that default does not necessarily mean that all the
money loaned is lost. In fact, it is usually possible to recover (eventually) at least some
of the money loaned, the proportion recovered being referred to as the recovery.
The party that buys the protection pays a fee to the party that sells the
protection. If the credit event occurs within the term of the contract a payment is
made from the seller to the buyer. If the credit event does not occur within the
term of the contract, the buyer receives no monetary payment but has benefited
from the protection during the tenure of the contract.
So, in the example above, Bank X would pay a fee to Bank Z, typically in the form of a
regular premium over the term of the swap. By doing so, it would effectively be
purchasing insurance against the risk of the bond defaulting.
There are two ways to settle a claim under a credit default swap:
1. A pure cash payment, representing the fall in the market price of the
defaulted security. However, the market value may be difficult to
determine.
2. The exchange of both cash and a security (physical settlement). The
protection seller pays the buyer the full notional amount and receives, in
return, the defaulted security.

In practice, settlement is often based on the difference between the face value of the
bond and the value of the recovery, R. So, in the first case, a cash payment based on
100 - R would be made, whereas in the second case, the bond (now worth R) would be
handed over and a cash payment of 100 made. Either way, the net payment to the buyer
of protection in the event of default is based on 100 - R .
Banks have historically been the largest users of credit default swaps, although
institutional investors have become significant participants in the market.
Lenders who have reached their internal credit limit with a particular client, but
wish to maintain their relationship with that client can use credit default swaps to
reduce their aggregate exposure to the client. Institutional investors use credit
default swaps to increase or reduce their credit exposure to the underlying bond
issuers.
Question 3.7
Explain what you think the last sentence could mean in the context of Bank X and
Company Y mentioned above.
Given the relationship need, the main users of credit default swaps are banks.
A credit-linked note consists of a basic security plus an embedded credit default

swap. They provide a useful way of stripping and repackaging credit risk.
Credit-linked notes are discussed in a little more detail in Chapter 4. They consist of a
credit default swap (which has already been discussed) embedded within a traditional
bond.
Credit spread options
A credit spread option is an option on the spread between the yields earned on
two assets, which provides a payoff when the spread exceeds some level (the
strike spread). The payoff could be calculated as the difference between the
value of the bond with the strike spread and the market value of the bond.
Like most other options, a credit spread option will typically have a strike date. In
addition, it will have a strike spread, of say 1%. Thus, a simple credit spread option
might give the holder the option to sell a corporate bond on the strike date and at a price
corresponding to the specified spread of 1% above the corresponding government bond
yield.

If the actual spread on the exercise date turns out to be 1.25% (ie the bond’s price has
fallen relative to the corresponding government bond, presumably due to a worsening of
its credit quality), then the holder will exercise the option, as he can sell the bond at a
price above the current market price. Conversely, if the spread turns out to be less than
0.9% (ie the bond is dear), he will not do so as he can sell it at a higher price in the
market. A credit spread option therefore provides protection against a widening of
credit spreads.
Question 3.8
Suppose that Bank X is concerned about the risk that its portfolio of utility company
long-term bonds might fall greatly in value. Explain how it could use a credit spread
option to reduce its exposure to this risk.

3 Swaps, swaptions, options and forwards
3.1 Swaps
A swap is an agreement between two parties to exchange cashflows in the

future. The agreement defines the dates when the cashflows are to be paid and
the way that they are to be calculated. Usually, the calculation of the cashflows
involves the future values of one or more market variables (eg interest rates,
security prices, commodity prices or currencies).
Interest rate swaps
In a “plain vanilla” interest rate swap (also known as a “par swap”), Company B
agrees to pay Company A cashflows equal to interest at a predetermined fixed
rate on a notional principal for a number of years. At the same time, Company A
agrees to pay Company B cashflows equal to interest at a floating rate on the
same notional principal for the same period of time. The currencies of the two
sets of cashflows are the same.
Note that:
 The notional principal is used only for the calculation of interest payments.
The principal itself is not exchanged.
 The floating-rate payment to be paid at a particular date is usually based on the

value of the relevant floating rate at the previous cashflow payment date. This
means that at any time the monetary amount of the next floating payment is
always known. In many interest rate swaps, the floating rate is LIBOR.
 It is also possible to have an interest rate swap in which both sets of cashflows
are based upon (different) floating rates.
 The phrase plain vanilla is used here because we are referring to the most basic
form of interest rate swap. Other more complicated swaps are often referred to
as exotic swaps. The terms vanilla and exotic are also used in connection with
other types of security, such as options.
Question 3.9
What is LIBOR?

Let’s look at an example of the cashflows under a “plain vanilla” swap.
Example
Consider a 5-year interest rate swap based on a notional principal of $50 million.
Under the terms of the swap, Company B agrees to make interest payments annually in
arrears based on a fixed interest rate of 6% pa, in return for which Company A makes
corresponding variable interest rate payments based on the 1-year (spot) LIBOR rate.
The cashflows paid can be represented in a diagram.
LIBOR
Company A Company B
6% Fixed
Note that on both the above diagram and all those that follow, the arrows represent the
direction of the interest rate payments.
Question 3.10
Complete the table below showing the cashflows actually paid and received by
Company A under the swap agreement in the above example.
Time LIBOR Floating Fixed payment Net cashflow to

payment paid received at Company A at year
(%, at start of
at year end year end end
year)
1 6.6
2 6.3
3 5.8
4 5.7
5 6.1

Using a swap to transform the nature of the liabilities and assets
The swap contract has the effect of transforming the nature of the liabilities. In
the example above, Company B can use the swap to transform a floating-rate
loan into a fixed-rate loan, while, for Company A, the swap has the effect of
transforming a fixed-rate loan into a floating-rate loan.
In the example above, suppose that Company B has previously agreed to borrow from
an external lender at a floating rate of LIBOR + ½% pa. In addition, Company A has
already borrowed from another source at a fixed rate of 6¼% pa. Once the swap has
been set up, Company B will have the following sets of cashflows:
 it will be paying a floating rate of LIBOR + ½% pa to its external lender
 it will be receiving a floating rate of LIBOR from Company A
 it will be paying a fixed rate of 6% pa to Company A.
The net effect of combining the three sets of cashflows is:
– (LIBOR + ½) + (LIBOR) – 6 = – 6½%
ie Company B will be a net borrower at a fixed rate of 6½% pa.
Question 3.11
At what floating interest rate will Company A be a net borrower under this swap?
The overall position of the two companies is illustrated in Figure 3.2.
LIBOR
LIBOR + ½%
Company A Company B
6¼% Fixed 6% Fixed
Figure 3.2: A and B use a swap to transform the nature of their liabilities
Equally, swaps can be used to transform the nature of an asset from one earning
a fixed rate of interest into one earning a floating rate of interest (or vice versa).
Thus, for example, a swap can be used in a similar way to that above when companies
A and B have previously agreed to lend to external borrowers at floating and fixed rates
respectively.

Arranging a swap
Usually, two non-financial companies do not get in touch directly to arrange a

swap. They each deal with a financial intermediary (such as a bank) which is
remunerated by the difference between the value of a pair of offsetting
transactions, providing neither client defaults on their swap.
Suppose that the swap between Companies A and B is arranged by a bank. The
resulting situation is illustrated in Figure 3.3 below.
Bank
LIBOR LIBOR
5.9% Fixed
6.1% Fixed
LIBOR + ½%
Company A Company B
6¼% Fixed
Figure 3.3: Interest rate swap with a bank as intermediary
In this case:
 A is a net borrower at a floating rate of LIBOR + 0.35% pa, ie 0.1% pa more
than before
 B is a net borrower at a fixed rate of 6.6% pa, ie 0.1% pa more than before
 providing neither A nor B defaults on their swap, the bank as intermediary will
end up making a profit of 0.2% pa on the principal of $50 million,
ie $100,000 pa for the 5-year life of the swap.
Question 3.12
Explain why the bank makes a profit of 0.2% pa.

The intermediary has two separate contracts, one with Company A and the other
with Company B. (In most instances, Company A will not even know that the
intermediary has entered into an offsetting swap with Company B, and vice
versa. ) If one of the companies defaults, the intermediary still has to honour its
agreement with the other company. The spread earned by the intermediary is
partly to compensate it for the default risk it is bearing. (In practice, any
outstanding risk to the intermediary is normally collateralised with securities,
minimising the default risk – these securities are deposited with the intermediary and
retained in the event of default by the counterparty. )
In practice, it is unlikely that two companies will contact an intermediary at the

same time and want to take opposite positions in exactly the same swap. For
this reason, a large financial institution will be prepared to enter into a swap
without having an offsetting swap with another counterparty in place. This is
known as warehousing swaps.
In this case the bank should assess carefully the risks it is taking on and may decide to
hedge them, for example using appropriate forwards and futures.
If we assume no possibility of default (which is reasonable when collateralised),

an interest rate swap can be valued as a long position in one bond compared to
a short position in another bond, since the notional principal is the same in both
cases. Alternatively, it can be valued as a portfolio of forward rate agreements.
In Chapter 11 we will consider in detail how both of these approaches can be used to
value swaps.
Question 3.13
Why is the principal not exchanged in an interest rate swap?
Variations
Variations on the vanilla interest rate swap described above include:

 zero coupon swaps (where each individual payment under the par swap is
traded separately)
 amortising swaps (where the principal reduces in a predetermined way)
 step-up swaps (where the principal increases in a predetermined way)
 deferred swaps or forward swaps (where the swap does not commence
immediately and so the parties do not begin to exchange interest payments
until some future date)

 constant maturity swaps, CMS, (where the floating leg of the swap is for a
longer maturity than the frequency of payments).
Whereas in a vanilla interest rate swap the floating leg might be a 6-month
interest rate paid, and reset, every 6 months, in a CMS the floating leg
might be a 5-year market interest rate but paid, and reset to current
market levels, every 6 months.
The duration of the fixed flows under the swap remains constant during
the swap’s life).
For example, imagine a UK investor believes that the difference between the
6-month LIBOR rate will fall relative to the 3-year swap rate for £ sterling. To
take advantage of this, the investor can buy a CMS, paying the 6-month LIBOR
rate and receiving the 3-year swap rate.
 extendable swaps (where one party has the option to extend the life of the
swap beyond a specified period)
 puttable swaps (where one party has the option to terminate the swap
early).
Of the above, zero coupon swaps are the most widely used variation by
institutional investors as they allow more precise hedging of interest rate risk
than par swaps alone would permit.
Currency swaps
Another popular type of swap is the currency swap. In its simplest form, this
involves exchanging principal and interest payments in one currency for
principal and interest payments in another currency. This requires that a
principal be specified in each of the two currencies – these are usually chosen to
be approximately equivalent using the exchange rate at the time the swap is
initiated. The principal amounts are usually exchanged at the beginning and at
the end of the life of the swap – as the companies involved normally want to borrow
the actual currencies.

Example
Suppose that Companies A and B undertake a 3-year currency swap in which A lends
£50 million to B at a fixed rate of 5% pa payable annually in arrears. In return, A
borrows $75 million from B at a fixed rate of 4% pa. Company A’s cashflows under
the swap will be as follows.
Time $ cashflow £ cashflow

0 +75 –50
1 –3 +2.5
2 –3 +2.5
3 –78 +52.5
Such a swap can be used to transform borrowings in one currency into

borrowings in another currency. It can also be used to transform the nature of
assets.
The principles involved here are analogous to those discussed with regard to interest
rate swaps. Thus, if A can borrow £50 million at 5% pa fixed, then undertaking the
swap would enable it to transform its borrowing into dollars at 4% pa fixed.
Again, the currency swap can be valued (in the absence of default risk) as a
position in two bonds. The value can therefore be determined from interest rates
in the two currencies and the spot exchange rate.
Question 3.14
Suppose in the previous example that immediately after the cashflows have been
exchanged at the end of the first year, the sterling interest rate is 4.50% pa at all terms,
the dollar interest rate is 3.75% pa at all terms (both continuously compounded) and the
spot exchange rate is $1.41/£1.00. What is the sterling value of the swap to
Company A?
We talk a lot more about the uses of swaps in portfolio management in Chapter 22.

Other types of swap
 Total return swaps – in recent years, and particularly following the growth
in structured products and exchange traded fund markets, total return
swaps have become commonplace. The most common approach is for
the receiver to receive the total return on a reference asset, in return for
paying the reference floating rate (eg 3 month LIBOR) plus or minus an
adjustment. The adjustment will allow for the net effect of hedging costs,
financing costs and dealing spreads. Total return swaps are available on
a wide range of equity, credit, interest rate, currency and commodity
assets.
Other common types of swap include:
 RPI and LPI swaps (swapping fixed rate for “index” return)
An RPI swap links one set of payments to the level of the retail price index
(RPI). Under an LPI (limited price indexation) swap the payments are again
linked to the RPI, but capped at a maximum rate, which is normally set at
between 0% and 5% pa.
 cross-currency swaps or currency coupon swaps (exchanging a fixed
interest rate in one currency for a floating interest rate in another
currency. This is a combination of an interest rate swap and a currency
swap. )
 Dividend swaps (Exchanging the dividends received on a reference pool
of equities in return for a fixed rate).
 Variance or volatility swaps (Exchanging a fixed rate in return for the
experienced variance or volatility of price changes of a reference asset).
 Asset swaps – exchanging the fixed cashflows due from a bond or other
fixed income asset in return for floating interest rates.
 commodity swaps – where one set of cashflows is exchanged for another based
on the current market price of a particular commodity.
Of course, the different types of swap can be combined in practice. So, it may be
possible to enter into an extendable equity swap or an amortising LPI swap.

3.2 Swaptions
One further development is the swaption (or option on swaps), which provides
one party with the right to enter into a certain swap at a certain time in the future.
Suppose a company knows that:

 in 1 year’s time it will be entering an agreement to borrow at a floating rate of
interest over a 3-year period
 it will want to swap the floating interest payments for a series of fixed interest
rate payments.
It could enter into a swaption (by paying a premium now) which gives it the option to
receive LIBOR in return for paying, say, 5% pa fixed for a 3-year period starting in 1
year’s time.
If in a year’s time the fixed rate that can be paid in exchange for receiving LIBOR
within a 3-year swap is greater than 5% pa, then it will choose to exercise the swaption
and obtain the swap on more favourable terms than those then available in the market at
that time. If instead the fixed rate turns out to be less than 5% pa, then it will choose
not to exercise the swaption and will instead obtain the swap on more favourable
current market terms.
Thus, a swaption can be used to provide companies with a guarantee that the
fixed rate of interest they will pay on a loan at some future time will not exceed
some level. The company is able to benefit from favourable interest rate
movements while acquiring protection from unfavourable variations. This can
be particularly useful for insurers wishing to offer policyholders the option of a
fixed rate product (eg guaranteed annuity options).
Equally, swaptions can be used to place a limit on a floating rate, by providing the
company with the option to swap that floating rate for a fixed rate.
Question 3.15
How does a swaption differ from a forward swap?

Swaptions are normally classified into three types, European, American and
Bermudan.
 A European swaption gives the holder the right, but not the obligation, to
enter into a swap at the strike rate at a fixed expiry date in the future.
 An American swaption gives the holder the right, but not the obligation, to
enter into a swap at the strike rate at any date up to the expiry date.
 A Bermudan swaption gives the holder the right, but not the obligation, to
enter into a swap at the strike rate at multiple fixed dates.
We will consider how to value swaptions in Chapter 12.
3.3 Options
We have seen that an interest rate swap can be thought of as an agreement to swap a
fixed-rate bond for a floating-rate bond. Furthermore it can be shown that at the start of
a swap, the value of the floating-rate bond is always equal to the principal amount of the
swap – this is discussed further in Part 3 of the course.
A swaption can be regarded as an option to exchange a fixed-rate bond for the

principal amount of the swap – a put option in the case of paying fixed and
receiving floating, a call option in the other direction.
Question 3.16
Why is a swaption equivalent to a put option in the case of paying fixed and receiving
floating?
As such, a swaption is an example of a more general class of bond option –

options to buy (or sell) a particular bond by a certain date for a particular price.
Such contracts may be traded separately or may be embedded into conventional
bonds to create puttable or callable bonds. The former allows the holder to
demand early redemption at a predetermined price at certain times in the future,
while the latter allows the issuing firm to buy back the bond at a predetermined
price at certain times in the future.
A callable bond is not normally callable during the first few years of its life. Thereafter
the predetermined strike price of a callable bond is usually a decreasing function of
term. Thus, the issuer might first be able to redeem the bond at a price of 112 after 5
years, 110 after 6 years, 108 after 7 years and so on. A callable bond will generally
offer a higher yield than an otherwise identical bond with no option features, whereas
the reverse is true of a puttable bond.

Similarly, loan and deposit instruments can also contain embedded options – for
example, prepayment provisions on loans and mortgages. These are effectively
call options on bonds because they give the borrower the right to buy back the loan
from the lender.
Question 3.17
Why will a callable bond generally offer a higher yield than an otherwise identical bond
with no option features?
We discuss options and their uses further in Chapter 22.
3.4 Forwards
For currencies, the simplest form of derivative contract is probably the forward –
an agreement to buy (or sell) an asset at a certain future time for a certain price.
Such contracts are traded in the over-the-counter market, and are commonly
used to hedge foreign currency risk.
The price in a forward contract is known as the delivery price. It is chosen so that the
value of the forward contract to both sides is zero at the time it is entered into.
Question 3.18
Suppose that a European bank needs to buy $1 million in 6 months’ time. How can it
use forwards to hedge the risk that the value of the Euro decreases against the dollar?
Forwards also exist in respect of interest rates – a forward-rate agreement (FRA)

is a forward contract where the parties agree that a certain interest rate will apply
to a certain principal amount during a specified future time period. Thus, an
interest rate swap can be regarded as a portfolio of forward-rate agreements.
Equally, a currency swap can be decomposed into a series of forward contracts.
Recall the 5-year swap between Companies A and B illustrated in Figure 3.2 above,
which is reproduced below.
LIBOR
Company A Company B
6% Fixed

This involved an agreement to exchange five sets of cashflows, an exchange occurring

at the end of each of the next five years. Although the first exchange is known at the
time the swap is agreed (as the first floating rate payment will be based on the level of
the floating rate at outset), the other four exchanges can each be considered as FRAs.
Note that, while the swap will usually be constructed to have zero initial value,
this does not mean that each of the individual forward contracts underlying the
swap also has zero value – rather, some will have positive and some negative
expected values. This is important when the credit risk in the swap is being
evaluated.
Thus, in the swap between A and B:

 value of FRA to A > 0 when forward rate < 6%
 value of FRA to A = 0 when forward rate = 6%
 value of FRA to A < 0 when forward rate > 6%.
Hence, if the term structure of interest rates slopes downward at the time the swap is
agreed then the later forward rates must be lower than the earlier ones. Thus, given that
the total value of the FRAs is zero, the values of the later FRAs must be positive for A
and the values of the earlier FRAs must be negative.
Question 3.19
How would the values of the FRAs vary for Company B if the term structure of interest
rates was upward-sloping?

4 Private debt
Definition
The term private debt refers to loan capital issued by companies that is not publicly
listed and traded on a stock exchange.
Private debt (or “private placement”) is a debt capital market transaction that
generally has covenant features similar to a bank loan and is often used as an
alternative to bank funding.
Covenants are requirements or restrictions placed on the borrower when a loan is

undertaken. They aim to provide a degree of security for the lender and may involve
either:
 a requirement to do something (a positive covenant), eg to meet specified
financial or non-financial criteria
 a requirement not to do something (a negative covenant), eg not to sell certain
assets used as security for a loan or not to borrow from third parties.
4.1 Typical features of private debt
Unlike a traditional public debt market transaction which is distributed to a wide

range of investors and can trade in an active secondary market, private debt is
not actively traded. Typically, it will be marketed to a much smaller number of
long-term “buy and hold” investors, with the deal eventually being distributed to
between 6 and 12 interested parties.
Thus, it is generally a lot less marketable than publicly issued debt, as it is neither
widely held nor actively traded. This is reinforced by the issue sizes involved, which
are typically smaller than in the public debt market. Private debt is typically issued by
small and medium-sized companies, usually in their first forays into raising additional
finance.
Although private debt can be issued in any major currency, most issues are
fixed-rate US dollar-denominated transactions. Private debt is issued for a range
of long-term maturities longer than three years for amounts ranging from £10m
to £300–400m.
When weighing up investment opportunities, private debt investors tend to be

very focused on covenant protection since illiquid markets mean they may be
unable to sell their private debt investments in the event of a credit downturn.

They may therefore demand a number of covenants, both imposing requirements and
restricting the activities of the borrower, in order to safeguard the security of the loan.
4.2 Reasons for issuing private debt
Although a private debt issuer almost inevitably cedes covenants to investors,

this is more than compensated for by the fact that it is able to issue capital
market debt without acquiring a formal long-term debt rating. (A formal rating
from at least one recognised debt-rating agency is required for most public debt
issues.)
A key issue influencing the choice between a public or a private issue is the relative
cost involved.
Question 3.20
Although the administrative costs associated with issuing debt privately are lower, what
is likely to be a disadvantage of doing so compared to a public issue?
From a treasurer’s perspective, the private debt market represents a major

capital source with relatively competitive pricing. Accessing this market also
allows the treasurer to free up credit lines with relationship banks – ie the
company’s main providers of banking services. In other words, the private debt market
offers an alternative to borrowing from a bank.
Indeed, the vast majority of private debt transactions are undertaken by

treasurers who want to refinance existing term loans from banks, but who would
rather not go to the trouble and expense of obtaining a credit rating. However, a
treasurer may be able to improve his covenant bargaining position (or improve
his pricing) by obtaining a private rating from an external rating agency. This
obviously depends on the relative sizes of the cost of obtaining the rating and the saving
in borrowing costs.
In the sterling market, a financial covenant is required for any issue with a
maturity greater than ten years or a credit rating less than a single A. Covenants
in the sterling market vary according to the maturity of the deal and the industry
sector of the issuer.
Financial covenants relate to requirements that the borrower meets specified financial
criteria.

In communicating to the bank or banks, the treasurer will need to make clear the
purpose of the funding. This will enable the treasurer to determine the levels at
which the all-in cost of private debt makes economic sense for the company
relative to borrowing from relationship banks (given that the company usually has a
choice between the different sources of funding). The purpose of the funding is always
one of the key items of information that a lender will require before agreeing to buy any
debt.
Private debt funding is generally medium-term to long-term (in excess of three

years). Although private debt can be repaid early, this will require the issuer to
make a costly “make whole” premium (usually around 50 basis points) – to
compensate the lender for the earlier than anticipated redemption. For this reason,
private debt will usually run until its final maturity.
Exact details of any “make whole” premium will be included in the legal documentation
issued with the debt.
Question 3.21
Give 3 possible examples of financial covenants that might be required for a private
debt issue.

Chapter 3 Summary
Money markets and money market instruments
The money market is a virtual market place of electronic communications between

banks, dealers and companies. Most money market instruments are issued at a discount
and redeemed at par.
Money market investments include:

 Treasury bills – these are short-term investments, issued by the national
government. They offer the lowest default risk amongst money market
instruments.
 Commercial paper – consists of unsecured notes issued directly by companies.
The rate of interest on commercial paper will generally be slightly higher than
that on an equivalent Treasury bill, the size of the margin depending on the
company’s credit rating.
 Repos – a repo (or repurchase agreement) is a form of secured lending whereby
an investor buys Treasury bills from a dealer who, in turn, agrees to buy them
back again at a later date at a specified (higher) price.
 Government agency securities – bills issued by a near-government sector of the
market.
 Bank time deposits – bank deposits with a specified term. If the investor wants
to access their investment before the maturity date he may be allowed to do so,
but a penalty will be imposed, eg the interest rate might be reduced.
 Bankers’ acceptances and eligible bills – a form of tradable invoice that has
been accepted (ie guaranteed) by a bank.
For companies looking to borrow in the money markets, the available options include:
 issuing commercial paper
 issuing eligible bills
 arranging a term loan from a bank
 arranging a line of credit with a bank – this could be either evergreen
(permission to borrow up to specified limit with no fixed maturity date) or
revolving (has a fixed maturity date)
 arranging a bridging loan from a bank
 arranging international bank loans.

Corporate debt
The higher yield on corporate bonds is due to default risk and liquidity risk. These two
risks are not necessarily independent. The excess of the yield on corporate bonds over
government bonds is made up of:
• Compensation for expected defaults.

• Investors may expect future defaults to exceed historic levels.
• A credit risk premium.
• An illiquidity premium.
Credit derivatives
Credit derivatives can be used to manage exposure to credit risk, the risk that a
counterparty defaults on a legal obligation to make a payment.
A credit default swap provides a payment if a particular credit event occurs, eg the
issuer of a bond defaults.
A credit spread option is an option on the spread between the yields earned on two
assets, which provides a payoff if the spread exceeds some level (the strike spread).
Swaps
A swap is an agreement between two parties to exchange cashflows in the future.
Swaps can be used to transform the nature of assets or liabilities and are arranged via a
financial intermediary.
In a “plain vanilla” interest rate swap, Company B agrees to pay Company A fixed
interest on a notional principal for a number of years in return for interest at a floating
rate on the same notional principal for the same period of time. The currencies of the
two sets of cashflows are the same. The principal itself is not exchanged.
An interest rate swap can be valued as a long position in one bond compared to a short
position in another bond, or as a portfolio of forward rate agreements.
A currency swap involves exchanging principal and interest payments in one currency
for principal and interest payments in another currency.

Other types of swap include:

 amortising swaps (principal reduces)
 step-up swaps (principal increases)
 deferred swaps or forward swaps (interest payments deferred)
 constant maturity swaps (floating leg has longer maturity than the frequency of
payments)
 RPI swaps and LPI swaps (swap fixed for index)
 cross-currency swaps or currency coupon swaps (swap fixed in one currency for
floating in another)
 extendable swaps (one party can extend life of swap)
 puttable swaps (one party can end swap early)
 equity swaps (swap equity index for interest rate)
 commodity swaps (cashflows based on commodity prices)
 asset swaps (cashflows from one asset are swapped for LIBOR)
 volatility and variance swaps.
Swaptions
A swaption gives one party the right to enter into a certain swap at a certain time in the
future on terms specified now.
Options
A swaption can be regarded as an example of a bond option, ie an option to buy (or sell)
a specified bond on a specified date for a specified price.
Puttable and callable bonds are conventional bonds that contain embedded options.
Forwards
A forward is an over-the-counter agreement to buy (or sell) an asset at a certain future

time for a certain price.
A forward-rate agreement (FRA) is a forward contract where the parties agree that a
certain interest rate will apply to a certain principal amount during a specified future
time period. Thus, an interest rate swap can be considered as a series of FRAs.

Private debt
Private debt refers to bonds that are not listed. Private debt generally has covenant
features similar to a bank loan and is often used as an alternative to bank funding. It is:
 not actively traded
 generally medium-term to long-term
 issued by small and medium-sized companies that do not wish to incur the
expense of a public issue.

Chapter 3 Solutions
Solution 3.1
You might have mentioned:

 Treasury bills
 local authority bills
 bills of exchange
 certificates of deposit (CDs)
 term deposits
 call deposits.
Solution 3.2
Reasons are:
 The short-term future is more certain than the long-term future. Investors can be
more confident that a particular company will survive a few weeks than they can
that it will survive the next twenty years.
 Only the more reliable companies can borrow using short-term instruments such
as commercial paper.
Solution 3.3
A bank time deposit is a bank deposit that has a specified term. If the investor wants to
access their investment before the maturity date they may be allowed to do so, but a
penalty will be imposed, eg the interest rate might be reduced.

Solution 3.4
There are two types of factoring: non-recourse and recourse (or invoice discounting).
1. Non-recourse factoring is where the supplier sells on its trade debts to a factor in
order to obtain cash payment of the accounts before their actual due date. The
factor takes the credit risk and also responsibility for credit analysis of new
accounts and payment collection.
2. With recourse factoring, a copy of the invoice is sent to the factor who then
gives the supplying company the money up front equal to a percentage of the
invoices it sends out. The credit risk remains with the supplying company who
is still responsible for collecting its debts. When the supplying company
eventually gets paid by a customer, it passes the money on to the factor.
Effectively, recourse factoring is a loan which is secured against the invoices.
Solution 3.5
Liquid assets are current assets, eg stocks and debtors.
Solution 3.6
This is because bond investors are typically risk-averse. So they will demand higher
returns from riskier bonds even after allowing for the expected default losses because of
the greater uncertainty regarding the returns provided.
Solution 3.7
Suppose that Bank X has decided to limit its exposure to any particular borrower to a
certain limit (eg 10% of its total lending) in order to avoid undue credit risk and that its
exposure to Company Y has already reached that limit. It may nevertheless wish to
provide further loans to Company Y – eg by buying part of a new bond issued by
Company Y – in order to maintain a good working relationship with it. It can achieve
this, without breaching its credit exposure limit, by entering into a credit default swap
with Bank Z based on the bond issued by Company Y.

Solution 3.8
Bank X could purchase a credit spread option which provides a payoff whenever the
average yield on its portfolio of utility company long-term bonds exceeds that on a
portfolio of similar government bonds by more than, say, 2% pa. By doing so, it would
limit its exposure to possible falls in the value of its utility bond portfolio.
Solution 3.9
LIBOR is short for the London Interbank Offered Rate. Broadly speaking, a LIBOR
rate is the short-term spot interest rate at which one large international bank is willing to
lend money to another large international bank. More specifically, LIBOR rates are the
rates of interest offered between Eurocurrency banks for fixed-term deposits.
A series of LIBOR rates exists for different terms (from overnight lending up to
12 months) in many of the major currencies. These include the Euro, US dollars,
UK sterling, Japanese yen, Swiss francs, Australian dollars and New Zealand dollars.
LIBOR zero rates are generally higher than the corresponding Treasury Bill rates. This
is because they are not risk-free, as banks are able to default on their loans.
The floating-rate payments under many interest rate derivatives are based on LIBOR
rates.
Solution 3.10
Company A’s cashflows (in $ millions)
Time LIBOR Floating Fixed payment Net cashflow

(%, at year payment paid received to Company A
start)
1 6.6 3.30 3.00 –0.30
2 6.3 3.15 3.00 –0.15
3 5.8 2.90 3.00 +0.10
4 5.7 2.85 3.00 +0.15
5 6.1 3.05 3.00 –0.05

Solution 3.11
Once the swap has been set up, Company A will have the following sets of cashflows:
 It will be paying a fixed rate of 6¼% to its external lender.
 It will be receiving a fixed rate of 6% from Company B.
 It will be paying a floating rate of LIBOR to Company B.
The net effect of combining the three sets of cashflows is:
– 6¼ + 6 – LIBOR = – (LIBOR + ¼)%
ie Company A will be a net borrower at a floating rate of LIBOR + ¼% pa.
Solution 3.12
The bank makes a profit of 0.2% pa because:

 It receives floating payments at LIBOR from A and makes floating payments at
LIBOR to B. It therefore makes neither a profit nor a loss on the floating rate.
 It receives fixed payments at 6.1% from B and pays fixed payments at 5.9% to
A. It therefore makes a profit of 0.2% on the fixed rate.
The bank’s total profit is therefore equal to 0.2% pa.
Solution 3.13
The principal is not exchanged in an interest rate swap because it is exactly the same on
both sides of the agreement, ie it is the same absolute amount in the same currency.

Solution 3.14
The (sterling) present value of the sterling payments received can be valued as a 2-year
sterling bond to give:
B£ = 2.5e -0.045 + 52.5e -0.045¥ 2 = 50.371
The (dollar) present value of the dollar payments received can be valued as a 2-year
dollar bond to give:
B$ = 3e -0.0375 + 78e -0.0375¥ 2 = 75.254

The current sterling value of the dollar bond is thus:
75.254
= 53.371
1.41
So, the net present value of the swap to Company A is equal to:
50.371 – 53.371 = –£3.00 million
Solution 3.15
Whereas a swaption gives its holder the option of entering a swap agreement at a
specified future date, under a forward swap both parties are committed to undertaking
the swap at a specified future date.
Remember that a swaption is an option that just happens to be an option on a swap, as

opposed to some other type of underlying asset.
Solution 3.16
Consider the case of a swaption, which gives you the option to pay fixed and receive
floating. If you include the notional principal, then the paying fixed side of the swap is
the equivalent of selling a fixed interest bond to the other party (ie they pay you a
principal now and in return you pay a series of fixed interest payments and return the
principal at the end of the term). Similarly, the receiving floating side is equivalent to
buying a floating rate bond (ie you pay a principal now and in return you receive a
series of floating interest payments and also the principal back at the end of the term).

In Chapter 11, we show that the value of a floating rate bond on the day it is issued is
always simply equal to the amount of the principal. (Intuitively this is because our best
estimates of the future variable payments are based on the current pattern of forward
rates, which are also used to discount those same payments. Thus, although any
increase in future rates is consistent with higher expected future cashflows, it also
means that those cashflows are discounted more heavily in order to calculate their
present value. )
Thus, the present value of the floating rate bond payments we receive is simply equal to
the principal amount. Hence, in entering the swap we have effectively agreed to sell a
fixed interest bond in return for the principal amount of the (floating rate) bond.
A swaption therefore gives us the option to effectively sell a fixed interest bond in
return for the principal amount of the (floating rate) bond and so is equivalent to a put
option on a fixed interest bond.
The same argument applies in reverse for a call option.
Solution 3.17
A callable bond will generally offer a higher yield than an otherwise identical bond with
no option features because it includes an option that can be exercised against the holder.
The fact that the issuer can choose to redeem the bond early (or not) leads to greater
uncertainty for the holder, for which it requires compensation in the form of a higher
yield.
Solution 3.18
The bank could buy a 6-month forward contract under which it agrees now the rate at
which it can exchange (sell) Euros for dollars on a certain principal amount in
6 months’ time.
Solution 3.19
In the swap between A and B, B is paying fixed and receiving floating. Thus:
 value of FRA to B < 0 when forward rate < 6%
 value of FRA to B = 0 when forward rate = 6%
 value of FRA to B > 0 when forward rate > 6%.

Hence, if the term structure of interest rates slopes upward at the time the swap is
agreed then the later forward rates must be higher than the earlier ones. Thus, given
that the total value of the FRAs is zero, the values of the later FRAs must be positive for
B and the values of the earlier FRAs must be negative.
Solution 3.20
A key disadvantage of a private debt issue compared to a public issue is likely to be the
additional cost arising from the higher return required by investors to compensate them
for the greater risks involved – due to a lack of information and marketability.
Solution 3.21
Possible examples of financial covenants include:

 a minimum ratio of current assets to current liabilities
 a minimum required level of interest cover on the particular issue of private debt
and/or on all outstanding debt
 a limit on the total level of higher or equal ranking borrowing
 a limit on the total level of total outstanding debt – as any problems with lower
ranking debt may also lead to problems with the higher ranking debt
 limits on the payment of dividends, so as to retain sufficient funds to service the
debt.





the course.

Chapter 4
Specialist asset classes (2)
Syllabus objectives

financial instruments:
 asset-backed securities, securitisations
 venture capital
 hedge funds
 currency
 infrastructure
 commodities
 insurance-linked securities
 new ways of investing in old asset classes.
0 Introduction
In this chapter we conclude our look at specialist asset classes and markets by
considering:
 asset-backed securities and securitisations
 venture capital
 hedge funds
 currency
 infrastructure
 commodities
 new ways of investing in old asset classes.

New investment classes considered include index funds, exchange-traded funds (ETFs)
and contracts-for-difference (CFDs).
These are further types of securities that may offer various advantages to pension funds
and insurance companies when held alongside the more traditional asset classes such as
public bonds and equities, property and cash.

1 Securitisation
1.1 Definitions
Asset-backed securities result from the securitisation of a revenue generating

asset held by the borrower. They typically take the form of bonds.
Securitisation is the issue of securities, usually bonds, where the bonds are
serviced and repaid exclusively out of a defined element of future cashflow
owned by the issuer.
So, a securitisation typically involves the pooling together of a group of assets,

combined with the issue of one or more tranches of asset-backed securities. The
cashflows generated by the pooled assets are used to service the interest and capital
payments on the asset-backed securities. The assets pooled together are often not very
marketable. Securitisation therefore converts a bundle of assets into a structured
financial instrument which is then negotiable. In doing so, it offers:
 a way for a company to raise money, that is linked directly to the cashflow
receipts that it anticipates receiving in the future
 an alternative source of finance to issuing “normal” secured or unsecured bonds.
Importantly, bond-holders have no recourse to any other cashflow or assets of

the issuer. At the same time, securitisations are often structured so that the creditors of
the original company have no claim on the cashflows generated by the securitised
assets.
1.2 Classes of securitised assets
Originally, assets chosen for securitisation were homogenous debt obligations

(such as residential mortgages or trade receivables) subject to relatively simple
terms and conditions. The scope of securitisation and asset-backed securities
(ABS) has grown rapidly in recent years and now includes classes such as:
 residential and commercial mortgage-backed securities (MBS).
Here the payments are secured or collateralised on the interest and capital
payments made under mortgages used to buy property.
 credit card receivables (CCABS).
These are collateralised on the payments made by credit card holders to the
credit card company.
 collateralised loan, bond and debt obligations (CLO, CBO and CDOs).

These three types of security are typically collateralised on existing bank loans,
bonds and a mixture of both bank loans and bonds respectively.
 insurance securitisations (where a financial security is created that is

backed by the receivables arising from an insurance book).
Other classes of assets that have been used to create ABS include:
 loans used by consumers to buy cars and boats
 small business loans
 royalties paid to performers – eg a $55m issue of bonds collateralised on the
future royalties from a number of David Bowie albums.
Indeed, almost any assets that generate a reasonably predictable income stream can, in
principal, be used as the basis of an asset-backed security.
The underlying assets are generally below investment grade, and the associated
loans are typically over-collateralised, both in respect of initial assets and cash
flow margins. In other words, as the underlying assets are often quite risky, the
securitisation may be structured so that the value of the underlying assets and their
associated future cashflows are expected to cover the interest and capital payments of
the asset-backed securities with something to spare. Here sub-investment grade credits
refers to “junk bonds” – ie bonds whose credit rating is sufficiently low that insurance
companies and pension funds have traditionally not purchased them.
Securitisation has become particularly common when a pool of assets has been
assembled (often with considerable effort), but now offers the prospect of a
secure income stream with minimal additional management required. For
example, in 1998 the UK insurance company NPI issued bonds backed by the future
profits of part of its life insurance business, which it continues to manage. Indeed,
securitisation is becoming an important source of finance for insurance companies.
Prepayment risk
However, one problem for the provider of finance is prepayment risk – the risk
that the loan may be repaid earlier than originally anticipated because the
underlying assets have been redeemed. The purchaser of the ABS may therefore
not receive the pattern of cashflows originally anticipated.
Credit risk
The other main risk is credit risk – the risk that the cashflows generated by the
securitised assets will prove insufficient to cover the promised payments on the ABS.

Question 4.1
For which type of asset-backed security is prepayment risk usually of most relevance?
1.3 Special purpose vehicle
The framework of securitisation is that the original owner of the assets

(sometimes called the originator) sells those assets to a corporate entity
specifically established for the purpose, called a special purpose vehicle (SPV).
The SPV will be structured to be “bankruptcy remote” in the event of the failure
of the borrower, ie it is a separate legal entity, usually a company in its own right.
Hence, in the event of default by the SPV, the investor has no recourse to the assets of
the original owner and vice versa.
The SPV then raises the funds to purchase the assets by issuing debt securities,
such as bonds, to investors – these are the asset-backed securities. The receivables
transferred into the SPV meet the principal and interest liabilities on the debt. In
addition, the SPV may grant security over the receivables to secure its obligation
to repay principal and interest. In which case the investors in the SPV would be
entitled to claim the underlying assets in the event of default.
Company X Other Assets of

Secured Assets
Company X
Cashflows on X sells assets to

secured assets SPV in return for
belong to SPV initial capital
SPV
SPV pays interest & Investors pay initial

capital payments on capital to SPV in
ABS to investors return for ABS
Debtholders
Figure 4.1: Structure of securitisation arrangement

The basic structure of a securitisation arrangement is illustrated in Figure 4.1 above.

Company X sells the secured assets that will generate the future income stream to the
special purpose vehicle (SPV), which in turns raises the required funds to purchase
them by issuing (asset-backed) bonds to investors. The cashflow stream generated by
the secured assets is then paid to the SPV, which in turn uses them to meet the interest
and capital payments on the asset-backed bonds.
Credit-linked note
A credit-linked note (CLN) can be used by the holder of corporate bonds to transfer the
credit risk on those bonds to other investors. This is done by setting up an SPV, which
then sells CLNs to investors and uses the proceeds to buy risk-free Government bonds.
At the same time, the SPV also sells a credit default swap, based on the original
corporate bonds to the original bondholder.
Example
Suppose that the risky corporate bonds yield 4½% pa, the risk-free Government bonds
4% pa and therefore that the credit default swap fee is about ½% pa.
The regular cashflows (prior to any default) are then:

 original bondholder:
– receives 4½% pa from the corporate bonds
– pays ½% pa credit default swap fee to SPV
– leaving 4% pa net (ie the risk-free rate)
 SPV:
– receives 4% pa from the Government bonds
– receives ½% pa credit default swap fee
– giving a total of 4½% pa (ie the risky rate)
This 4½% pa is then passed onto the investors in the SPV, who effectively receive the
risky return on the original corporate bonds in return for taking on board the default
risk.

Question 4.2
Suppose that:
 the nominal amount of each of the corporate bonds, the Government bonds and
the CLNs is $100
 the original corporate bonds pay R (< $100) in the event of default.
Outline the cashflows that will be exchanged in the event of default by the issuers of the
original corporate bonds.
1.4 Format of the asset-backed securities
The borrowings are normally made in a multi-tranche format, such as the CDO
structure discussed below, with credit ratings or credit default protection obtained
for (at least) the major tranches. The tranches will be repaid in order of rating,
with the actual timing of amortisation / repayment dependent on the underlying
assets, early repayments on them and any default losses and recoveries.
The securitised assets are sometimes classified according to whether they are
amortising or non-amortising.
Question 4.3
What do you think the terms amortising loan and non-amortising loan mean?
Excess remaining collateralisation may be returned to the original asset owner or

kept by the bond holder. Conversely, arrangements may be put into place to cover any
shortfalls in the payments to the holders of the ABS. For example, the payments may
be guaranteed by a third party. The details of all such arrangements will all be set out in
the legal documentation governing the issue of the ABS and the prospectus published
when the ABS are first issued.
Thus, CLOs, CBOs and CDOs could involve combining the credit risks of
different instruments into a portfolio which is then divided and repackaged as
several new securities. In other words, a range of different bank loans and bonds is
pooled into a single portfolio of securitised assets, which is then used to back several
different tranches of ABS.

The new (asset-backed) securities are backed by the portfolio of bonds, and the
cashflows from the portfolio are divided up into tranches and assigned to the
different new securities created. The new securities are designed to have
different credit risk features, by construction.
This is so that they will appeal to a range of investors, who have different preferences
with regard to risk and return. By structuring the bond tranches in the way that best
meets the various requirements of the different potential investors, it may be possible to
reduce the overall cost of borrowing.
Thus the cashflows from the underlying portfolio might be used to create:
 a bond with fixed coupon rate. This is the most senior security and its
coupons are paid first. It is termed senior debt and might carry a AAA
rating.
 a bond whose coupons are paid as long as there is enough left after the
payments to the senior debt is made. This bond might carry a BB rating,
and is often known as the mezzanine piece or tranche.
 a claim on the residual cashflows from the original portfolio after the two
senior classes are paid. This third tranche might be a high-yield
speculative bond, or it might be considered as an equity claim.
Such a structure is called a collateralised debt obligation (CDO), if the underlying assets
are bank loans and/or bonds. However, a similar structure involving a number of
different tranches of ABS can be used irrespective of the underlying securitised assets.
Question 4.4
Why might a company that wants to raise money (via a securitisation) go to the trouble
and expense of setting up a multi-tranche securitisation, rather than just issuing a single
asset-backed security?
As with any other issue of securities, the issuing company will usually be advised by an
investment bank regarding such factors as the likely issue price and the most
appropriate way in which to structure the issue.

2 Private equity
Definition
Private equity is the provision of equity capital where there is no immediate exit
route via the secondary market. So, private equity is investment in unquoted
companies that are not listed on a stock exchange. Instead their shares are issued and
traded privately.
2.1 Forms of private equity
Private equity comes in two main forms:
1. venture capital – capital for businesses in the conceptual stage or where

products are not developed and revenues and/or profits may not have been
achieved.
Venture capitalists are rarely just “silent partners”, investing their capital and
then having no involvement in the operation of the business. Rather, their
expertise, their guidance, and possibly their contacts, are often crucial to the
success of the business. Indeed, some degree of involvement in the management
of the private company is often a precondition to investment in the first place.
2. leveraged buy-outs – equity capital for acquisition or refinancing of a larger

company.
This differs from an ordinary acquisition because the shares of the acquired
company no longer trade on the open market; instead, they are held by the
private equity investors. The acquisition will be funded largely by borrowing,
particularly if the buyers have insufficient personal funds to finance the entire
purchase themselves.
Management buy-outs are a form of leveraged buy-out in which the existing

management buy-out the existing owners of the company – ie buy their shares
and hence a controlling interest in the company. Similarly, a management buy-
in occurs when the buyer is an external management team. Typically such a
buy-out is highly leveraged (hence leveraged buy-out), as most of the money
raised to buy control is obtained by the borrowing. The resulting capital
structure is thus highly leveraged or geared, with the bonds issued typically
having non-investment or “junk” status.
After the buy-out or buy-in, the management of the private company typically
has a substantial equity stake in the company and so should have a large
incentive to try and ensure that the company is successful.

Other forms include:
 development capital – growth or expansion working capital for mature

businesses in need of product extension and/or market expansion.
This development capital may be provided en-route to a public issue when the
company is sufficiently large and profitable. It can be used to fund organic
growth, ie the expansion of existing lines of production, or new projects in
different markets.
 restructuring capital – new equity for financially or operationally distressed

companies.
These are situations in which an unquoted company may seek additional private equity
finance, whereas a quoted company may have a rights issue.
A management buy-out often involves replacing the existing public equity of the
company with new private equity, in which the buy-out team own a controlling interest.
Question 4.5
List the reasons why it might be advantageous to take a public company into private
ownership?
Private equity funds
Providers of private equity are often brought together in a private equity fund.
Private equity funds make unlisted investments. As such there is unlikely to be a

quoted price for the investment and there will be no easy way to sell the
investment, even in small amounts. Indeed there may well be restrictions on when
and how the investment may be sold, to which investors will have had to agree on
entry.
2.2 Advantages and disadvantages of private equity
Private equity funds may be appropriate owners of businesses where:

 the risk profile is unsuitable for public ownership
 the cost of capital may be reduced under private ownership (for example by
using very high levels of financial gearing), or
 where valuation is difficult in the public arena for any other reason.

So, there are circumstances where private equity finance may be a very appropriate
form of finance.
Question 4.6
Can you think of any disadvantages of venture capital finance to the current owners of a
business?
A move to private ownership will often be associated with management changes,

or at least a review of existing management’s financial incentives. This will usually
involve ensuring that the management’s compensation depends directly on the success
of the business, so as to ensure the alignment of investors’ and management’s interests.
Returns in private equity can be very high, as with any private business venture.
Private equity returns can be very mixed – some investments do spectacularly well and
some fail completely.
The risks associated with private equity vary considerably according to the form.
Initial “seed” venture capital may see 80% of ventures failing, while “development”
capital failures may be only 10%.
Private equity isn’t a homogeneous asset class. The different forms have very different
characteristics and levels of risk, as will the individual companies themselves.
Diversification within a private equity portfolio is therefore important.
Similarly, failure rates for restructuring capital will often be very high, compared to
management buy-ins and buy-outs.
Recall that a management buy-in is the provision of funds to an external management

team to enable them to buy into an established company. A management buy-out
involves providing funds to an existing management team to enable them to buy an
established company or part of a company, eg a particular product or division.

Proponents of private equity investment claim that:

 private equity out-performs (over the long term), although many venture
capital investments fail, those that do succeed often generate very high returns.
The main reason for investing in private equity is therefore the high returns that
may be available.
 it is a loosely correlated asset which may be able to enhance portfolio
performance without materially increasing risk, ie it’s good for
diversification.
Assessment of these claims is complicated by the impact of “survivorship” bias –

the fact that elimination of the disappearing (failed) ventures from the analysis will
bias the reported results upwards. The results demonstrate that there is an
exceptional premium to be gained from skilful management selection. As we’ve
noted, there is a wide variety of potential private equity investments. To do well from
these opportunities, specialist expertise is required.
As an example of survivorship bias, consider the share price data for the five companies
in the table below:
Return on
Company 1 January 2014 1 July 2014 1 January 2015 share over the
year
A £1.00 £1.20 £1.10 10%
B £1.00 £1.70 £2.40 140%
C £1.00 £2.10 £0.00 –100%
D £1.00 £1.05 £0.95 –5%
E £1.00 £0.40 £0.30 –70%
Company C collapsed in August and so the shares are worthless at the end of the year.
The actual return an investor who invested equally in the five companies would have
achieved is –5.0%. However, if a past performance table was being drawn up at the end
of the year and Company C was excluded as it no longer existed, the performance
shown would be 18.75%.
Question 4.7
What are the possible disadvantages of private equity to institutional investors?

Typically the highly risky nature of private equity investment has acted as a strong
deterrent to investment by more traditional investors. However, it is argued that the
potential for high returns and the opportunities they may provide for diversification
when compared to other more traditional investments should in fact make them suitable
investments for insurance companies and pension funds, at least as a small part of a
widely-diversified fund. This would also have the beneficial effect of making it easier
for private companies to raise funds.
Question 4.8
Which of the four main forms of private equity described towards the start of this
section are likely to be the most risky?
Investors can diversify risk by buying into quoted venture capital and development
capital investment trusts or by having segregated funds managed for them by
private equity firms. Use of a fund-of-funds (which invests in a number of other
private equity funds) offers greater diversification but usually involves a double
layer of fees.
So, the choices available for an investor who wants to invest in private equity are:
(i) do so directly by purchasing shares in private companies
(ii) pay a private equity firm to invest your capital for you
(iii) invest in a private equity collective vehicle, eg an investment trust
(iv) invest in a fund-of-funds – which invests in a range of private equity funds.
Note the difference between the last three options. In (ii) and (iii), lots of investors
invest in the fund, which then supplies equity capital to businesses. In (iv), there is an
additional layer – lots of investors invest in the fund, which then invests in a range of
private equity funds, which then supply equity capital to businesses. This is where the
extra layer of fund management fees comes from.
2.3 Operation of a private equity fund
The arrangements for putting in and taking out investors’ money will be specified in
detail up front. In practice, there is considerable variation between funds. As an
example, a private equity fund may be set up as a limited partnership with a fixed life.
At the end of this period, capital is shared between the investors in some way, eg as
specified in the partnership agreement.

Private equity funds usually have an 8-year to 12-year life, although this cycle will
increase for early-stage investments and reduce for more mature investments,
eg venture capital investments may have a longer life than leveraged buyouts.
Apart from very small payments associated with administration and set-up costs,
the fund’s cashflows will be between the marketing agent, the manager, the
investors and the investments. There are unlikely to be tax cashflows or debt
cashflows as the fund will typically be in a zero tax environment and any debt
raised to finance an individual investment will be non-recourse to the fund.
In other words, if the underlying venture is being funded by a mixture of debt and
private equity, the financing is structured so that the servicing of the debt is the sole
responsibility of the venture and not that of the private equity fund.
Prior to the fund launch there will be a 3- to 6-month initial fund raising with
monies usually raised by a marketing agent receiving usually 1% to 2% of funds
committed. The cash flow structure allows investors’ commitments to be drawn
down as required. A first closing will take place giving the manager the right to
call on the funds committed, make investments and earn fees. Often the fund will
continue to raise money for a time up to the final closing date. Hence new
investors may join the fund and commit money over a relatively long period of time
of say 12 months.
Commitment of funds does not require the investor to transfer any cash at the time
of commitment. However, the manager may call on committed funds with little
notice and often in tranches of 5% to 10% during the investment period.
All purchases will be made by the end of the investment period which will be say 3
years from the final closing date. This gives the manager a reasonable time to
make investments whilst leaving time for divestment during the fund life.
A typical investment will be held for say 3 to 5 years. Sale proceeds will be
returned to the investors. It is therefore possible for an investor to commence to
receive distributions after say 3 years when part of his commitment has not yet
been drawn down. In fact it is often the case that an investor’s net investment in
the fund will be much less than the committed amount. A mature portfolio with
regular new commitments could become a self-financing cash generator within
7 to 10 years.
Undrawn commitments at the end of the investment period will expire, and the
investor becomes free to use the funds for other purposes. At the end of the
fund’s agreed life, any remaining investments might be distributed to the investors
pro-rata, the fund life extended or transferred into a new fund.

The manager is remunerated by a fee of the order of 2 per cent per annum of
commitments plus a share of profits. This profit share is the incentive to achieve
strong performance and is often called the “carry” or the “carried interest”.
The “carry” paid to the manager is often 20% of all profits over a hurdle amount.
The hurdle amount would typically be the return of all drawn commitments plus
interest at 8% per annum.
That is to say, the investments must exceed some specified rate of return before the
manager is entitled to any share in the profits.
Question 4.9
Explain what is meant by the:

(i) first closing date
(ii) final closing date
(iii) investment period.

3 Hedge funds / absolute return funds

Definition
A hedge fund can be defined as an investment fund that aims to meet high or
absolute returns by investing across a number of asset classes or financial
instruments.
A hedge fund is essentially a type of collective investment vehicle. Nowadays the term
hedge fund is often used to refer to any investment fund that isn’t restricted to a long-
only, non-leveraged investment strategy.
Question 4.10
What is meant by a “long-only, non-leveraged” strategy?
3.1 General features of hedge funds
Hedge funds typically have less restrictions on:

 borrowing
 short-selling
 the use of derivatives
than more regulated vehicles such as mutual funds. This allows for investment
strategies that differ significantly from the long-only, non-leveraged strategies
traditionally followed by investors.
So it greatly increases the opportunity set of available investment strategies, thereby

offering opportunities for higher investment returns.
Typical features of hedge funds in addition to those mentioned above include:

 The manager normally has a great deal of investment freedom.
 Hedge fund fees typically include a performance-related component in addition
to an annual management charge.
 The minimum investment amount is often high and there may be limits on the
total size of the fund. As we shall see, the strategies followed by hedge funds
can often best be executed with only relatively small amounts.
 There may be lock-up periods, ie minimum investment periods, and notice
periods.

In the early years of hedge funds they were normally the preserve of high net
wealth individuals but increasingly institutional clients such as pension funds
have made an allocation to hedge funds.
Hedge funds were originally characterised by:

 the placing of many aggressive positions on different assets
 a high level of borrowing given the limited size of the capital of the funds
compared to the size of the individual investments
 a mix of investments for which the price movements would be expected
mostly to cancel each other out, except for the positive effect the hedge
fund is looking for
We will look at this idea in more detail when we consider the different classes of
hedge funds.
 a willingness to trade in derivatives, commodities and non-income
bearing securities
 a higher risk tolerance than other funds.
3.2 Classes of hedge funds
The term hedge funds now covers a wide spectrum of investment strategies
although some of the more common ones are:
1. global tactical asset allocation funds

2. event-driven funds
3. market-neutral funds
4. multi-strategy funds.
Global Tactical Asset Allocation funds
These concentrate on economic change around the world and sometimes make
extensive use of leverage and derivatives.
These funds will take a combination of long and short positions that reflect the hedge
fund manager’s views on how macroeconomic factors such as the levels of international
asset markets, interest rates and currencies will move. These views will depend on
economic trends globally and major international events.

Event-driven funds
These trade securities of companies in reorganisation and / or bankruptcy

(“distressed” securities) or companies involved in a merger or acquisition (“risk
arbitrage”).
These funds invest to try and profit from price movements caused by anticipated
corporate events.
Securities, eg shares or loan capital, in “distressed” companies are often available at a

price well below the par value. A hedge fund may feel able to make profits from
buying these securities as:
 many traditional institutional investors will be unable or unwilling to buy these
stocks so there will be less demand putting pressure on prices
 there are likely to be price anomalies which a hedge fund can exploit through
research and expertise.
Either an active or a passive approach to investing in distressed securities is possible.
Question 4.11
Explain what you think “active” and “passive” mean in this context?
Question 4.12
If the manager of a distressed fund wanted to hedge the equity market risk, what could
he do?
A risk arbitrage fund may simultaneously take long and short positions in both
companies involved in a merger or acquisition. This typically is a low-risk, as opposed
to a risk-free, strategy.

Example
Suppose a hedge fund manager believes that A plc is planning to acquire a certain target
company, T plc, by offering one A share for each T share. The manager will take a long
position in (ie buys) the shares of T and goes short in the shares of A. If the takeover
goes ahead, the price of T will converge upwards towards the price of A. By taking a
long position in one share and a short position in the other, the manager gets the profit
from the relative movement of the share prices and is immune to the movement of the
market as a whole.
The risk is that the merger or acquisition does not go ahead. This “event” risk is
generally uncorrelated to overall market movements.
Market-neutral funds
These simultaneously enter into long as well as short positions at a market or

sector level , while trying to exploit individual security price movements.
These funds aim to exploit inefficiencies in the markets by making stock selection
profits, eg to take a long position in (buy) securities that the manager considers to be
underpriced, and so expects to appreciate in value, and take a short position in (sell)
securities that the manager considers to be overpriced and so expects to depreciate.
When the prices correct, the manager can take a profit. The fund as a whole is designed
to be market-neutral, ie as many short positions as long positions are taken, so that the
performance of the fund is not affected by general movements in the market.
The extent of market neutrality varies between funds. Funds may be beta-neutral and/or
currency-neutral. They may also be neutral in some more stringent ways – eg by equity
sector or by size of company.
Question 4.13
What does it mean to describe a fund as beta-neutral?

Multi-strategy funds
These invest in a range of investment strategies to provide a level of

diversification.
Multi strategy hedge funds will use a combination of the above on the same set of
assets. So, for example, a multi-strategy fund might short-sell equities, investing in
more property, whilst simultaneously focusing on event driven strategies for its
property portfolio. The idea is that this increases diversification, which can help to
smooth returns.
Question 4.14
In what sense is does this increase diversification?
3.3 Structure and past performance of hedge funds
Short selling
As hedge funds have the ability to take short positions they were often viewed as
absolute return strategies which would produce positive returns even when
markets were negative. The financial crisis of 2008/2009 demonstrated this was
not the case and many hedge funds posted negative returns during this period.
Suppose Hedge Fund A pays B a small fee to borrow Share X, which Hedge Fund A
then sells to C for cash. Once the price of X has fallen, Hedge Fund A uses some of this
cash to buy X at the new lower price. This share is used to pay off B, leaving the
remainder of the cash as profit for the Hedge Fund A.
In practice, many investors are not permitted to borrow and short sell securities that
they do not own. However, one of the ways in which hedge funds are less tightly
regulated than most investors is precisely that they are allowed to do this. It therefore
makes it easier for them to make profits when markets are falling.
Other characteristics of hedge funds typically include:
 opaqueness
 illiquidity and
 high fees.

Legal structure
Hedge funds often have complex legal structures and the fund structures are
held offshore to minimise tax and regulatory requirements. The Cayman islands
and Bermuda are two popular locations for hedge funds.
Hedge funds have historically been subject to less regulation and financial
reporting than mutual funds although legislation is being introduced in a number
of developed markets which will require far more onerous reporting in the future.
Past performance
Gaining insight into the performance characteristics of the different types of

hedge funds is not straightforward. Monthly return information released by
hedge funds is collated and distributed by a number of analysts. However, the
data can be influenced by:
● Survivorship bias – when the data does not realistically reflect survivors
and failures. When the emphasis is on survivors, average returns will be
overestimated and volatility will be underestimated. Also, when a fund is
added to a database, data vendors tend to “backfill” that fund’s
performance history.
We have already met this idea of survivorship bias in the discussion of private
equity. Backfilling simply means adding the fund’s past history into the
database. A hedge fund is more likely to choose to add its past performance to
the database if that performance is good.
● Selection bias – funds with a good history are more likely to apply for
inclusion. Backfilling will then cause a significant upward bias.
● Marking to market bias – since the underlying securities may be relatively

illiquid, funds will typically use either the latest reported price or their own
estimate of the current market price for valuation. The use of “stale”
prices can lead to underestimation of true variances and correlation.
The issue here is that if a hedge fund invests in securities that aren’t tradable (eg
over the counter derivatives) or for which transactions are infrequent (eg certain
equities) then a current market price isn’t readily available. The “price” used
instead for performance measurement purposes is likely to be less volatile than
the true value. The extent to which this is a problem is clearly very dependent
on the investment strategy of a particular fund. Comparisons between very
different types of hedge funds may therefore be distorted.

There are other practical problems with analysing performance data for hedge funds.
Many hedge funds have been in existence for only a short period of time so there is a
lack of data on which to base any analysis. For example, a fund that has been in
existence for six months and has demonstrated good performance may have just been
lucky or may be executing a strategy that has done well in the particular market
conditions that have occurred over the period.
Claims of hedge fund superior performance can be questioned since return

distributions are far from normal – many of them tend to be negatively skewed.
Question 4.15
What does it mean for a distribution to be negatively skewed?
Standard measures of performance such as a portfolio’s alpha (the excess return

that cannot be explained by the fund’s beta) and its Sharpe ratio (see Chapter 15)
will be biased upwards as a result.
This is because the risk is in each case measured in term of the standard deviation
which, being a symmetric measure or risk, does not give a true indication of the level of
(downside) risk involved.
The Sharpe ratio (which is discussed in detail in Chapter 15) is defined as:
Rp - r
S =
sp
where:
 Rp is the return on the portfolio
 r is the risk-free return
 s p is the standard deviation of the portfolio returns.
Rather than looking at summary statistics, the investor should consider the
whole return distribution.
This is a key message here. It is important to analyse the past performance data in lots
of ways, rather than to rely on a single summary statistic. For example, plots of the data
(eg a plot of the cumulative distribution function of the returns) may highlight the
existence of outliers and the symmetry or skewness of the data.

Fees
Hedge fund fees are significantly higher than the fees on more traditional collective
investment vehicles. Hedge funds can charge higher fees because:
 they have historically provided higher returns
 demand exceeds supply – the capacity of some hedge funds is limited.
Question 4.16
Why is the capacity of most hedge funds more limited than traditional collective
investment vehicles?
A fund of hedge funds is an investment vehicle that invests in a number of hedge funds.
An investor choosing this vehicle gets exposure to all the included hedge funds. The
idea behind funds of hedge funds is that an investor diversifies the risk of investing with
a single hedge fund manager, without needing the time and expertise to construct his
own portfolio. The fund of funds manager is responsible for selecting the hedge funds
in which to invest. He commands a fee for doing this.
Most hedge funds charge a fixed annual fee of 1–2% plus an incentive fee of 15–
25% of the annual fund return over some benchmark. Funds of hedge funds
charge similar fees and, although they generally obtain rebates from the
managers they invest in, the extra layer of fees puts substantial pressures on
fund-of-funds performance.
Reference
The following paper is useful if you want to find out more about hedge funds:
 Caslin J. J., (2004), Hedge Funds, British Actuarial Journal, Volume 10, Part
III, No.47, pp441-521.

4 Currency
4.1 Definition
The foreign exchange (currency or forex or FX) market exists whenever one
currency is traded for another. It is by far the largest market in the world, in
terms of cash value traded, with trillions of dollars changing hands daily. The
market includes trading between large banks, central banks, currency
speculators, multinational corporations, governments and other financial
markets and institutions.
4.2 Spot FX
Spot FX deals are delivered in two working days’ time, with settlement actually
taking place in the two separate countries (even though the deal may be done in
a third country).
Generally, currencies are almost always quoted against the US dollar and trades
are known by shorthand codes such as:
 “Cable” (Sterling – US dollar)
 “Swissy” (Swiss franc – US dollar)
 “Euros” (Euro – US dollar)
 “Bill and Ben” (Japanese yen – US dollar).
Settlement will be on the same “working day” in both countries, but because of
time zone differences, settlement will take place earlier in the Far East, followed
by Europe and then in the USA. The resulting settlement risk is sometimes
referred to as “Herstatt risk” following the bankruptcy of the Herstatt Bank in
Germany in 1974 causing it to default on the foreign currency it owed to
counterparties.
It was 4:30 pm in Germany and 10:30 am in New York on the 26th June 1974 when
Herstatt's licence was withdrawn by German regulators due to a lack of income and
capital to cover liabilities that were due. Unfortunately some banks had already paid
Deutsche Marks (Euros now) to Herstatt during the day, believing that US dollars
would be returned later the same day. When the licence was withdrawn, Herstatt
stopped all its outgoing dollar payments and the banks never got their money!

Most international markets use “direct” or “normal” quotes (domestic per unit of
foreign currency), but London uses “indirect” or “reciprocal” quotes (foreign per
unit of domestic currency). Dealers quote in the form of a “bid – ask spread”,
thus when combining quotes to calculate a “cross-rate” (where neither of the
currencies is US dollars) it is important to use the correct values from the
standard quotations.
Due mainly to historical precedent, FX rates are quoted in one of two formats:
1. domestic value of foreign currency unit (eg in the US, one British pound is
worth US$1.5050)
2 number of foreign currency units per domestic unit (eg in the US, 107.00 yen
purchases US$1).
For simplicity in their domestic markets, most international markets quote currencies
using the first format. Format 1 quotes are simply the reciprocal of 2, and vice-versa.
For example, $/yen 107.00 can be converted from 2 to 1 as 1/107.00=.009346.
4.3 Forwards
The other main type of deal on the FX market is the forward rate, which is the
guaranteed price agreed today at that the buyer will take delivery of the currency
on a specific future date. For most major currencies, the most liquid forward
contracts are in the 1–6 month maturities, although forward deals in some
currencies are available for 3 to 5 years ahead. The market makers in the FX
market are mainly the large banks.
Example
Company X in the UK agrees to sell aircraft parts to Company Y in the US for

$9,000,000. The terms of the deal only call for payment after the goods are shipped.
So, you will not receive payment for 90 days.
To secure the UK £ sterling equivalent, Company X sells dollars to Bank Z with a

settlement date of 90 days in the future. If the forward exchange rate was 1.5, it would
agree to swap $9,000,000 with £6,000,000 in 90 days’ time.
At maturity, Company X transfers the $9,000,000 to Bank Z’s account and its account
would be credited with £6,000,000.

Pricing of forward contracts is known as “Covered interest parity” (CIP) and

involves the spot rate and money market interest rates in the two countries. If
rd and rf are the interest rates in the domestic and foreign markets and F and S
are the forward and spot rates, then, for a one year contract:
F = S ¥ (1 + rd ) (1 + rf )
Question 4.17
For the example above, calculate the current exchange rate if the force of interest in the
UK is 4% pa and the force of interest in the US is 2% pa.
In practice, outright forward rates do not usually appear on a dealer’s screens.

Instead, “forward points” are quoted where forward points = F - S . Thus the
“outright” forward rate is the spot rate plus forward points.
The actual forward rate quoted can be compared with a “synthetic” forward rate
calculated by looking at the cost of borrowing funds in the domestic market and
switching the funds into the foreign currency on the spot market and earning
foreign interest. If the actual forward rate does not equal the synthetic forward
rate then a riskless arbitrage profit is available. Such arbitrage profits could be
assumed to be short lived in nature, although practical complexities such as bid
– ask spreads and other transaction costs may influence this.
Speculation in the forward market is based on views about the likely movement
of spot rates over the term of the forward contract.
 Suppose the current (July 200X) quoted dollar sterling forward rate is
F0 = 1.64 ($ £ ) for delivery on October 200X.
 Suppose you believe the spot rate in October will be ST = 1.66 ($ £ ) ,

ie you believe that sterling will be worth more in the cash market in
October than indicated by the current forward rate.
 If your guess about ST turns out to be correct then you can make a
speculative profit.
Question 4.18
How would you make this profit as a UK based investor?

Note that this is a highly risky transaction since if the spot rate in October is
below 1.64 ($ £ ) then you will make a loss (which could be very large). This is
also a leveraged transaction since the speculator uses none of its own funds
either today or on the round trip transaction in October.

5 Infrastructure
The financing of long-term infrastructure, industrial and public services projects
is based upon a non-recourse (or limited recourse) financial structure where
project debt and equity used to finance the project is paid back from the cash
flow generated by the project.
Infrastructure tends to be separated into two broad subsets:

1. economic
2. social.
Economic infrastructure includes:

 highways
 water and sewerage facilities
 energy distribution
 telecommunication networks.
Social infrastructure encompasses:

 schools
 universities
 hospitals
 public housing
 prisons.
The financing for either subset may come from government, local councils, private
companies or a mixture.
Example
In 2005, the UCH hospital, part of University college London, was built using £422
million of private infrastructure finance.

5.1 Distinguishing characteristics
Infrastructure assets are generally characterised by high development costs

(high barriers to entry) and long lives. They are generally managed and financed
on a long-term basis. Historically it was seen as the role of government to fund
and manage these assets for the good of the population.
Today, the role of the government as the provider of public services is

increasingly being questioned both in terms of absolute cost to taxpayers and as
to whether a government can deliver the assets as efficiently as a private
company competing for the privilege.
From the government’s perspective there is a strong case for privatisation,

where the debt raised by the private partner remains on their balance sheet, not
on that of the Treasury.
Advantages claimed for privatisation include:
1. Better customer service as private organisations depend on the quality of service

being provided and public satisfaction to generate profits.
2. Private business generates more revenue (and/or operate at lower cost)

compared to government enterprises, so governments can indirectly increase
revenues by leasing out enterprises to private organisations.
Question 4.19
What are the disadvantages of privatisation?
These factors have resulted in a gradual migration from the public provision of
infrastructure to the private sector. The private provision of these assets may
take many forms from joint ventures, concessions and franchises through to
straight delivery contracts. Essentially the private sector is being brought in to
design, build, finance and/or maintain public sector assets in return either for
long term contracted payments from the government or for access to the
revenue generated from the asset.

Infrastructure assets display a number of characteristics that distinguish them

from more traditional equity or debt investments:
 The assets themselves tend to be single purpose in nature, such as a gas

pipeline, toll road or hospital.
 The private investor’s participation in the asset is often for a finite period.
This is generally a function of the agreement the investor has made with
the government authority, or a function of the natural useful life of the
asset.
 Infrastructure assets are characterised by their long lives. In fact the

capital invested in these projects is often referred to as ‘patient’ capital, in
that the initial development involves high upfront capital costs with
payback occurring over the asset’s generally lengthy life.
 One of the key characteristics of infrastructure assets, and what can make
them particularly attractive as investments, is that they tend to be, or
exhibit the characteristics of, natural monopolies. Under a natural
monopoly, economies of scale are such that the unit cost of a product will
only be minimised if a single firm produces the entire industry output.
This environment has the potential to weaken market forces, particularly

when there are few, if any, alternative suppliers of the infrastructure. In
this case, firms operating in a natural monopoly, protected from new
competitors by the high barriers to entry, may be able to earn abnormal
profits by charging higher prices.
As a result of these monopolistic characteristics, infrastructure assets tend to be

subject to varying degrees of government regulation, depending largely on the
degree of natural monopoly. This is not necessarily to the detriment of investors
in infrastructure, as it provides a level of certainty regarding the income streams
that will flow from the asset.
5.2 Risk
The risks of an investment in infrastructure may be generally divided into:

 those specific to the infrastructure asset and
 those affecting the broader asset class.

Asset specific risks
The asset specific risks encompass risks pertaining to the design, construction
and operation of the infrastructure asset. The asset class risks include:
 market / economic risk
This is important when consumers can choose alternative services such as with
toll roads, railways and ports. Occasionally, the Government absorbs this risk
explicitly or by default. In a Mexico toll road, the Government awarded the
concession guaranteeing a minimum amount of traffic. If this could not be
achieved, then the concession period would be extended.
One element of market risk is demand risk – ie the overestimation of customer

demand and “willingness to pay” for the proposed infrastructure. In several
cases, like the toll road network in Mexico, the demand for the facility is high
but inadequate willingness to pay on the part of the users raises serious questions
about the viability of such projects.
 regulatory risk and political risk.
A lack of clarity in Government policies and selection procedures has created

political risk a key risk in infrastructure development.
 operating risk
This may arise due to underestimation of operating costs. If the pricing of

infrastructure services is regulated by the government, the burden of
underestimation of operating costs cannot be passed on entirely to the users.
Infrastructure assets may also exposed to large-scale disasters, such as the fire in
the Channel Tunnel in 2008.
The asset specific risks will largely depend on the maturity of the asset. For
example, in the construction phase, there is considerable risk associated with
the construction process.
In the initial high-risk planning phase only equity capital is suitable for financing. The
construction phase may be financed by a combination of equity and debt with
guarantees.
Importantly, a key feature of infrastructure assets is that as an asset matures its

risk profile declines and valuation increases, all other things remaining equal.

Broader risks
Of the more generic risks affecting the infrastructure asset class, perhaps the
most pertinent is interest rate risk. The prevailing level of interest rates can have
an impact on the discount rates applied to the valuation of infrastructure
investments, and on the debt portion of the investment structure.
Over the medium to longer term however, any initial fall in value as interest rates
rise is mitigated as revenue from the underlying asset grows. Generally, revenue
increases are derived from inflation-linked pricing increases and the volume
increases that occur in a growing economy.
Of specific relevance to infrastructure projects is foreign exchange risk. Given that

infrastructure projects involve costs and revenues in the local currency, the foreign
exchange exposure taken for such investments, especially in the nature of off-shore
debt, can prove to be risky.
5.3 Investment considerations
Although infrastructure assets vary in terms of the level of regulation they face,
this regulation generally results in income streams that exhibit low growth. To
compensate investors for this, infrastructure investments tend to be higher
yielding than equity investments.
Question 4.20
How might an individual seek to invest in infrastructure assets?
In terms of capital values, this stable, high yield results in infrastructure assets
displaying a lower level of price volatility than equity investments over the longer
term. It also acts as a support to the price of infrastructure assets in periods of
poor returns in the broader equity market. As such, infrastructure is often
referred to as a ‘defensive’ asset.
Forecast returns from individual infrastructure investments vary depending on

the characteristics of the underlying asset, its maturity, risk and taxation
treatment in the context of the prevailing macro environment. Over the longer
term, as industry structures and regulatory regimes mature, the listed
infrastructure sector will most likely behave like a hybrid between an equity and
a bond.

6 Commodities
Commodities can be defined as any products that can be used in commerce,
ie any goods that are traded. For most people the term refers to internationally
traded agricultural goods such as coffee, fuels such as oil and raw materials
such as copper. However, institutional investment in commodities rarely means
direct investment in the goods themselves, such as the purchase of a warehouse
full of coffee. Institutional commodity investment is investment in derivatives
based on the price of the underlying commodity.
6.1 Commodity investment
Commodity futures were originally devised to reduce the risks to which farmers and
others were exposed.
Consider a farmer who is about to plant a crop of potatoes. He has no idea what the
crop will ultimately be worth. It may be that there is a glut of potatoes at the time he
brings his crop to market, and the price is very low. Alternatively potatoes may be very
scarce, and the farmer may be able to obtain a correspondingly higher price for his crop.
Clearly the uncertainty to which he is exposed would be substantially reduced if he

could guarantee the price that he might obtain in advance. To do this he needs to sell
sufficient potato futures to cover the amount of the crop that he expects to harvest. If he
can do this, then he is guaranteed to receive a fixed price for the crop when it is
harvested.
Similarly, it may be advantageous for a consumer of potatoes (eg a chip manufacturer)

to ensure his future supplies at a fixed price in advance. The consumer will need to buy
sufficient potato futures to cover the amounts he expects to need to purchase. It was to
meet the needs of those people who needed to reduce their exposure to future
commodity price movements that commodity futures were originally devised.
Question 4.21
Who else, apart from producers and consumers, might need to hedge their risks in this
way?

6.2 Commodity derivatives
For futures contracts, details of the contract prices are published each day in the
Financial Times. Information published includes the settlement price, the change on the
day, high and low prices for the day, the volume of contracts traded and the open
interest. In addition the size of the contract (eg 10 tonnes of cocoa) and the unit of
trading is usually given.
Commodity futures are widely traded on major exchanges such as NYSE Liffe
and the Chicago Mercantile Exchange (CME). Options on the futures are also
available. Some of the commodities on which exchange traded futures are
available are listed in the table below.
Energy Precious Base metals Agricultural Meat &

metals Livestock
Crude oil Gold Aluminium Cocoa Live cattle

Heating oil Platinum Al Alloy Coffee Lean hogs
Natural gas Silver Copper Sugar Pork Bellies
Lead Potatoes
Nickel Wheat
Tin Barley
Zinc
Energy contracts are traded on the International Petroleum exchange in London.

Precious metals are traded on the New York Metal Exchange. Base metals are traded
on the London Metal Exchange.

Contract specification
The specification of a futures contract in, say, lead is considerably more

complex than that of a contract for a future based on an investment index. It will
be necessary to specify:
 contract size
 delivery dates
 quality of the product
 method of packaging
 package size
 delivery site
 method of resolving disputes about quality.
So, for example, the contract for a lumber futures contract might specify:
 the types of wood which are acceptable
 the lengths into which the wood must be cut
 the grade of the timber
 the country or state in which the timber has been grown
 the places which are acceptable for delivery of the contract.
Most of this trading will take place on exchanges and will therefore involve
standardised contracts. These will specify the type and quality of the underlying
asset as well as delivery dates, quantities and prices. Over the counter non-
standardised contracts can also be arranged.
Commodity futures contracts usually call for settlement by physical delivery of

the underlying asset or by transfer of warehouse receipts. Most contracts,
however, are closed-out before the contract maturity date.
6.3 Commodity indices
Indices of commodity prices are produced by investment banks such as

Goldman Sachs and other compilers. Contracts based on an index allow
diversification (and avoid the danger of having to take delivery of the underlying
product).
This is because contracts based on an index are always cash settled, so there is no
possibility of taking delivery (or of being required to make delivery) of the underlying
commodity.

The Goldman Sachs Commodity Index (GSCI) is a weighted average of the prices of 22
highly liquid exchange-traded futures contracts. Futures and options based on the GSCI
have been traded on the Chicago Mercantile Exchange since 1992. The underlying
futures contracts include base metal futures traded on the London Metal Exchange,
agricultural futures traded on the Chicago Mercantile Exchange, and a number of other
futures contracts. The exact components of the index vary slightly depending on the
time of year. By buying a future on the index, an investor gains exposure to a whole
portfolio of commodity prices.
6.4 The economic function of commodity futures
Commodity futures and forward contracts are used for risk management by
 commodity producers who wish to reduce uncertainty in the future cash

flows that they will receive for their product; and
 commodity consumers who wish to reduce the uncertainty in the amount

they will have to pay for their future supplies.
Question 4.22
Does a commodity buyer who wishes to fix the price of the commodity in advance have
to take delivery of the asset specified in the futures contract?
Such users of futures contracts are contracting to supply or to take delivery of a

specified quantity of the commodity at some future date. The reduction in
uncertainty has a cost in reduced flexibility, particularly for consumers who are
likely to be less certain of the amount of raw materials they will require in the
future than producers are of the amount they will wish to sell.
6.5 Investment characteristics
It has been argued that commodity futures should be considered as “short-term

equities”. They are real assets whose value is determined by short-term
economic factors rather than expectations over the longer term. This gives
some diversification from the traditional institutional real assets of property and
equity shares.
Question 4.23
In what sense is a commodity future a real asset?

6.6 Valuation of commodity futures
In the valuation of commodity futures a distinction has to be drawn between

commodities which are commonly held as investment assets and those which
are held for commercial purposes.
For commodities, such as precious metals, which are held as investments, no-
arbitrage arguments can be used to show that the value of a future must be
given by a formula very similar to the one used for gilt and equity index futures:
Future price = spot price of underlying + cost of carry.
Question 4.24
Explain in general terms by using an arbitrage argument how the equation above is
derived.
Here the cost of carry is the financing cost of holding the underlying, plus
storage costs. Because the cost of carry is positive, the futures price is normally
above the spot price. This is known as a contango market.
Question 4.25
The spot price of gold is $1,442 per ounce. The price of a three month gold future is
$1,448. The cost of storage/insurance for gold is 20c per ounce per quarter, and the
current risk free interest rate is 0.4% pa. Explain how to make riskless profits in excess
of the risk free rate by using gold futures.
For the above formula to be enforced by arbitrage the underlying commodity

must be loanable. In other words it would be possible for a speculator to
synthesise a short futures position by borrowing the underlying asset and
selling it at the spot price.
In the case where the underlying commodity is not widely held as an investment
there is no such simple mathematical relationship between the futures price and
the spot price. If the commodity is not held as an investment, there will not be
arbitrageurs who are prepared to trade in the commodity on their own account. So
arbitrage arguments to determine the futures price will not be valid, and there is no
reason why the equation used in the previous paragraph should hold. The usual
situation is that there is a positive value to ownership of the physical commodity
(eg as a protection against future shortages or in order to be able to take
advantage of them by selling at a high price).

This value is described as the convenience yield of the commodity and the
formula becomes:
Future price = spot price + cost of carry – convenience yield.
When the convenience yield is higher than the cost of carry the futures price will
be below the spot price, a situation known as backwardation.
Question 4.26
For which futures markets might you expect the convenience yield to be higher than the
cost of carry?
6.7 Suitability for institutional investors
The role of commodities as a diversifying asset class is that:

 commodities offer significant real returns that are produced by doing real
economic work within the economy
 the returns accrue to the long-only investor without the need for active
management, and
 commodities offer a package of diversification benefits unlike any other
asset.
Specifically, in those environments that have produced the worst results from
financial assets – rising inflation, excessive global demand, supply disruptions –
commodities have produced higher returns than any other asset class used by
institutional investors.
Crude oil and gold are good examples of this. In times of uncertainty about supply,
eg major political instability, these commodities have increased in value because of
their high intrinsic value compared to financial assets.
More importantly, those returns have been based on real underlying economics,
suggesting that a similar pattern of returns is likely to recur in the future.
One of the difficulties in predicting future returns on financial assets is the problem of
identifying other (non-economic) effects such as changes in investors’ incomes or
preferences.
Unlike other asset classes, commodities are concerned with short-term supply and
demand and short-term risk.

As with many questions in investment, there is no universal agreement on the suitability

of commodities as an institutional asset class.
Arguments for institutional investment in commodities, particularly in recent times,

include:
 There is a genuine squeeze on supply in many raw materials due to the growth
in China (among others), which has lead to substantial rises in base metals,
energy and certain other commodities. If this continues, then the prices will
continue to rise until demand weakens or alternatives are found.
 The uncertainties in the oil sector in particular appear likely to continue for
some time.
 Returns show low correlation with other assets in institutional portfolios.
Although the arguments presented above would seem to imply that commodity
futures are a suitable investment for institutional investors they are not widely
held by UK institutions. Those who do not see commodities as attractive would
argue that
 there is no strong historical evidence for a real return from commodities
 the markets are volatile, being driven by a number of factors unrelated to
the underlying economic factors that affect institutional liabilities.
 the high level of specialist expertise required to trade commodities profitably
can be prohibitive.
6.8 The carbon markets
A recent development has been the emergence of trading in carbon credits,

where carbon is a regulatory derived commodity. A variety of tradable
instruments have been created in an attempt to regulate greenhouse gas
emissions. The most liquid markets are in Certified Emission Reductions (CERs)
from Clean Development Mechanisms (CDMs) carried out in developing
countries and in European Union Allowances (EUAs). EUAs are traded both on
exchanges (such as the European Climate Exchange) and through the OTC
market. Exchange activity is currently confined to spot and future transactions,
but options on EUAs are expected to be launched in the future. There is also
growing indirect investment through Carbon Funds and indices based on carbon
credit prices.
The carbon markets are relatively small, but have grown rapidly. The World Bank
estimated that the size of the carbon market was £64 billion in 2007.

7 Insurance-linked securities
Insurance-linked securities (ILS) are securities whose return depends on the
occurrence of a specific insurance event, which can be either related to non-life
(eg catastrophe bonds) or life risks. The ILS market has been in existence since
the mid 1990s, when the first catastrophe bonds were issued.
From an insurer’s perspective, ILS offer the ability to transfer risks from its
balance sheet to investors in return for payment of a risk premium. Alternatives
to transfer include retention or reinsurance. Depending on the structure of the
ILS, other benefits to an insurer may include reduced capital requirements or
acceleration of profit emergence from an insurance book.
Investors will hold ILS based on their risk/return characteristics. These are likely
to be particularly attractive at a portfolio level as insurance risks have weak
correlations to equity and credit markets. Constructing a portfolio of ILS
requires specialist expertise as it requires an understanding of the underlying
insurance risks, and ILS structures can be complex. A number of ILS funds have
been set up, which typically invest in a range of insurance risks or perils in order
to generate a diversified return stream. However, there are tail risks that may
result in the case of an extreme event that results in several perils across a wide
area (eg a hurricane / tropical cyclone that causes significant coastal and inland
damage).
A typical catastrophe bond structure is shown below:
Floating rate +
Premiums spread
Insurer SPV Investors
Proceeds
Losses
Return of
principal
This diagram is part of the Core Reading.
In this diagram, the bondholders (Investors) purchase their bonds (Proceeds) from the
SPV and will receive the risk-free rate (Floating rate) plus a risk premium (spread) for
taking on the risk of the catastrophe being insured. The premiums paid by the insurer
should reflect the likelihood and cost of the catastrophe being insured. This premium
will effectively be passed on to the bondholders in the spread.
If the catastrophe occurs, the payment from the SPV would assist the insurer recover
losses, as all (or some) of the principal would pass to the insurer.

So, the bondholders are effectively taking on the catastrophe risk previously borne by
the insurer and receiving a higher expected return on their investment for bearing the
risk.
The process for creating a catastrophe bond is as follows:
1. The ceding insurance company establishes a special purpose vehicle in a

tax efficient jurisdiction.
2. The SPV establishes a reinsurance agreement with the sponsoring
insurance company.
3. The SPV issues a note to investors; this note has default provisions that
mirror the terms of the reinsurance agreement.
4. The proceeds from the note sale are invested in money market
instruments within a segregated collateral account.
5. If no trigger events occur during the risk period, the SPV returns the
principal to investors with the final coupon payment. If trigger events
occur, the assets of the SPV are first used to meet the insurer’s losses,
before any return of principal (if any).
7.1 Examples
Protecting against extreme mortality loss
In 2005, Swiss Re transferred over $362m of extreme mortality risk to the capital
markets using a 5-year catastrophe bond. According to the ratings agency, Standard &
Poor’s (S&P), only a large event risk such as nuclear explosions in large cities in the
5 countries, a full-scale ground war or a major epidemic (eg a global flu pandemic)
would cause a loss to the investors.
The above Core Reading diagram would look like this:
Premium Floating rate +

Swiss Re SPV spread Capital
markets
Proceeds (investors)
Losses from
extreme Return of
mortality loss principal if no
covered by extreme
principal mortality loss

Earthquake risk for railways
In 2007, Munich Re structured a catastrophe bond on behalf of the East Japan Railway
Company to transfer earthquake risk to the capital markets. The volume of bonds sold
was $260m and the bonds were given a S&P rating of BB+. The trigger for paying out
was based on the magnitude of the earthquake.
Question 4.27
Draw a diagram showing the potential cashflows involved here.
FIFA
FIFA securitised its World Cup earnings in both the 2002 and 2006 tournaments. The
deal was valued at $260m and was structured by Credit Suisse First Boston. The bonds
were given a high investment grade of A3 by Moody’s.
Question 4.28
Draw a diagram showing the potential cashflows involved here.
Question 4.29
Having seen the above 3 examples,
(i) what are the advantages of transferring catastrophe risk in this way?
(ii) why would the banking and capital markets be prepared to buy the bond?

8 Structured products
A structured product is a pre-packaged investment strategy in the form of a
single investment.
A typical structured product will consist of two components:
1. A Note – essentially a zero-coupon debt security that provides capital

protection, ie guarantees a return of all or part of the initial investment at
maturity.
This is sometimes referred to as the “principal guarantee” function. The

guarantee may only be in place if the structured product is held until maturity.
2. A derivative component that provides exposure to one or several

underlying assets such as equities, commodities, FX or interest rates.
Returns from the derivative can be paid out in the form of coupons during
the lifetime of the product, or added to proceeds at maturity.
Let’s say an investor invests £100 for 5 years. £90 of this may be used to buy a risk-
free bond and the remaining £10 can be used to purchase the options and swaps needed
to implement the desired investment strategy.
Question 4.30
Why can’t an individual investor do this themselves?
In some, more complex, structured products, the amount invest in the

zero-coupon debt security can vary dynamically over time depending on a
predetermined view. And in others, the capital protection may itself be
dependent on the performance of the underlying assets.

Advantages
Structured products are also typically provided in a packaged format that

provides advantages to investors over investing directly in the underlying
derivatives, for example:
1. Practical – investors may be unable to invest themselves in the

underlying derivatives.
This could be that investors are not allowed to invest directly or that the trading
costs prevent it being worthwhile.
2. The structured product also provides a pre-packaged investment strategy

that does not require active intervention by the investor.
This saves time and also the costs of expertise that would otherwise be required.
3. Legal – the format may be designed to satisfy legal or regulatory

requirements as to accessible investments for a retail or institutional
investors.
So, an investor who previously did not have direct access to certain derivatives
may be able to invest indirectly in them.
4. Tax – the tax treatment from the structured product may be more
favourable than direct investment.
5. Accounting – for example, the product may be structured so as to avoid

income statement volatility from the underlying derivatives.
6. Favourable expected return / risk profile – depending on the type of structured

product, enhanced returns and/or reduced volatility are claimed for these
products.
Opacity
When investing in structured products, investors can find it difficult to assess

whether a quoted price is competitive. This reflects that a structured product is
a composite of several market exposures (which may themselves be opaque)
and will often contain counterparty risk based on the issuer.
Also, distribution costs are generally not explicit and are normally implicit in the
quoted price. Whilst it may be possible to track prices from several issuers for a
simple structure, and thereby establish that a competitive price has been
achieved, this is much more difficult to achieve with more complex or exotic
structures or where proprietary indices are being used.

8.1 Examples
Structured products are very different from one another because a large number of
derivatives and underlying assets can be utilised. Two common examples include:
 Interest rate-linked notes and deposits
 Equity-linked notes and deposits.
Interest rate-linked notes
An interest rate-linked note or deposit is structured to pay one of two coupons linked to
an index rate defined over a specific range and over a reference period:
 a higher coupon if the indexed rate stays within a certain range during a
reference period
 a lower coupon or zero if the indexed rate is outside that range during the same
reference period.
Because of the rate range and the higher interest accrual when rates are within that
range, these notes are sometimes also referred as Range Accrual Notes.
Equity-linked notes
A simple example of a structured product would be a 5-year bond with a maturity

payment linked to the higher of 100% of the initial investment and the
performance of the FTSE-100 price return index over the period. In this case,
part of the initial investment would be used to purchase a zero-coupon bond to
provide the return of the initial investment, and the remaining funds would be
used to buy an equity call option. The investor does not receive coupons during
the investment term and does not benefit from dividend income on the equity
index.
Such products can be sold to retail investors who would otherwise be unable to
buy equity options and who wish to benefit from the upside in the equity
markets, are prepared to forego regular income but do not wish to put their
capital at risk.

Example
A bank issues a 5-year bond which entitles the holder to the return on the FTSE 100 up
to a maximum level of 50% growth over the 5-year period. The bond has a guaranteed
minimum level of return so that investors will receive at least x% of their initial
investment back. Investors cannot redeem their bonds prior to three years.
Explain how the bank can determine the value of x% at which it makes neither profit
nor loss.
Solution
If an investor buys a bond, then the bank can invest the money in the FTSE 100 so that
it is not exposed to movements in the FTSE 100. However, the bank is guaranteeing
that investors will receive at least x% of their initial investment back. The bank can
hedge against losses greater than this by buying a put option on the index with a strike
price of x% of the current index value. This put option will cost a certain amount of
money, p, say.
The bank is also limiting the investors’ return to 150% of their initial investment.
Because of this, they can afford to sell call options with a strike price of 150% of the
current index value. This call option will be priced at c, say. If c = p then the bank will
make neither a profit nor a loss. So the problem reduces to working out the price of the
call option c and then the value of x such that c = p.
In reality, using computers and a suitable option-pricing formula such as the

Black-Scholes formula, this would take a matter of seconds.
Question 4.31
Explain why, in this example, the bank does not need to make an assumption about the
growth of the FTSE 100 index in determining x.

Other structured products
More complex structured products enable investors to gain exposure to a range

of different underlying asset classes, and to take more complex investment
views, for example that markets will remain bound within a particular range and
not hit certain extreme high or low levels.
Examples include:
 FX and commodity-linked notes and deposits
 Hybrid-linked notes and deposits
 Credit-linked notes and deposits
 Market-linked notes and deposits
Question 4.32
What are the main advantages claimed for structured products over direct investment?
8.2 Risks
The risks associated with many structured products, especially those products that
present risks of loss of principal due to market movements, are similar to those risks
involved with derivatives.
Risks for investors to consider include the following:
 Counterparty risk – there is exposure to the asset or entity that provides

any guarantee on the product. For example, Lehman Brothers provided
the guarantee on a number of retail and institutional structured products.
These “guarantees” were not worth very much when the company filed for
bankruptcy in 2008!
Question 4.33
What are the two main ways to reduce counterparty risk?
 Liquidity risk – typically the payout under the product, including any
guarantees, are fixed for a given maturity date. If investors wish to access
their funds prior to maturity then they will be typically be exposed to the
cost and price at which the underlying derivatives can be unwound.

These costs could well be greater if the investor needs the funds very quickly.
 Complexity – structured products can have relatively complex payouts

and exposures, and investors should understand the risks involved.
In practice, very few investors will understand precisely how the value of the
structured product moves with the underlying assets.
 Legal / tax / accounting – investors should form their own view on the
legal / tax / accounting benefits of the structured product and its
suitability for their circumstances.

9 New ways of investing in old asset classes

Futures, options and swaps are used extensively to gain exposure to traditional
asset classes. These are covered elsewhere (see Chapter 3). Other recently
developed classes of instrument used for this purpose include:
 Index Funds
 Exchange Traded Funds
 Contracts for Differences.
When comparing the different methods of achieving an investment allocation, it

is important for an investor to understand any differences between the returns
that might be achieved, and the risks and costs (fees and other expenses) of
each method.
Where direct investment in the underlying asset, derivative contract or

structured product are viable options, these should also be considered.
9.1 Index Funds
An Index Fund is an ‘open-ended’ unitised collective investment scheme that

attempts to mimic the performance of a particular index. As such, it is passive
management in action.
Investment management styles are discussed fully in Chapter 20.
However, due to the impact of management expenses they are not widely used
by institutional investors. As with all mutual funds, the investor purchases or
redeems directly from the fund at NAV (calculated at the end of each trading
day).
Advantages
Advantages of index funds include:

 low expertise – tracking a target index does not require significant investment
expertise (and hence cost).
 low dealing costs – tracking a target index boasts the low fees of passive
management .
 simplicity – the investment objectives of index funds are easy to understand.
Once an investor knows the target index of an index fund, the securities held the
index fund are easily understood.

 no “style drift” – passively managed funds need not be concerned with the drift
in investment style that can occur with actively managed funds. Drifting
between investment styles can reduce a fund’s diversity and subsequently
increase risk.
Disadvantages
Question 4.34
What do you think are the disadvantages of index funds?
9.2 Exchange Traded Funds
Exchange Traded Funds (ETFs) are the ‘closed-ended’ investment trust

equivalents of (mutual) Index Funds. An ETF represents shares of ownership of
a unit investment trust (UIT) which holds portfolios of stocks, bonds, currencies
or commodities. The investor purchases the shares on a stock exchange in a
process identical to the purchase or sale of any other listed stock.
ETFs are an unusual type of security that mixes many of the features of unit trusts and
investment trusts that you will be familiar with from Subject CA1. On the one hand
they are referred to above as “closed ended” because in normal conditions, the number
of shares is fixed. This is like an investment trust.
However, authorised professionals, referred to as “Authorised Participants (APs)” can

approach the manager of the ETF and swap shares in the underlying portfolio for newly
created shares. This often happens in quite large sizes, rather than ones and twos.
Example
Suppose that an ETF tracks the FTSE100 index. If an AP approaches the manager with
a bundle of the 100 shares in the FTSE100, he can exchange these for new shares in the
fund. The process can work in reverse if the AP wishes to exchange some ETF shares
for a bundle of FTSE100 stocks.
So the fund can be considered “open ended” in this sense and hence, is more like a unit
trust.

The ETF’s performance tracks an underlying index, which it is designed to

replicate. Although the first ETFs tended to track broad market indices, more
recent ETFs have been developed to track sectors, investment styles, fixed
income, global investments, commodities and currencies. By the end of 2012
global ETF assets were in the region of $2trn, with the largest single fund (SPDR
S&P 500) having assets under management in the region of $120bn.
An important characteristic of an ETF is the opportunity for arbitrage. When the

ETF price starts to deviate from the underlying net asset value (NAV) of the
component stocks, participants can step in and take profit on the differences.
This is the AP activity referred to earlier.
As usual, the actions of arbitrageurs result in ETF prices that are kept very close
to the NAV of the underlying securities.
This is one of the big advantages of ETFs relative to investment trusts, which often
trade at substantial discounts to the NAVs of the company. This does not happen with
ETFs.
Types of ETF
There are several different types of ETFs, including:
1. Index ETFs – these are similar to index funds in that they hold securities and
attempt to replicate the performance of a stock market index.
Popular families of index ETFs include:

 SPDRs (which track the S&P 500 and major sectors of this index)
 iShares (which cover broad-based US, international, industry
sectors, fixed income and commodities)
 PowerShares including the QQQQ NASDAQ 100 ETF.
ETFs will not exactly replicate index performance due to tracking error.
This is due to differences in composition, management fees, expenses
and handling of dividends.
2. Commodity ETFs – these invest in commodities, such as precious metals and

futures. Among the first commodity ETFs were gold exchange-traded funds,
which have been offered in a number of countries (see iShares above).
3. Bond ETFs – examples include VIPERs (which range from broad-based to

industry sector as well as international and bond ETFs)

4. Currency ETF or ETCs
5. Actively managed ETFs
6. Leveraged ETFs – a special type of ETF that attempt to achieve returns that are
more sensitive to market movements than non-leveraged ETFs. They require the
use of derivatives.
Differences between ETFs and unit trusts and investment trusts
 Costs (annual fees) – ETFs generally charge lower fund management fees
(“annual management charges”) than either unit trusts or investment trusts. This
is because they are usually tracker funds, which can be run very cheaply.
 Costs (commission) – ETFs are exchange-traded so trading incurs commissions

and stock exchange trading fees, similar to an investment trust. There are no
bid/offer spreads set by the managing company as is the case for unit trusts.
 Tradability – ETFs can be traded in exactly the same way as shares in real time.
This is an advantage relative to unit trusts, where the manager will generally
trade only once a day.
 Diversification – Because they are designed to track indices, some of which

have several thousand shares, they may be very diversified portfolios.
9.3 Contracts for differences
A Contract for Differences (CFD) is a contract stipulating that the seller will pay
to the buyer the difference between the current value of an asset and its value at
contract time.
For example, a CFD provider may quote an offer price of £4 for one share in Tesco.
Let’s say that we buy 100 Tesco CFDs at this price to be settled the next day. If on the
next day, the Tesco share price increases to £4.20, then we will be paid
100 × 20 pence = £20.
If the difference is negative, then the buyer pays instead to the seller.
If on the next day, the Tesco share price decreases to £3.85, then we will lose
100 × 15 pence = £15.

CFDs allow investors to take long or short positions and, unlike futures
contracts, have no fixed expiry date, standardised contract or contract size.
Trades are conducted on a leveraged basis with initial margins typically ranging
from 1% to 30% of the notional value.
Let’s say that we have a 5% margin requirement of £20. With a typical 0.1%
commission (40 pence), the total initial outlay would be £20.40.
CFDs are available over-the-counter in the UK, Europe, Australasia, the Far East
and Canada. CFDs are not permitted in the US (due to restrictions by the US
SEC on OTC financial instruments). Exchange-traded CFDs have recently been
introduced in Australia.
CFDs were initially used by hedge funds and institutional investors to hedge
their exposure to stocks in a cost-effective way.
Based on equity swaps, they had the additional benefit of being traded on margin and
being exempt from stamp duty.
Originally (in the early 1990s) they were offered on LSE shares but have expanded
to include indices, many global stocks, commodities, treasuries and currencies.
By the late 1990s CFDs were being offered to retail investors. They were popularised
by a number of UK companies, whose offerings were typically characterised by online
trading platforms that made it easy to see live prices and trade in real time.
The most popular types of CFD are now based on the major global indices (Dow
Jones, NASDAQ, S&P 500, FTSE, DAX and CAC). CFD-related hedging is
estimated to account for more than 25% of the volume in the London Stock
Exchange.
Initial and variation margin applies to CFD trading. As with most OTC derivative
trading, there is residual counterparty risk that the counterparty to the contract
fails to meet their financial obligations.
If the counterparty to a contract fails to meet their financial obligations, the CFD may
have little or no value regardless of the underlying instrument. This risk is mitigated
slightly by the margining system

Other risks include:
 market risk - the main risk with a CFD is market risk, as the contract is designed
to pay the difference between the opening price and the closing price of the
underlying asset.
 liquidity risk - if prices move against an open CFD position additional variation
margin is required to maintain the margin level. The CFD provider may call
upon the party to deposit additional sums to cover this, and in fast moving
markets this may be at short notice. If funds are not provided in time, the CFD
provider may close/liquidate the positions at a loss for which the other party is
liable.

Chapter 4 Summary
Asset-backed securities and securitisations
Securitisation is the issue of securities, usually bonds, where the bonds are serviced and
repaid exclusively out of a defined element of future cashflow owned by the issuer. It
offers a way for a company to raise finance.
The securities issued are referred to as asset-backed securities (ABS). They pay
coupons based on the cashflows generated by the securitised assets.
The main classes of asset-backed securities (ABS) include:

 residential and commercial mortgage-backed securities (MBS)
 credit card receivables (CCABS)
Securitisations are usually structured around a special purpose vehicle (SPV), which is
typically set up to be bankruptcy remote with regard to the original company.
The borrowings are normally made in a multi-tranche format involving several

differently ranking levels of debt, eg senior, mezzanine and equity. This is done so as
to appeal to the various risk / return preferences of different investors, thereby reducing
the overall cost of capital.
Private equity
Private equity is the provision of equity capital where there is no immediate exit route
via the secondary market, ie investment in unquoted securities.
The forms of private equity include:

 venture capital – capital for businesses in the conceptual stage or where
products are not developed and revenues and/or profits may not have been
achieved
 leveraged buy-outs – equity capital for acquisition or refinancing of a larger
company
 development capital – growth or expansion working capital for mature
businesses in need of product extension and/or market expansion
 restructuring capital – new equity for financially or operationally distressed
companies.

Management buy-outs are a form of leveraged buy-out in which the existing

management buy-out the existing owners of the company – ie buy their shares and
hence a controlling interest in the company. Similarly, a management buy-in occurs
when the buyer is an external management team.
Providers of private equity are often brought together in a private equity fund.
Private equity funds may be appropriate owners of businesses where:

 the risk profile is unsuitable for public ownership
 the cost of capital may be reduced under private ownership (for example by
using very high levels of financial gearing), or
 where valuation is difficult in the public arena for any other reason.
Proponents of private equity investment claim that:

 private equity outperforms (over the long term)
 it is a loosely correlated asset which may be able to enhance portfolio
performance without materially increasing risk.
Assessment of these claims is complicated by the impact of survivorship bias.
Investors can diversify risk by buying into quoted venture capital and development
capital investment trusts or by having segregated funds managed for them by private
equity firms. Use of a fund-of-funds (which invests in a number of other private equity
funds) offers greater diversification but usually involves a double layer of fees.
Hedge funds / absolute return funds
A hedge fund can be defined as an investment fund that aims to meet high or absolute
returns by investing across a number of asset classes or financial instruments. Hedge
funds typically have less restrictions on:
 borrowing
 short-selling
 the use of derivatives

The term hedge funds covers a wide spectrum of investment strategies although some of
the more common ones are:
1. global tactical asset allocation funds – concentrate on macroeconomic changes

around the world
2. event-driven funds – trade either distressed securities or securities of companies
involved in mergers and acquisitions (risk arbitrage)
3. market-neutral funds – enter simultaneously into long and short positions, whilst
taking no overall exposure to the market
4. multi-strategy funds – a combination of the above.
It is sometimes claimed that hedge funds offer the prospect of higher returns and
diversification, however, measuring and interpreting hedge fund past performance is not
straightforward. This is because historical data can be influenced by:
 survivorship bias – when the data does not realistically reflect survivors and
failures
 selection bias – funds with a good history are more likely to apply for inclusion.
Backfilling will then cause a significant upward bias.
 marking to market bias – whereby the use of “stale” prices can lead to
underestimation of true variances and correlation.
Investors should therefore look at the whole of the return distribution rather than rely on
a single summary statistic.
Currency
The FX market exists whenever one currency is traded for another. It is by far the
largest market in the world, in terms of cash value traded, with trillions of dollars
changing hands daily.
Currency transactions are either spot transactions or forward transactions.
Infrastructure
The financing of long-term infrastructure, industrial and public services projects is

based upon a non-recourse (or limited recourse) financial structure where project debt
and equity used to finance the project is paid back from the cashflow generated by the
project.

Economic infrastructure includes:

 highways
 water and sewerage facilities
 energy distribution
 telecommunication networks.
Social infrastructure encompasses:

 schools
 universities
 hospitals
 public housing
 prisons.
Commodities
Commodities are traded on various markets around the world, primarily in Chicago and
London. Commodity futures are based on the prices of the underlying commodities
including agricultural produce, energy and metals.
Commodity futures are priced as:

Future price = spot price + cost of carry – convenience yield.
Commodity futures and forward contracts are used by producers and consumers who
wish to reduce the uncertainty in the amount they will pay or receive for the product.

Insurance-linked securities
Insurance-linked securities (ILS) are securities whose return depends on the occurrence
of a specific insurance event. Examples include catastrophe bonds and bonds related to
life risks. The process for creating a catastrophe bond is:
1. An SPV is established in a tax efficient jurisdiction.

2. The SPV establishes a reinsurance agreement with the company.
3. The SPV issues a bond to investors with default provisions that mirror the terms
of the reinsurance agreement.
4. The proceeds from the bond sale are invested in a segregated account.
5. If default occurs, the assets of the SPV are used to meet the insurer’s losses.
Structured products
A structured product is a pre-packaged investment strategy in the form of a single

investment. A typical structured product will consist of two components:
1. A note – essentially a zero-coupon debt security that provides capital protection
2. A derivative component that provides exposure to one or several underlying
assets such as equities, commodities, FX or interest rates.
Index funds
An Index Fund is an ‘open-ended’ unitised collective investment scheme that attempts

to mimic the performance of a particular index. As such, it is passive management in
action.
Exchange-traded funds (ETFs)
ETFs exhibit features that are like investment trusts in some ways and unit trusts in
others. They trade at NAV, and rarely at a discount, yet they are quoted on the stock
market and can be traded in real time. They are generally index tracking funds, with
low annual management charges, and the range of ETFs available has increased
enormously over recent years.
Contracts for differences
A Contract for Differences (CFD) is a contract stipulating that the seller will pay to the
buyer the difference between the current value of an asset and its value at a specific
time.

This page has been left blank so that you can keep the chapter summaries
together for revision purposes.

Chapter 4 Solutions
Solution 4.1
Prepayment risk is usually of most relevance for mortgage-backed securities based on

residential property, as a mortgagee may often try to redeem the mortgage prior to the
originally agreed redemption date.
Solution 4.2
In the event of default by the issuer of the original corporate bonds, the following
cashflows will be exchanged:
 The original bondholder will receive $R (the “recovery”) from the original
bonds and $(100–R) from the credit default swap, giving a total of $100.
 The SPV will receive $100 from the Government bonds and pay $(100–R) under
the terms of the credit default swap, giving a total of $R. This will then be
passed on to the investors in the SPV.
Solution 4.3
An amortising loan is one that must be paid over a specified period with regular
payments of both interest and capital – eg a repayment mortgage used to purchase a
residential property.
A non-amortising loan does not require principal payments on a schedule so long as

interest is paid regularly – eg credit card debt.
Solution 4.4
A company will structure a securitisation using a multi-tranche format, rather than a

simple asset-backed security with just a single tranche of debt, if by doing so it is able
to appeal to the different risk and return preferences of a range of different investors.
This in turn will enable the company to sell the asset-backed securities for a higher
combined price, so reducing the overall cost of borrowing.

Solution 4.5
Taking a public company into private ownership might be advantageous for one or
more of the following reasons:
 there may be fewer regulatory restrictions on its activities, so giving it greater
freedom to make profits
 it may benefit from a closer relationship with a typically smaller number of more
sophisticated investors who may provide management input
 it incurs lower costs in complying with less onerous financial reporting
requirements
 the lack of a quoted market share price may enable the management to take a
longer-term view when making investment decisions.
Solution 4.6
Possibly the biggest disadvantage is the loss of control over the company. Also, the
capital may only be made available in tranches with the availability and/or cost of the
later tranches being dependent on the venture capitalist.
Solution 4.7
Possible disadvantages of private equity investment include:

 lack of liquidity and marketability
 variable past performance record
 difficulty in valuation
 need for specialist investment advice
 high costs
 lack of reliable information
 regulatory constraints.
Solution 4.8
Venture capital and restructuring capital are likely to be the riskiest. This is because
venture capital involves a very new company, many of which fail, and restructuring
capital typically involves providing money to companies in financial trouble
(financially distressed companies), many of which again tend to fail.

Solution 4.9
(i) First closing date
The first closing date (which is typically 3 to 6 months after marketing of the fund
commences), is the date at which the fund manager can start to call on the investors to
hand over the cash they have committed to invest. This will enable the fund manager to
start making investments in companies. It also enables the fund manager to start
receiving his fee, as typically part of his fee will be a percentage of funds committed.
(ii) Final closing date
The final closing date is the end of the marketing period of the fund – ie after this date
there are no new commitments to provide funds for investment. The final closing date
is typically 12 months after the start of the marketing.
(iii) Investment period
The investment period is the time during which the investors pay over the funds they
have committed and the fund manager makes the investments in businesses. The end of
the investment period is typically 2 or 3 years after the final closing date.
Solution 4.10
A long-only, non-leveraged strategy is one where it is not possible to short sell

(borrowed) assets (in anticipation of price falls) or to borrow to provide further capital
for investment. This may be because the investor is prevented from doing so either by
regulation or by the legal documentation governing the running of the investment fund.
Solution 4.11
An active approach to managing a distressed securities fund will involve investigating

companies to assess their potential for survival and recovery and, quite possibly, being
involved in this recovery process.
A passive approach will involve buying securities in struggling companies, with little
fundamental analysis into their value. The manager will then hold on to the securities
until the company recovers or else sell them on (if possible) if recovery later seems
impossible.

Solution 4.12
To hedge the general equity market risk he could use derivatives, eg sell equity index
futures.
Solution 4.13
Beta is a measure of systematic risk. A fund is beta-neutral if the beta of the long
portfolio is equal to the beta of the short portfolio.
Solution 4.14
The focus here is on diversification of strategy. So, in the example, if the short-selling
of equities to buy property doesn’t work out, the strategy may still have done relatively
well compared to other similar ones if the event-driven aspect of the property portfolio
does well.
Solution 4.15
A distribution is negatively skewed if its third central moment m3 , and hence its
m3
coefficient of skewness ( ), is less than zero. That is to say, it has a long lower tail –
s3
there are more big falls than big increases.
Solution 4.16
A hedge fund manager’s fee typically depends primarily on absolute performance, not
the funds under management. Therefore, the hedge fund manager wants to maximise
absolute return and not the funds under management. Many hedge funds will be able to
generate better returns on a smaller level of funds. This is because they will not move
prices against them when trading on arbitrage opportunities or they will be able to buy
sufficient quantities of distressed companies, etc. The extent to which this is true will
depend on the type of hedge fund – a global fund buying large market capitalisation
stocks will not have as limited a capacity as a distressed securities fund.

Solution 4.17
Using the information given in the question, we get:
( )
F = 6, 000, 000 = S ¥ (1 + rd ) 1 + r f = S e0.04¥90 365 e0.02¥90 365
¤ S = 5,970, 484
Dividing the $9,000,000 by this gives a spot exchange rate of 1.5074.
Solution 4.18
You would sell the dollar forward, ie agree in July 2015 to hand over $164 in return for
£100 in October. Come October, if your guess about the spot rate is right, you could
then:
 borrow £98.80 and use it to buy $164 at the October spot price of 1.66 ($/£)
 sell the $164 to receive the £100 as agreed
 pay back the £98.80 immediately
 leaving a profit of £100 – £98.80 = £1.20.
Solution 4.19
Disadvantages of privatisation:
1. The biggest threat is reliability. There is nothing to guarantee the private

organisation in the long-term, whereas a government can back up its enterprises
with public funds. There is more chance of bankruptcy in a private organisation.
2. Private companies’ main motive is to maximise shareholder value – this may be

to the detriment of the public. This may require the government to regulate the
private enterprise, incurring additional costs.
3. Some departments have a strong social responsibility that can only be ensured
by government. For example, the police, or traffic management.

Solution 4.20
The main problem for an individual wanting to invest is the extremely high unit size of
investment. They could try:
1. investing directly in a company whose sole purpose is an infrastructure project
2. investing in an infrastructure investment or unit trust
3. investing in shares in a company that invests heavily in infrastructure
4. forming a syndicate to fund the investment
5. by being astonishingly rich in the first place!
Solution 4.21
Anyone involved in the production chain, eg transporters, wholesalers and retailers of

the commodity.
Solution 4.22
Not necessarily. Provided that the price of the future moves in line with the price of the
actual commodity needed, the consumer may close out the futures transaction, and use
the profits to help pay for the commodity in the cash market. For example, a consumer
may require an asset that is very slightly different from that underlying the futures
contract. If the price of the required asset and the price of the futures contract move
together, then any increase in price in the required asset will be offset by an increase in
the value of the future held.
Solution 4.23
A commodity future is a real asset in the sense that its price will reflect expectations of
inflation over its future life. However, since the life of a future is relatively short
(measured in months rather than years), the inflationary effect at current low levels of
inflation may well be small, and changes in expectations of future inflation over the
lifetime of the future are likely to be swamped by price volatility caused by other
factors.
A future on a commodity price index may be a better match for inflation (especially
“cost push” inflation).

Solution 4.24
Consider the purchase of the underlying asset. This purchase can be carried out in one
of two ways. If the purchase is made on the cash market the spot price S will be paid.
In addition, for the period of the futures contract, the storage costs SC for holding the
asset must also be paid. So the total cashflows are S + SC.
Now consider the same purchase made through the futures market. The futures price is
F. In addition income can be received from investing the money which is not required
to make the purchase until the end of the time period. So there is a net inflow of iS, say,
ie income on the cash price that has not had to be paid.
Equation these cashflows we get S + SC = F – iS. Rearranging this we get the equation
for the futures price.
Solution 4.25
Using the equation above, we find that the price of the future ought to be:
$1,442 + $0.20 + 0.001  $1,442 = $1,443.64
(Where 0.1% has been used as the risk-free interest rate in a quarter.)
Instead the price is $1,448, greater than the fair value figure. So, gold futures are
currently expensive. To make a profit from them we must sell the future and buy gold
in the cash market, as follows:
 borrow $1,442 at the risk-free rate for 3 months
 buy an ounce of gold for $1,442
 sell a three month gold future
 insure and store the gold for 20 cents
 at the end of three months deliver the gold in exchange for $1,448
 repay the borrowings.
The return on the strategy ($1,448 – $0.20 – $1,442  (1.001) = $4.36) is about 0.3% in
the quarter, well in excess of the risk-free rate of interest An arbitrageur could borrow
and invest in this deal many times over, gearing the firm up and increasing the return
correspondingly.

Solution 4.26
In a market where storage and other costs are low, but the market is liable to sudden
shortages, ie supply is very variable. This is particularly likely to happen for
agricultural crop futures, where adverse weather conditions can dramatically reduce the
supply of a particular commodity. Also, arbitrageurs are less likely to be active in crop
markets than they are in markets for other assets such as gold or silver.
Solution 4.27
Return from a
Premium BB+ rated bond
East Japan SPV Investors
Railway (arranged by
Company Munich Re) Proceeds
Losses from ($260m)
earthquake
covered by Return of
principal principal if
no
earthquake
Solution 4.28
Return from an
Premium A3 rated bond
SPV
FIFA Investors
(arranged by
Credit Suisse Proceeds
Losses if First Boston)
FIFA’s Return of
earnings not principal
achieved due
to
catastrophic
event

Solution 4.29
(i) Advantages
● it may be available when reinsurance is not (either the market may be saturated,
or reinsurers may be unwilling to reinsure those particular risks).
● it may be cheaper than traditional reinsurance.
● it is effective at transferring risk.
(ii) Why the banking and capital markets may be prepared to buy the bond
● it will help them to diversify their investment portfolio.

● capital markets may have the capacity to accept the risk.
● they may perceive the return to be adequate compensation for the risk.
Solution 4.30
Theoretically an investor can just do this themselves, but the costs and minimum
transaction volume requirements of many options and swaps are beyond many
individual investors.
Solution 4.31
The bank will choose the value of x so that they can sell call options at the same price
needed to purchase the put options. If they also invest the investors’ money straight
into the FTSE 100 index, then they are completely immunised from the outset and any
growth of the FTSE 100 will not affect their profit or loss.
Solution 4.32
1. Access to derivatives that are otherwise inaccessible.

2. Pre-packaged nature saves time and cost of expertise.
3. Access to derivatives that are otherwise legally uninvestable.
4. Possible favourable tax situation
5. Better contribution to accounting ratios than direct investment.
6. Possible enhanced returns and reduced volatility.

Solution 4.33
1. Mark out specified assets as security.

2. Collect margin payments.
Solution 4.34
Disadvantages of index funds include:

 tracking error – if the fund is slow to rebalance as the constituent values of the
index change, the fund value could deviate from the index value over time.
 no outperformance - an index fund seeks to match rather than outperform the
target index.
 reduced return due to index changes - whenever an index changes, the fund is
faced with the prospect of selling all the stock that has been removed from the
index, and purchasing the stock that was added to the index.
If there are a large number of constituents in the index, this cost could be
significant.

ST5-05: Environmental influences Page 1
Chapter 5
Environmental influences
Syllabus objective
(c) Demonstrate knowledge of the influences over the commercial and economic
environment from:
 central banks
 main investor classes
 government policy.
0 Introduction
This relatively short chapter looks at some of the main factors influencing the
commercial and economic environment. Some of this material should be familiar from
Subjects CT7 and CA1, and possibly from your general knowledge and experience.
The layout of this chapter is as follows:

 Section 1 describes the roles of central banks, concentrating mainly on their
influence on the money supply.
 Section 2 classifies the main investors in the market into groups and considers
how the objectives of these groups influence the economy and investment
markets.
 Finally, Section 3 looks at how government policy can have a significant impact
on many areas of the commercial and economic environment.

Page 2 ST5-05: Environmental influences
1 Central banks
1.1 The influence of central banks
The influence of central banks varies according to the division of power between
related government ministries, central banks and other regulatory bodies. The
degree of independence of the central bank from the political echelon will also
determine the bank’s importance.
In the US, the central bank (the Federal Reserve) is fully independent of the
government. In the UK, the central bank (the Bank of England) is not fully
independent. It does however have the power to set short-term interest rates, which it
does in order to meet the UK Government’s published inflation target of 2% pa based
on the Consumer Price Index (CPI). This index and target replaced the previous target
of 2.5% pa based on the Retail Price Index in January 2004. The CPI is identical to the
Harmonised Index of Consumer Prices, for which the independent European Central
Bank also has a 2% pa inflation target.
1.2 The interests of a central bank
A central bank may be interested in:

 monetary, interest rate and inflation policy
 banking regulation
 implementation of government borrowing
 performance and integrity of financial markets
 intervention in currency markets
 printing and minting of notes and coins, and
 taxation.
However which of these are set by the central bank in a particular country (and
which are truly determined by an independent central bank rather than just
implementing decisions made by political entities) will vary from country to
country.
In many states, central banks are now primarily concerned with monetary policy
and control:
 adjustment of banking sector liquidity
 control of money supply growth and short-term interest rates.

Banking regulation in the UK used to be the responsibility of the Bank of England.

before the regulatory functions were transferred to the Financial Services Authority
(FSA). In April 2013 three new regulatory bodies were established:
 the Financial Policy Committee (FPC)
 the Prudential Regulation Authority (PRA)
 the Financial Conduct Authority (FCA).
The PRA and the FCA have effectively taken over the functions of the FSA.
Question 5.1
What is the main economic variable that the money supply is used to control?
1.3 Adjustment of banking sector liquidity
Money market intervention is achieved through buying and selling bills to

influence the level of liquidity within the banking sector and short-term interest
rates. This will include activity to stabilise rates (when cash flows between the
government and private sectors would otherwise impinge on bank liquidity).
Central bank buying and selling of bills is known as open market operations or OMOs.
If the central bank buys bills back from the banks in the money markets, this increases
the amount of money in the banking sector allowing the banks to expand the money
supply. Similarly, the central bank selling bills will reduce the money supply.
As well as this use of market intervention to control banking sector liquidity and hence
the money supply, the central bank may also use non-market (direct) controls
such as:
 setting minimum liquid reserve ratios
 setting interest rate ceilings for bank deposits
 issuing directives regarding the types of lending to be undertaken.
Question 5.2
Describe how each of these controls influences the money supply.

1.4 Quantitative easing
Quantitative easing was discussed in Subject CT7. It usually means printing money.
Quantitative Easing (QE) is a monetary policy used by some central banks to

increase the supply of money. It usually involves both a direct increase in the
money supply (ie electronically “printing” money) and a knock-on effect from the
fractional reserve system, increasing the money supply further, although it can
involve just making changes to the fractional reserve system.
The fractional reserve system refers to funds being received by banks and loaned on to
other customers. This means that the bank reserves are only a fraction (the reserve
ratio) of the quantity of deposits in the banks.
QE is usually implemented by a central bank first crediting its own account with
money it creates out of nothing (“ex nihilo”). It then purchases financial assets,
for example, government bonds, quasi-government debt, mortgage-backed
securities and corporate bonds, from banks and other financial institutions in a
process referred to as “open market operations”. It can also involve changing
the reserve requirements for banks which, through the fractional reserve system,
would increase the money supply.
The use of QE has evolved in recent years. Central banks using QE as a

monetary policy tool typically give a degree of forward guidance to the market
regarding the anticipated levels of QE that they intend to conduct in the short to
medium term. This is part of a general evolution in the use of monetary policy,
whereby communication by central bankers is increasingly used as a monetary
policy tool to influence the yield curve and consequently economic activity.
Example
On 7 August 2013, the Bank of England Monetary Policy Committee (MPC) made the
following forward guidance statement:
The Committee intends at a minimum to maintain the current highly stimulative stance
of monetary policy until economic slack has been substantially reduced, provided this
does not entail material risks to either price stability or to financial stability.
In particular, the MPC intends not to raise Bank Rate from its current level of 0.5% at
least until the Labour Force Survey headline measure of the unemployment rate has
fallen below the threshold of 7% (subject to conditions). (It is currently 5.5% as at May
2015.)

2 Main investor classes

Investors may be classified into:
 private individuals (“households”)
 managers of short-term and long-term mass savings products (“financial
intermediaries”)
 corporates (“businesses”)
 foreign investors.
Note that this isn’t a “cut-and-dry” classification. For example, family businesses,
multinational companies and charities and other institutions don’t fit neatly into one of
these groups of investors. However, it is a helpful classification when thinking about
the main investors in the markets. In addition to these groups of investors, other parties
involved in the investment markets include governments and government agencies (see
Section 2.5 below), central banks and regulators.
The different categories, and investors within each category, will vary in their
 time horizons – eg whether they want investment returns over the short term or
the long term
 appetite for risk – ie the extent to which they are averse to or tolerant of risk
 taxation position – this will reflect both the tax rules that apply to the particular
type of investor and the individual investor’s own particular set of
circumstances, eg how wealthy or otherwise.
Also investments which are risky for one investor may be less or more so for
another investor depending on the different liability profiles and other features of
the investors.
Example
Consider fixed-interest government bonds in a developed country. They are risk-free

for an investor with fixed monetary liabilities in that currency but involve risk for an
investor with liabilities linked to retail prices in another country.
Question 5.3
What are the risks faced by the second investor in the above example?

A willingness on the part of investors to make certain types of investment will

tend to encourage the kind of economic activity that will create such
investments. For example the existence of a sophisticated, well-funded and
aggressive private equity market in the US has been cited as an important part of
the growth of technology start-ups.
In contrast, UK institutions invest in private equity and venture capital to a much lesser
extent.
We will now briefly consider the main investor classes in turn.
2.1 Households
Households are potentially interested in a wide range of assets. Diversification

is often a key consideration, particularly given that the typical householder will:
 have only a relatively small amount of wealth to invest
 much of that wealth may be tied up in the house in which he or she lives.
Other considerations for households when making investment decisions include:

 liabilities (generally real in nature)
 liquidity
 uncertainty over future income and outgo
 tax
 level of investment expertise
 stability of asset values
 investment and risk characteristics of available assets
 attitude to risk.
You may recall the discussion of some of these and related in the Subject CA1 chapter
on personal investment.
The importance of diversification leads to the need for financial intermediaries

who form a link between households and the businesses that need to finance
investments in real assets.
The alternative to investing in the products and services of a financial intermediary is to

invest directly in the underlying assets (eg shares, bonds, properties) themselves.

2.2 Financial intermediaries
A financial intermediary channels resources between lenders (ie investors) and

borrowers. Given this fairly generic definition, it is no surprise that there is a wide
range of financial intermediaries, eg banks, insurance companies, pension funds,
collective investment vehicles.
Financial intermediaries sell their own liabilities to raise funds that are used to
purchase the liabilities of other corporations.
Consider the example of a bank. When an investor deposits funds with the bank, a
liability is created on the bank’s balance sheet. The bank may then use the deposit to
give a loan to another party. This creates an asset (a debtor) on the bank’s balance
sheet.
As a further example, consider a life insurance company selling a savings product, such
as an endowment assurance policy. The life insurance company is “selling” a liability
(a benefit payable on death, surrender or maturity) and is using the “funds” it raises (the
premiums) to buy the liabilities of other corporations (eg by investment in shares or
corporate bonds).
Financial intermediaries offer several advantages compared to direct investment:

 they pool the resources of many small investors, and are therefore able to
lend considerable sums to large borrowers. They may therefore enable
small investors to gain access to investments which they could otherwise not do
so by themselves, eg large property developments.
 by lending to many borrowers, intermediaries achieve significant
diversification, meaning they can accept loans that individuals might
regard as too risky
 intermediaries build expertise through the volumes of business they do.
For example, the investment manager of a life insurance company is able to
spend a lot more time thinking about and making investment decisions than the
average individual is able to do so.
 lower dealing, administration and management costs through economies of
scale.
Question 5.4
What are possible disadvantages of financial intermediaries?

2.3 Businesses
Businesses typically need to raise money to finance their investment in real

assets. “Real assets” here refers to assets (such as buildings and machinery) that are
used by the business to generate profits rather than investments that offer a real return
(such as index-linked bonds).
In issuing securities to the public, they have several objectives. These typically
include:
● to get the best possible price for their securities
● to market the issues at the lowest possible cost.

These seem reasonable! The funds that a business will actually have available
after issuing securities to the public are given by the total price investors pay for
the securities less the costs of the issue. This is clearly maximised by getting the
best possible price from investors and incurring the lowest possible costs.
 to issue securities that best meet their requirements with regards to the term,
pattern and flexibility of funding.
For example, if they anticipate a need for borrowing at a floating rate over the
next 5 years only, then they might choose to issue a 5-year floating-rate bond.
Conversely, if they do not wish to commit themselves to interest payments, then
they might prefer to issue shares.
Issuing securities is complex, time-consuming, costly and requires specialist expertise.

Most businesses don’t issue securities sufficiently regularly to be experts in the process,
so if they undertake the process themselves they are unlikely to achieve their objectives.
It is for this reason that they often seek the aid of an investment bank to help them
achieve their fund raising objectives.
In order to achieve these objectives, investment banking firms specialise in such

activities. They:
 advise the issuing firms on the prices they can charge.

An investment banking firm will have good knowledge of the market and will
suggest appropriate issue prices and interest rates.
 handle the marketing of the security issue to the public.

This involves advertising the issue to potential investors, maintaining records of
applications and determining allocations, handling investors’ money and
actually issuing the securities.

 seek to protect their reputation for honesty by checking and certifying the
quality of the information offered.
The ability of an investment bank to successfully issue securities relies on the
reputation it has established. The investment bank will suffer if it is associated
with an unsuccessful issue or one where investors are disappointed. Therefore
the bank has a strong incentive to ensure the quality of information offered.
 innovate security design and packaging to stimulate demand.

A business that issues securities directly would prefer to issue simple securities
that are less expensive to arrange. This may be at odds with the needs of
investors, who may prefer a greater variety of securities. There is a role for
investment banks here as they may use their expertise and knowledge of
investors to develop securities with features that will prove attractive. They may
also be able to package “plain vanilla” securities in a way that makes them more
attractive to investors. An example here is the design of several different
tranches of debt in a securitisation issue.
2.4 Foreign investors
Globalisation means that foreign investors are increasingly important in most

investment markets. The importance of their role will in part reflect the general
attractiveness of the particular market to foreign investors. For example, foreign
investors will typically not be attracted to markets in which they are subject to different
(and more restrictive) rules than local investors, nor to markets in which they perceive
that there may be political risks. Their preferences may also differ from those of local
investors due to:
 the impact of currency movements
 the different rules and regulations to which they are subject in the countries in
which they are based.

2.5 Governments
Governments are not major investors. However, they do play a number of critical roles
in the investment markets.
Businesses are not the only group needing to borrow. Governments also need to
finance their expenditure by borrowing. They exploit their creditworthiness in
order to borrow at the lowest rates. They are usually deemed to be the most
creditworthy borrowers in the market because they are always able to finance their
borrowings by further borrowing, raising taxes and/or printing money.
Question 5.5
What two main types of security do national governments issue?
Question 5.6
In addition to borrowing, what other sources of finance are available to governments?
Borrowing is not the only involvement of governments in the markets. They also
regulate the financial environment. However, much financial innovation may be
viewed as responses to government tax and regulatory rules.
For example, the government may introduce new tax rules to ensure it raises sufficient
revenue. Financial intermediaries may then devise new investment products to exploit
any loopholes in the tax laws, so enabling investors to avoid tax on their investment
returns. Likewise new investments may be designed to reduce the impact of changes in
regulatory and/or tax regimes.

3 Government policy
Government policy clearly has the potential to impact every aspect of the
commercial and economic landscape. The government effectively sets the rules
within which investors and borrowers operate.
3.1 Main forms of government policy
The main forms of government policy are:
 Monetary policy – the control of some measures of the money supply

and/or the level and structure of interest rates.
Recall from Subject CT7 that monetary policy is a particularly effective tool in
controlling the rate of inflation.
 Fiscal policy – decisions on the level and structure of taxation and

government expenditure and hence, by implication, the public sector
borrowing requirement (or debt repayment).
The level and structure of taxation can have a major influence on the
attractiveness both of starting up and running a business and also of investing in
different asset types.
The public sector borrowing requirement (PSBR) or fiscal deficit is the excess
of government expenditure over government income from taxation. If this
quantity is negative it is known as the public sector debt repayment (PSDR) of
fiscal surplus.
 National debt management policy – the manipulation of the outstanding

stock of government debt instruments held by the domestic private
sector, in order to influence the level and structure of interest rates or the
availability of liquid reserve assets to the banking sector.
Note that national debt management policy is closely inter-linked with monetary
and fiscal policy.
 Exchange rate policy – directed towards achieving some target for the
exchange rate of the domestic currency in terms of foreign currencies,
perhaps with the objective of influencing the country’s international
trading and investment patterns.
To the extent that governments can influence currency exchange rates,
this will influence the competitiveness of a location for internationally
traded goods. It is the relationship between currency exchange rates and
the price in local currency of inputs, including labour, that determines
competitiveness.

The lower the value of the domestic currency and the local currency cost of
factor inputs (land, labour and capital), the more competitively priced will be the
goods and services produced.
 Prices and incomes policy – aimed at influencing the rates of wage and
price inflation.
Prices and incomes policies aim to control these variables (and hence inflation)
directly by imposing maximum increases. Governments have encountered
practical problems when trying to implement such policies including distortions
between public sector and private sector wages.
The government does not consider and make decisions regarding each of these forms of
policy in isolation – particularly as different policies may have contradictory influences
on the economic environment. Rather, it will implement a package of policies to best
target its sometimes conflicting policy objectives.
3.2 Other forms of government policy
In addition to these main forms of government economic policy, there is a wide range of
other areas where government policy can and does influence the commercial and
economic environment.
Taxation
Policy regarding taxation, its overall level and distribution between personal
direct, indirect, corporate and other (eg stamp duty) will affect demand for goods
and services, including labour, because of the impact on the prices. It will
therefore affect the profitability of businesses and the (net) returns provided by
investments.
Recall that direct taxes are levied on income paid to factors of production. Corporate
taxes are an example of these as they are levied on company profits, whereas indirect
taxes are levied on expenditure.

Competition policy
Competition policy will be a crucial element of the operating environment,

especially for the increasing number of naturally oligopolistic industries.
Question 5.7
What is an oligopolistic industry?
Important examples of oligopolistic industries include those in which financial

intermediaries operate, eg banking, insurance.
In the UK, the body responsible for most competition issues is the Competition
Commission (whose predecessor was the Monopolies and Mergers Commission). An
example of competition policy having a major impact on an oligopolistic industry was
the granting of third generation mobile phone licences to a limited number of
companies.
The role of competition and fair trading controls and monopolies regulators are
discussed further in Chapter 8.
Labour policy
Labour policies will set the background for the flexibility of labour and the
bargaining power of organised labour. The related domain of social policies will
determine the cost of health services, welfare benefits and state pensions, which
typically are funded largely through taxation.
To the extent these are provided by government and paid for out of charges
which are separate from taxation, they will have to be separately added to the
cost of labour. Such “on costs” to employment (typically labelled “national
insurance” or “health insurance”) can be a crucial element of total labour costs.
Examples of labour policies include policies determining the powers of trade unions and
minimum wage legislation. These are likely to influence the cost of labour and hence
the relative competitiveness of businesses operating in different jurisdictions. They
may also influence the choice of multinational companies as to where they choose to set
up operations.

Government incentives for investment
Incentives for investment can vary enormously and will be important to both
suppliers of investment goods and to companies making investment decisions.
Here we mean investment in the economic sense, ie the creation of new capital goods.
Incentives may take the form of grants, subsidies and/or tax breaks for specific types of
investment and/or research and development.
Government funded, or otherwise encouraged, investment in infrastructure will

help determine how easy it is for an organisation to put in place the physical
requirements of its business within a territory.
It could therefore be used to attract investment from overseas, eg a multinational

company locating a car production plant.
3.3 Effectiveness of government economic policy in practice
In reality, there is considerable overlap between policies.
Early post-war period
Throughout the post-war period and until the 1970s, monetary policy played a
subsidiary supportive role to fiscal policy in most states including the UK.
Governments tended to emphasise the use of demand management techniques
in an attempt to “fine tune” the economy. A basically Keynesian approach was
therefore adopted.
Demand management is the use of fiscal policy in particular, and also monetary policy,
to offset external shocks (eg an oil price shock) to stabilise the level of economic
activity and maintain close to full employment.
If such demand management techniques were being used, in a recession a government

would generally increase its expenditure and expand the money supply in order to boost
economic activity and reduce unemployment.
The money supply was often allowed to accommodate money demand, with little
attention paid to the possible inflationary implications. Inflation was in any case
only moderate up to the end of the 1960s.

Question 5.8
Why would the money supply be allowed to expand?
From the 1970s onwards
From the 1970s onwards, a much more positive role was adopted for monetary
policy in many states, with explicit recognition being given to the control of the
money supply as an important element in the fight against inflation. This was
because controlling inflation became an important policy objective in its own right,
rather than governments concentrating exclusively on full employment. This was
largely in response to the very high levels of inflation witnessed in the 1970s. For
example, the inflation rate in the UK peaked at over 20% pa.
Monetary policy was brought to the forefront of the economic policy package,
and the other policies were seen as being merely supportive to this – in other
words, a more monetarist approach was emphasised.
In the UK, this was partly a result of the monetarist views of the Conservative
government. The monetarist view is that demand management policies are likely to
distort the economy and move it away from its equilibrium. Therefore, Monetarists
focus on achieving low inflation to allow the market to efficiently reach equilibrium and
hence its full employment level, without incurring the costs associated with inflation –
recall that these were discussed in Subject CT7.
Governments have adopted Medium Term Financial Strategies aimed at reducing

inflation (via a policy of strict monetary control) while reducing the proportion of
national resources taken for public sector use and the burden of taxation on the
working population.
In the UK, the Medium Term Financial Strategy (MTFS) involved the government
setting out targets for and projections of key variables (eg the money supply and PSBR)
over the next four years. The intention was that this would give the private sector more
certainty regarding the government’s plans for managing the economy and so be
reflected in private sector decision-making.

It was hoped that this would then help in achieving the basic aims of the MTFS,
namely:
 low inflation – put simply, if the MTFS outlined a policy aimed at reducing
inflation which the private sector viewed as credible, then private sector agents
would come to expect lower inflation.
 increased economic growth through:

– reduced taxation of the working population, which increased the
incentive to work harder
– greater investment encouraged by a greater degree of economic certainty
leading to increased business confidence
 an increase in the proportion of economic resources employed by the private

rather than the public sector, the former being viewed as more efficient.
Such “supply side” measures are aimed at boosting incentives and, hopefully,
encouraging long-term economic growth.
An important element in the globalisation of business has been the liberalisation

of trade and capital markets, in both developed and emerging economies. With
more companies operating on a truly global basis there has been much greater
mobility of capital, due to the increased competition and pressure to produce
where profit can be maximised.
These trends have had significant implications for tax policy, as cross-border
investors will generally be looking to maximise their returns net of tax. Where
countries are competing for foreign investment there will be pressure to reduce
taxes, particularly the corporate income tax rate. Capital would therefore flow to
the countries with lower tax rates.
There has been a growing perception that governments lose substantial tax
revenues through companies shifting profits to locations where they are subject
to a more favourable tax treatment. This is evidenced by the rise in cross-border
tax schemes, such as:
 moving earnings to a country with a lower tax rate (eg internal group
leverage such as financing subsidiaries in high tax countries primarily
with debt)
 profit shifting through transfer mis-pricing, ie by setting prices for intra-

group transactions which are inconsistent with market rates or by levying
high charges for the use of intellectual property such as trademarks

 taking advantage of differences between tax regimes, eg through the use

of ‘hybrid’ instruments (which may lead to a tax deduction in one country
without incurring taxation in another).
3.4 Economic policy objectives
It is sensible to have formulated economic targets to assess how effectively economic

policy is working. The success of a government’s economic policy can best be
assessed in terms of the major economic objectives:
 unemployment
 inflation
 balance of payments
 economic growth.
Question 5.9
What would be a desirable outcome for each of the above objectives?
3.5 Effects of interest rates on the domestic economy
With the focus of economic policy being directed at monetary policy, it is

appropriate to consider the effects of changes in interest rates on the major
elements of the domestic economy:
 A major direct effect of higher interest rates for the personal sector is
likely to arise via the increase in mortgage loan interest payments, which
will reduce disposable income and hence personal sector expenditure.
Consumers’ expenditure may also be discouraged by higher rates on
credit facilities and higher rates of interest may also encourage higher
levels of saving.
 The impact on the business sector is likely to be detrimental since capital

investment and economic growth prospects will be reduced. This is due
to the increased opportunity cost of committing funds for investment and
the higher cost of borrowing. Also, the reduction in anticipated levels of
economic activity, and higher domestic currency exchange rates, will
reduce the viability of capital investment projects.
With higher interest rates, fewer projects being considered will demonstrate a
positive net present value, investment is therefore likely to be lower.

 Higher levels of interest payments on outstanding debt will reduce

corporate profitability, as existing borrowing costs are a large element of
ongoing costs for many companies.
Lower levels of consumption and investment are likely to lead in turn to lower rates of
economic growth. All of these features are likely to result in reduced employment
prospects and a slower rate of improvement in living standards.
3.6 Effects of interest rates on the balance of payments
As regards the balance of payments, an increase in domestic interest rates is

likely to attract an inflow of foreign investment funds and may also encourage
the repatriation of domestic funds held overseas. Thus, there is likely to be
upward pressure on the domestic currency’s exchange rate.
The overall effect of an increase in interest rates is therefore likely to be a decrease in

economic activity.
Recall from Subject CT7 that the balance of payments account contains two major
elements:
1. the current account, which records all trade transactions with the rest of the
world, plus other current income flows and current transfers
2. the financial account (formerly known as the capital account). This records
investment transactions with the rest of the world (including investment in
physical assets, financial securities and bank loans and deposits).
The effects on the other elements of the capital account (now known as the
financial account) will depend on investors’ expectations of domestic growth
prospects. If it is believed that domestic activity is likely to be depressed, then
there may be reduced inward flows of direct capital investment in physical capital
assets.
The effect on the current account will depend on the extent to which exchange
rates alter. If exchange rates rise, then this is likely to lead to an adverse
movement in the volumes of trade, but the ultimate effects on the current
account will depend on the elasticities of demand for traded goods and services.
In practice, a rise in the exchange rate is likely to lead ultimately to a reduction in the
value of net exports.

4 End of Part 1
What next?
1. Briefly review the key areas of Part 1 and/or re-read the summaries at the end
of Chapters 1 to 5.
2. Attempt some of the questions in Part 1 of the Question and Answer Bank. If
you don’t have time to do them all, you could save the remainder for use as part
of your revision.
3. Attempt Assignment X1.
Time to consider – “learning and revision” products
Marking – Recall that you can buy Series Marking or more flexible Marking Vouchers
to have your assignments marked by ActEd. Results of a recent survey suggest that
attempting the assignments and having them marked improves your chances of passing
the exam. Students have said:
“The insight into my interpretation of the questions compared with that of

the model solutions was helpful. Also, the pointers as to how to shorten
the amount of work required to reach an answer were appreciated.”
Face-to-face Tutorials – If you haven’t yet booked a tutorial, then maybe now is the
time to do so. Feedback on ActEd tutorials is extremely positive. Here are a few
comments made by past students:
“I find the face-to-face tutorials very worthwhile. The tutors are really
knowledgeable and the sessions are very beneficial.”
You can find lots more information on our website at www.ActEd.co.uk.
Buy online at www.ActEd.co.uk/estore


Chapter 5 Summary
Central banks
In many countries, central banks are primarily concerned with monetary policy. This
involves setting interest rates in order to control inflation and may also involve
implementing direct controls, for example setting minimum reserve ratios for banks.
Central banks may also be involved with:

 banking regulation
 implementation of government borrowing
 performance and integrity of financial markets
 intervention in currency markets
 printing and minting of notes and coins, and
 taxation.
The extent of involvement will depend on the division of power and responsibility
between the central bank, the government and other regulatory bodies.
Main investor classes
Investors may be classified as:

 households
 financial intermediaries
 businesses
 foreign investors.
When households are making investment decisions, the need for diversification is often
a key consideration.
Financial intermediaries manage mass savings products. They may offer the following
advantages:
 pooling of investors’ resources enabling lending of large amounts
 diversification
 expertise
 lower costs.

Businesses usually employ the services of investment banks to assist in issuing new
securities to ensure they maximise the amount of finance raised.
Investment banks:
 advise on the price to be charged
 handle the marketing of the issue
 verify the quality of the information supplied
 innovate security design and packaging.
Governments also influence investment markets, eg by issuing securities and through

regulation.
The main forms of government policy are:

 monetary policy
 fiscal policy
 national debt management policy
 exchange rate policy
 prices and incomes policy.
However, government policy in all areas can potentially affect the economic and
commercial environment. This means we also need to consider the levels and types of
taxation, competition policy, exchange rate policy, etc .
Interest rates affect:

 personal sector expenditure
 business sector investment and economic growth prospects
 corporate profitability
 the balance of payments.
There has recently been concern about some companies avoiding tax (legally) by:
 financing subsidiaries in high-tax countries mainly with debt to reduce profits
 reducing profits in high-tax areas through excessively high transfer pricing for
intra-group transactions
 transferring profits through the use of hybrid instruments that arbitrage between
tax regimes.

Chapter 5 Solutions
Solution 5.1
Inflation
Solution 5.2
Minimum liquid reserve ratios
Banks expand the money supply through lending. They are able to do this because they
need only to keep a proportion of the deposits made with them in the form of liquid
investments. Imposing minimum liquid reserve ratios therefore restricts the ability of
banks to expand the money supply by restricting the money multiplier.
Interest rate ceilings for bank deposits
Setting an interest rate ceiling for bank deposits restricts the ability of the banks to
compete for investors’ money. This reduces the amount of money coming into the
banking system and so limits the extent to which bank lending is able to expand the
money supply.
Directives on types of lending
Here the central bank restricts the expansion of the money supply by directly restricting
lending. For example, the central bank could restrict the extent to which consumer
credit is available (eg by limiting the proportion of a purchase that can be made on
credit) or impose restrictions on mortgage lending.
Solution 5.3
Inflation risk and exchange rate risk.

Solution 5.4
Possible disadvantages of financial intermediaries include:

 the additional layer of costs to the investor
 the products offered by intermediaries might not meet the exact requirements of
the investor – eg if the investor wishes to invest in long-term Government
bonds, but the intermediaries only offer general Government bond funds
 the products offered by intermediaries may be inflexible – eg if they have a fixed
term and early redemption penalties
 the investor loses an element of control over their investment choice.
Solution 5.5
The two main types of government security are:

1. Treasury bills, for short-term borrowing
2. Government bonds (much greater volume), for long-term borrowing.
Solution 5.6
The main alternative for governments is to raise revenue through taxation (including
national insurance).
In theory the sale of public assets, profits from nationalised industries and the printing
of money are additional ways of raising finance. However, the amount available from
sales of assets and nationalised industries is usually limited and printing money brings
its own problems, in particular inflation and currency weakness.
Solution 5.7
An oligopolistic industry is one in which there are a small number of competing firms,
each of which believes that its own actions will lead to some form of non-negligible
reaction from the other firms.
Solution 5.8
If the money supply wasn’t expanded, the increased demand for money would cause
interest rates to rise, which would have dampened down economic demand.

Solution 5.9
● Unemployment – low, so as not to have economic resources lying idle that could
be put to use producing goods and services.
● Inflation – low and stable, so as to avoid the costs associated with inflation, both
anticipated and unanticipated.
● Balance of payments – at a level that does not constrain the achievement of the
other objectives. A stable exchange rate is also often viewed as desirable in
order to encourage international trade.
● Economic growth – high and stable, as growth leads to more goods and services
and hence a higher standard of living.





the course.

ST5-06: The theory of finance Page 1
Chapter 6
The theory of finance
Syllabus objectives
(h) Demonstrate a knowledge and understanding of the theory of finance.
(i) Discuss the relationship between financial management and acting as an

entrepreneur.
(ii) Outline the possible motives for mergers and divestitures.
(iii) Discuss the key findings in behavioural finance.
(iv) Outline the main steps involved in financial planning.
0 Introduction
This chapter introduces some basic ideas relating to the theory of corporate finance.
Section 1 discusses the two key decisions relating to financing of a company’s

operations, namely the capital budgeting decision (what to invest in) and the financing
decision (how to finance that investment).
Section 2 recaps on agency theory, which is covered in Subject CT2.
Section 3 describes the different types of, and different motives for, mergers and
acquisitions. The assessment of mergers and acquisitions is considered in detail in
Subject SA5.
Section 4 introduces the interesting field of behavioural finance, which looks at how a
variety of mental biases and decision-making errors affect financial decisions.
Behavioural finance recognises that individuals sometimes appear to act in ways that
contradict the predictions of traditional economic theory.

Page 2 ST5-06: The theory of finance
Finally, Section 5 describes long-term financial planning, which is concerned with the
management of long-term capital, and short-term financial planning, which considers
the management of short-term, working capital.
Students will be expected to be familiar with the relevant material from Subject
CT2, in particular, the various relationships within an organisation, agency
theory and maximising shareholder wealth.
Behavioural finance is covered in Subject CT8 and is also included in this chapter.

1 Introduction to corporate finance

In order to carry on business, companies need to employ real assets, both
tangible and intangible. By real assets, we mean the assets that are used by the
company in its normal line of business to generate profits.
Question 6.1
What are tangible and intangible assets?
To acquire such assets, the company must raise finance – by issuing financial
assets or securities, pieces of paper that confer claims to their holders on the company’s
real assets. Thus the financial manager (who is responsible for the financial
operations of the firm) stands between:
 the firm’s operations (ie the purchase of real assets, which are then used by the
firm to undertake projects in order to generate profits) and
 the financial markets (where investors hold the financial assets issued by
the firm to obtain money).
The role of the financial manager as the link between the firm’s operations and the
financial markets is summarised by the following diagram.
Financial markets
(investors holding
financial assets)
cash raised by
cash returned
selling financial
to investors
assets
Financial Manager
cash
(makes investment and
reinvested
financing decisions)
cash used to
cash generated
purchase real
by operations
assets
Firms operations
(portfolio of real
assets)
Figure 6.1: The role of the financial manager

1.1 Capital budgeting and financing
Finance involves two basic issues:

1. What real assets should the firm invest in? (the investment or capital
budgeting decision)
2. How should the cash for the investment be raised? (the financing
decision).
Capital budgeting decision
Firms use real assets to undertake projects – a firm can essentially be thought of simply
as a collection of projects. These projects generate revenues and incur costs. The aim
of the firm should be to undertake those projects for which the revenues exceed the
costs in order to generate profits on behalf of the owners of the firm – typically the
shareholders. The capital budgeting decision considers the choice of projects, and
hence real assets, in which the firms should invest.
In practice, the capital budgeting decision is often complicated by the fact that:
 there may be more than one apparently profitable project between which to
choose
 it is very difficult to estimate the future profitability of a project.
Financing decision
The typical project requires a significant expenditure prior to the receipt of the first
revenues. In addition, it may be several years before incoming revenues first exceed
outgoing costs and so the project becomes profitable. A net investment will therefore
be required to get the project off the ground. The financing decision considers how best
to raise the required finance.
The second question is the responsibility of the treasurer who:

 looks after the company’s cash,
 raises new capital and
 maintains relationships with banks, shareholders and other investors.
The first question is normally the remit of a controller or, in many instances, the
Chief Financial Officer (CFO).
In principal the CFO has overall responsibility for the company’s financial operations
and as such the treasurer is normally subordinate to him or her. However, in a small
company, the controller and the treasurer may be the same individual.

However, capital budgeting decisions will be tied into plans for product
development, production and marketing and so will involve managers from these
areas (as well as any staff specialising in corporate planning).
Responsibility for financial issues will, ultimately, rest (by law or custom) with the
board of directors. In practice, boards usually delegate decisions for small or
medium-sized matters. However, responsibility for large financial decisions is rarely
delegated.
The importance of capital budgeting is due to the complexity of the analysis

involved and the cost of mistaken decisions. It is difficult to project the prospective
cashflows arising from a particular project with any great confidence. Further
complications arise when allowing for different possible scenarios, incorporating
options into the analysis and discounting the cashflows.
Investment in working capital is largely routine and involves few complications or

risks.
Investment in fixed capital, however, often involves complex choices between:

 alternative capital assets, each with various advantages and disadvantages
 dates of commencement and
 methods of financing – eg bank loan, issuing debt, issuing equity.
Question 6.2
What is working capital? What is fixed capital?
These choices are both complex and critical, given the scope for (and very high
cost of) erroneous decisions. Moreover, fixed capital outlays often have a serious
bearing on the direction and pace of a firm’s growth. As such, they determine the
opportunities open to a firm and the directions in which it can move.
This is because fixed capital choices can involve the commitment of large sums of
money for long periods of time.
Progress in management depends on applying logic to experiences, to known or

assumed facts in order to enlarge the area of understanding. Investment
decisions are no exception. Even where it is impossible for financial analysis to
improve the actual fortunes of a particular project, it may nevertheless be able to:
 delineate the risks involved in the project,
 highlight the salient factors – ie those that lead to the greatest uncertainty
 possibly suggest methods by which these risks might be reduced.

More generally, it may provide greater insight on which to base informed and sensible
investment and financing decisions.
Financial analysis
Financial analysis in capital budgeting involves bringing together estimates and

ideas from a variety of disciplines – marketing, technology, accounting, tax, law –
in order to reveal their financial implications.
As its name suggests, financial analysis in this context simply means analysing the
financial implications of different possible courses of action. An in-depth financial
analysis of a project may require the input of experts from each of several different
disciplines such as those listed above.
Ultimately, the problems of capital budgeting in any enterprise are both financial
and political. Leaving the investment appraisal of a project to be conducted by the
very people who are most concerned to see the project accepted – the department
primarily interested in the project – is to expect impossible objectivity.
In other words, all decisions are ultimately made by human beings who are not always
impartial and objective.
The use of a specialist finance function is an attempt to enforce impartiality and

realism. However, the possible downside of this is that the finance function may lack
specialist knowledge of the particular project under consideration.
Question 6.3
What is the financing decision? Who are the main parties involved in the financing
decision?

2 Agency theory
Ultimate responsibility for financial decisions within a company will usually lie with
the directors. In practice, they will often delegate operational decision making to
the executives, while retaining control of strategic issues. This gives rise to the
issues considered under agency theory, which is covered in Subject CT2.
We strongly recommend that you revisit this material, but we also give a quick
summary here.
Summary of agency theory
The directors of a company make strategic decisions on behalf of its shareholders,

whilst delegating operational decisions to managers. This separation of ownership and
management can lead to principal-agent problems and agency costs if the interests of
the owners and managers diverge.
Conflicts of interest may also arise between other stakeholders in a business, notably
between lenders and the providers of equity capital, and may be reinforced by
information asymmetries. Agency theory considers issues such as the nature of the
agency costs, conflicts of interest (and how to avoid them) and how agents may be
motivated and incentivised.
Question 6.4
When are agency costs incurred?
Question 6.5
How might the interests of a company’s management be aligned with those of the
shareholders?

CT2 Core Reading
You may have passed Subject CT2 before the material on Agency theory was moved
from ST5 to CT2. If so, here is the Core Reading that you will have missed out on in
your studies:
The directors are acting on behalf of the ultimate shareholders (who elected
them). Such separation of ownership and management has advantages –
freedom for ownership to change without affecting operational activities,
freedom to hire professional managers – but also disadvantages if the interests
of the owners and managers diverge. Such conflicts are referred to as principal
– agent problems, and give rise to agency costs. These include the costs
associated with monitoring the actions of others, and seeking to influence their
actions.
The scope for conflict between owners and managers is evident – managers may
be motivated by objectives which are at variance with the desires (and interests)
of the shareholders. Conflicts of interest may equally arise between other
stakeholders – junior management, other employees, customers, suppliers,
pensioners, and the state. Of particular interest is the potential for conflict
between providers of finance, notably lenders (such as banks and bondholders)
and the providers of equity capital (the shareholders). Fundamentally, this can
be characterised as the difference between the lenders’ short-term desire for
security and the shareholders’ long-term interest in the development of the
company. At times, however, the interests of different sub-groups of financiers
may diverge.
Such problems may be easier to resolve if all parties share the same insights
into the fortunes of the company. However, information asymmetries will often
exist between the various classes of stakeholder. Written agreements between
the various classes of stakeholder may specify key aspects of the relationship
between them, but cannot realistically cover all possible future eventualities.
Such agreements therefore need to be supplemented by less formal
understandings and arrangements.
Agency theory, which considers the relationship between a principal and an

agent of that principal, includes issues such as the nature of the agency costs,
conflicts of interest (and how to avoid them) and how agents may be motivated
and incentivised.

3 Motives for mergers and acquisitions
3.1 Introduction
Mergers with (or acquisitions of) an existing operation can often provide the
greatest scope for principal — agent problems and the destruction of shareholder
value. For example, managers may take over other companies as an exercise in empire
building rather than for the strict benefit of shareholders.
Consideration of the motives for, and the assessment of, mergers and acquisitions
is therefore a very important topic.
3.2 Types of merger
Mergers and acquisitions can be classified in three forms:

1. horizontal
2. vertical
3. conglomerate.
Horizontal mergers
A horizontal merger involves two firms engaged in similar activities – for example,
two supermarket chains.
Such mergers are usually undertaken to benefit from economies of scale, such as
sharing core services common to both organisations. Another reason is to exploit
complementary resources or to access opportunities only available to larger
organisations. A more aggressive motive may be to eliminate inefficiencies
(including underperforming management).
An example of complementary resources might be where two supermarket chains have

shops located in two different countries. If each wishes to expand its operations into the
other country, then it might be quicker and easier to do so via a merger, than by setting
up a new operation from scratch.
An example of an opportunity available only to larger organisations might be the

provision of a utility service such as electricity on a national (as opposed to a local or
regional) basis.

Underperforming management could of course be eliminated without recourse to a

takeover. However, it is often easier for outsiders/newcomers to restructure the
management of a company than for existing insiders. In addition, the elimination of
inefficiencies might also be a motive for the other types of merger discussed below.
Question 6.6
How were economies of scale defined in Subject CT7?
Vertical mergers
Vertical mergers are those involving companies engaged in different stages of a

production process – for example, a supermarket chain and a food production
company.
Merged, the new company spans (and controls) a greater part of the process from
raw materials to the final consumer. In this way, co-ordination and administration
can be improved. So the supermarket is better able to control the supply of food to its
stores.
Equally, access to complementary resources may be improved (as with horizontal

mergers).
Conglomerate mergers
Historically, the majority of mergers fall into the third category, conglomerate
mergers, as they involve firms in unrelated lines of business – for example, a
supermarket chain and a financial services provider. (However, in recent years, this
process has gone into reverse with the break-ups of many conglomerate
organisations. )
Motives for conglomerate mergers
Motives for conglomerate mergers include:
 utilisation of unused tax benefits – if two different companies have different

tax positions, then one may take over the other in order to make sure that any
valuable unused tax shields will definitely be used
 utilisation of surplus funds – for example, if a company has surplus funds and
few profitable investment opportunities, then it could use its cash to purchase
another company’s shares.

 protection against threat of takeover – by increasing the size of the business
 diversification – which reduces the exposure of the merged company to the

fortunes of either sector
 enhancement of earnings per share – a company may be able to increase its

earnings per share by taking over another company with a lower price earnings
ratio. The earnings per share of the merged company will increase if the merger
reduces the total number of shares in existence without affecting total earnings.
 exploitation of lower financing costs – often large companies are able to

obtain finance more cheaply, perhaps because they are deemed to be more
creditworthy, as each merged firm can guarantee the borrowings of the other.
In addition, there could be scope for other economies of scale.
Question 6.7
Why can conglomerate mergers lead to economies of scale?
Some of the above motives for conglomerate mergers might equally apply to the other
types of merger. For example, a horizontal merger might be motivated both by a desire
to eliminate inefficiencies and also by a desire to utilise unused tax benefits.
It should be said that not all these motives are without critics. Indeed, it must be
questioned whether motives such as utilisation of surplus funds and
diversification are proper for the management of a company, given that the
shareholders could achieve a similar result themselves, if desired – by adjusting
their own shareholdings to obtain a suitably diversified portfolio. For example, it is
often argued that a company with few profitable investment opportunities should simply
return the surplus funds to its shareholders, by means of either dividends or share
repurchases.
The assessment of mergers and acquisitions is considered in more detail in SA5.
Question 6.8
Why might it be argued that a company definitely shouldn’t merge purely to achieve
diversification on behalf of its shareholders?

4 Behavioural finance
4.1 Introduction
The field of behavioural finance looks at how a variety of mental biases and
decision-making errors affect financial decisions. It relates to the psychology that
underlies and drives financial decision-making behaviour.
Although traditional economic theory assumes that individuals and investors always act
rationally, which usually means with the aim of maximising some interpretation of
expected utility, experimental and actual evidence suggests that this may not always be
entirely the case.
Much of the work to date has concentrated on the impact on prices in capital
markets (indeed, some “contrarian” investment funds are run on the basis of
taking advantage of errors made by other investors).
A contrarian fund is one that tends to take the opposite view to the rest of the market –
ie it will tend to buy shares when most people in the market are recommending sell and
vice versa. For example, it might sell shares when the market is “high” or rising on the
basis that the market tends to overreact to positive news and so is likely to be
overvalued.
In investment consultancy, behavioural arguments can be applied to trustees and

used to justify proposed investment management structures.
In practice, the management of an investment portfolio in accordance with an

investment objective will require both:
 an investment strategy
 a choice of investment management structure.
Once these have been determined, the implementation of the chosen investment strategy
will then require the selection of the individual investments and investment managers.
If it is recognised that the trustees responsible for the direction of investment policy are
subject to the types of mental bias identified by behavioural finance, then the
recommended investment management structure may be chosen to reflect those biases.
Likewise, if capital markets are indeed influenced by behavioural factors, then those
investors who recognise this may be able to exploit this knowledge to the disadvantage
of investors who don’t.

Common themes found in research on behavioural finance include:

 anchoring and adjustment
 prospect theory
 framing (and question wording)
 myopic loss aversion
 estimating probabilities
 overconfidence
 mental accounting
 the effect of options.
4.2 Anchoring and adjustment
Anchoring is a term used to explain how people will produce estimates. They start
with an initial idea of the answer (“the anchor”). They then adjust away from this
initial anchor to arrive at their final judgement.
Thus, people base perceptions on past experience or “expert” opinion, which they
amend to allow for evident differences to the current conditions. The effects of
anchoring are pervasive and robust and are extremely difficult to ignore, even
when people are aware of the effect and aware that the anchor is ridiculous.

The following example is taken from the paper:
 Northcraft G B, and M A Neale , Experts, amateurs and real estate: an anchoring

and adjustment perspective on property pricing decisions, Organizational
behaviour and human decision processes, 39.
Example
An experiment was conducted in which a large number of real estate agents were asked
to value a property and come up with a recommended selling price. They were each
provided with an information booklet containing a large volume of information
concerning the property. The booklet was identical for all of the agents, except that
four different versions were used, each with a different listed (ie suggested) price for the
property. It turned out that the average selling price recommended by the agents
increased with the listed price as shown in the following table.
Listed price ($) Average recommended selling

price ($)
119,900 (Version 1) 117,745
129,900 (Version 2) 127,836
139,900 (Version 3) 128,530
149,900 (Version 4) 130,981
The effect of anchoring and adjustment grows with the size of the difference
between the anchor value – the original estimate provided – and the pre-anchor
estimate – the mean estimate people make before being exposed to an explicit
anchor. In other words, the bigger this difference, the greater the influence of the
anchor value on the post-anchor estimate.
Thus, for example, we could ask an estate agent to value a house without giving them
any clues (such as a listed price) or anchor values. The resulting estimate would be a
pre-anchor value. We could then tell them the listed price/anchor value and get them to
re-estimate the value of the house with this additional information. The resulting
estimate would be the post-anchor estimate.
In the above example, the anchor value is the listed price. Thus, the agents’ estimates
were influenced by the “anchor” or benchmark given to them in the form of the listed
price. In addition it turns out that the further the anchor value gets from the “true”
value, then the more it will pull people’s estimates away from the true value.

The effects of anchoring are pervasive and robust and are extremely difficult to
ignore, even when people are aware of the effect and aware that the anchor is
ridiculous. Even patently ridiculous anchor values have been shown to influence post-
anchor estimates.
4.3 Prospect theory
Prospect theory is 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 based on total wealth with a concept of value defined in
terms of gains and losses relative to a reference point. This generates utility
curves with a point of inflexion at the chosen reference point.
Prospect theory attempts to explain why people may make asymmetric choices when
faced with similar possible gains and losses. It was originally developed by Kahneman
and Tversky in their paper:
 Kahneman, D and Tversky, A (1979), Prospect theory: an analysis of decision
under risk, Econometrica 47.
In this paper, Kahneman and Tversky describe an experiment in which they asked
people to choose between two alternatives:
1. Alternative 1: an 80% chance of winning $4,000 and a 20% chance of winning

nothing
2. Alternative 2: a 100% chance of winning $3,000.
Although the first alternative offers higher expected winnings ($3,200 v $3,000 for
certain), 80% of people chose Alternative 2. This choice is consistent with the
assumption of risk aversion that underpins expected utility theory. A risk-averse person
may prefer a more certain outcome, even if the expected gains are lower (because the
additional value derived from the extra certainty outweighs the additional value of the
higher possible return. ).
The same people were then offered the following choice:

 Alternative 3: an 80% chance of losing $4,000 and a 20% chance of losing
nothing
 Alternative 4: a 100% chance of losing $3,000.

Here 92% of people chose Alternative 3, even though the expected losses are greater
(expected losses of $3,200 v a certain loss of $3,000). This evidence suggests that
rather than being risk-averse, people may actually become risk-seeking when facing
losses.
So, prospect theory assumes that:

 value is based on gains and losses relative to some reference point
 people are typically risk-averse when considering gains relative to the reference
point and risk-seeking when considering losses relative to the reference point.
value placed on
gain or loss
losses gains
reference point
Figure 6.2: Prospect theory value function
Prospect theory suggests that the decision made depends on how a problem is presented
or “framed”, ie whether the available choices are presented as gains or losses relative to
the chosen reference point. If the alternative choices are presented as possible gains,
then the value function is concave, reflecting the risk-averse nature of individuals.
Conversely if they are presented as possible losses, then the value function is convex
reflecting the risk-seeking nature of individuals. So, the value function will be as
shown on the diagram above.
Prospect theory is therefore associated with the concept of framing.

4.4 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. Changes in the way a question is framed of
only a word or two can have a profound effect.
Question 6.9
Which of the following two alternatives would you prefer?

1. $30 for certain plus a 50% chance of losing $20
2. $10 for certain plus a 50% chance of winning $20
In the same way, “structured response” questions are found to convey an implicit
range of acceptable answers.
In the book:
 Plous S, (1993), The psychology of judgement and decision making, McGraw-
Hill Inc
Plous describes an experiment in which people were asked the following questions
about the length of a film (the same one) they had all recently watched:
 Question 1: How long was the movie?
 Question 2: How short was the movie?
The mean answer to the first question was 2 hours and 10 minutes, whereas that to the
second question was 1 hour and 40 minutes!

4.5 Myopic loss aversion
This is similar to prospect theory, but considers repeated choices rather than a
single “gamble”. It may therefore be relevant when considering investment choices,
which can often be thought of as a series of repeated gambles. For example, if an
investor reviews and possibly changes its investment strategy on an annual basis, then
the investment strategy decision can be thought of as a series of repeated one-year
gambles.
Research suggests that investors are less “risk-averse” when faced with a multi-
period series of “gambles”, and that the frequency of choice / length of reporting
period will also be influential.
As its name suggests, myopic loss aversion relates to investors’ aversion to short-term
losses. The basic idea is that investors have been shown to be less “risk-averse” when
faced with a repeated series of “gambles” than when faced with a single gamble. Thus,
if the investor recognises that the investment strategy decision is in fact a series of
repeated short-term gambles and consequently takes a long-term view when
determining strategy, then they are likely to be less risk-averse than if they instead
consider only the immediate short-term gamble and so take too short-term a view. In
this latter case, they will tend to focus more on the short-term risk of loss than is
necessarily in their best interests, the consequence being that their resulting portfolio
ends up being overweight in less risky assets.
In addition, the extent of investors’ short-sightedness may be influenced by the

frequency with which they review their investment choices and/or the length of the
reporting period. For example, a pension fund that has to report its financial position
every year may be more averse to very short-term investment losses than one that has to
report only every three years.
Question 6.10
What might be the consequence on its investment strategy of requiring a pension fund
to report its financial position annually rather than triennially?

4.6 Estimating probabilities
In many situations, investors need to estimate probabilities, for example, in order to

assess the riskiness of a particular security. However, research again suggests that
investors’ estimates may be influenced by a number of biases.
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.
In particular, experiments suggest that individuals are prone to underestimate the
probability that a negative event may occur.
 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).
As the amount of detail increases, the more specific (less generalised) the event
becomes and the less probable the occurrence of such a specific event must
become.
 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.
An example here concerns the incidences of deaths due to car crashes and
cancer. When asked to estimate the relative numbers of deaths due to each,
people tend to overestimate the numbers of deaths due to car crashes perhaps
because they receive more publicity and are easier to imagine.

4.7 Overconfidence
People tend to overestimate their own abilities, knowledge and skills. For example,
if you ask 100 people if they are better than average drivers, then you might not be
surprised if more than 50% of them reply “yes”!
Question 6.11
Do you think you will pass the Subject ST5 exam?
Moreover, studies show that the discrepancy between accuracy and

overconfidence increases (in all but the simplest tasks) as the respondent is more
knowledgeable! (Accuracy increases to a modest degree but confidence
increases to a much larger degree. ) If this is true then it may not be wise to pass the
Subject ST5 exam!
Overconfidence could therefore be a potentially serious problem in fields such as

investment where most of the participants are likely to be highly knowledgeable.
Moreover, the available evidence suggests that even when people are aware that they
are overconfident they remain so.
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.
A possible example of the first type of event was the dot. com crash that
followed the dot. com bubble of 1999/2000. A possible example of the second
type of event is when an underdog is heavily beaten in a sporting event.
Although supporters may have had high hopes of an upset prior to the event,
after the event a heavy defeat will always have seemed inevitable.
 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).
For example, failing an exam might reinforce an existing preconception that the
exam system is a lottery – even if the real reason for failure was a lack of
preparation. In contrast, passing an exam might reinforce a view of the exam
system as a lottery, even if it was in fact due reward for months of long, hard
study!

4.8 Mental accounting
People show a tendency to separate related events and decisions and find it
difficult to aggregate events. Thus, rather than netting out all gains and losses (as
standard financial economic theory would suggest) people set up a series of “mental
accounts” and view individual decisions as relating to one or another of these
accounts.
Question 6.12
Consider the following scenarios:

 Scenario 1: You lose $10 today and find a $10 note on the street tomorrow.
 Scenario 2: Neither of the above events occurs.
Which scenario would you prefer?
An example of when mental accounting might be of relevance relates to the paying off
of a mortgage early. Consider the following two situations:
1. have a 100k mortgage and 10k of savings in the bank
2. use 5k of savings to pay off part of your mortgage, so that you end up with a 95k
mortgage and 5k of savings in the bank.
In theory (ie ignoring issues such as tax and the interest rates applicable) you should be
indifferent between these two situations because either way you have a net indebtedness
of 90k (and somewhere to live!).
In practice, however, this may not be the case. Some people may actually feel happier
in the second situation because they feel that a smaller mortgage means that they have
less debt. This will be the case if they use separate mental accounts for savings and
debt.
In practice, of course, the choice of course of action will be driven to some extent by
issues such as tax, the interest rates applicable and the need to hold some liquid assets.

4.9 Effect of options
Experimental evidence also suggests that the range of options or choices presented to
people may influence their choices.
In addition to the “framing” effect discussed in Section 5.4 above, other issues
include:
 the primary effect – people are more likely to choose the first option
presented
 the 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.
More specifically, the sooner/later the decision is made, the more likely it is that
the first/last option will be chosen.
 other research suggesting 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.
Much standard financial economic theory (such as portfolio theory) assumes that
investors know the actual distribution of future investment returns when making
their investment choices – although they don’t know what the actual investment
return will turn out to be in any future period. The terms ambiguity and
uncertainty are both used to refer to a situation in which the investor is uncertain
about the distribution of future investment returns. A investor who dislikes such
ambiguity will tend to err on the side of caution when making a investment
choice. The investor will also be prepared to pay for further information that
reduces the degree of uncertainty faced.
Question 6.13
List the eight common themes found in research on behavioural finance.

4.10 Further reading
The material in this section is based on the paper:

 Nigel Taylor (2000), Making actuaries less human: lessons in behavioural
finance, Staple Inn Actuarial Society (SIAS).
This is an easy-to-read paper, which is well worth studying if you are interested in these
ideas. It can be downloaded from the SIAS website: www.sias.org.uk.
Behavioural finance is also discussed in Section 3 of the following paper:

 Hodgson T. M. et al (2000), The concept of investment efficiency and its
application to investment management structures, British Actuarial Journal
Volume 6, Part III, No.28: pp 451–528.

5 Financial planning
5.1 Introduction
Financial planning can be undertaken on a long-term (capital budgeting) or a

short-term (cash management) basis.
Long-term financial planning is concerned with a company’s long-term investment

decisions and capital requirements – ie long-term loans, debt and equity – whereas
short-term financial planning is concerned with the management of short-term or
working capital requirements.
Long-term planning is primarily a responsibility of the finance function within the

organisation, liaising with senior management to ensure consistency with
business plans. Short-term planning is more closely associated with operational
issues, since it will involve consideration of credit policy and possible deferment
of settling accounts payable.
Credit policy relates to the trade credit a company gives to its customers. For each
particular customer the company will need to determine:
 how much credit to advance (including none at all)
 over what period to advance the credit
 the rate of interest to be charged for that credit, which could be zero.
In determining its credit policy, the company will need to assess the short-term
creditworthiness of the particular customer. The determination of credit policy is
discussed in more detail in Subject SA5.
5.2 Long-term financial planning
“Long-term” planning commonly looks 3 to 5 years ahead (although for capital

projects 10 or 12 years would not be unusual). It assesses the company’s
requirements for capital to finance its business operations over the long term.
The development of financial plans should begin by consideration of an

organisation’s business plans – its anticipated product development and sales
objectives. Whereas business plans relate to the business operations of the company,
financial plans relate to how those business operations are to be financed.

These will typically need to consider the organic development of existing activities,
and also plans for new developments (whether expansion or retrenchment).
Sensitivity analysis should begin at this stage, by exploring business plans under
a range of scenarios – as it is never possible to predict future trading conditions with
certainty. You may recall the discussion in Subject CT2 on how to use probability trees
for this purpose.
Once the business plans have been developed, they can be converted into
financial plans starting with the forecast of future cashflows. Analysis of the
anticipated need for working capital and growth in fixed assets, together with
considerations of tax, dividend and interest payments, will enable the financial
manager to plan for capital budgeting and structure. Whereas capital budgeting
decisions relate to the total amount of capital required, capital structure decisions relate
to the mix of the capital raised between the different possible types of debt and equity.
Once again, sensitivity analysis will be needed in order to allow for possible
changes in the financial environment – changes which again cannot be predicted with
certainty in advance.
Given that a company’s operations can be characterised as a portfolio of projects, the

approaches and methods used here are likely to be similar to those discussed in the
appraisal of capital projects, as discussed in Subjects CT2 and CA1.
Financial planning therefore focuses on the sources and uses of funds as well as
the implications for borrowing and financial structure. Clearly, an iterative process
will be involved as the implications of the business plan are explored.
The financial plan will also have to consider non-operational issues such as the
possibility of breaching financial covenants and the impact of additional borrowing
on credit ratings.
Likewise the level of gearing reported on the company’s balance sheet may also be a
consideration.
Question 6.14
What are financial covenants?

5.3 Short-term financial planning
“Short-term” planning often takes the form of a 12-month “rolling” plan.
Short-term financial planning revolves around the analysis of working capital

requirements. Current assets and liabilities are collectively known as working capital.
Question 6.15
List the main classes of current assets and liabilities.
In addition to consideration of credit management, there is also the need to

determine stock (inventory) policy, both as regards raw materials and finished
goods. The operational advantages of holding buffer stocks will need to be
balanced against the implications for cashflow and the opportunity cost of capital.
Seasonal factors may be of considerable importance in many industries.
Credit management refers to the collection of revenues in respect of goods and services
supplied, ie from trade creditors. Ideally, the company would like to receive these
revenues as quickly as possible. However, an excessively strict credit policy could
adversely affect relations with key customers. Conversely, the company would prefer
to delay payments to its suppliers, again in so far as this doesn’t adversely affect its
relations with those suppliers.
Holding sufficient buffer stocks helps ensure that the firm will be always able to
manufacture and supply goods promptly in response to unforeseen increases in demand.
It may also be worthwhile if it enables the company to obtain lower raw material prices
on orders from suppliers. The main disadvantage is the opportunity cost of the capital
tied up in the stocks – given that the money tied up in stocks could otherwise be
invested in other assets that are either more liquid (eg cash) or that generate investment
returns (eg short-term securities).
Question 6.16
What other possible costs are involved in holding buffer stocks?
A key element in short-term financial planning is the translation of the sales and
production plans (underlying the long-term projections) into cashflow projections,
allowing for the settlement policies adopted in respect of accounts payable and
receivable. In other words, allowing for the fact that cash normally changes hands
sometime after the good or service is actually bought or sold.

Attention must also be given to the non-cash elements in projected accounts, such
as the need to add back depreciation provisions, and the delays before tax,
interest and dividend payments have to be made. Short-term financial plans will
allow for such factors, and will seek to establish a minimum operating cash
balance with which the organisation wishes to operate (in order to allow for
unexpected eventualities).
Question 6.17
What is the main advantage and disadvantage for the company of holding cash?


Chapter 6 Summary
Introduction
Finance involves two basic issues:

1. What real assets should the firm invest in? (the capital budgeting decision)
2. How should the cash for the investment be raised? (the financing decision)
The main parties involved in financing decisions are the treasurer, the controller / Chief
Financial Officer and the board of directors.
Agency theory
The directors of a company make strategic decisions on behalf of its shareholders, whilst
delegating operational decisions to managers. This separation of ownership and
management can lead to principal-agent problems and agency costs if the interests of the
owners and managers diverge.
Conflicts of interest may also arise between other stakeholders in a business, notably
between lenders and the providers of equity capital, and may be reinforced by
information asymmetries. Agency theory considers issues such as the nature of the
agency costs, conflicts of interest (and how to avoid them) and how agents may be
motivated and incentivised.
Mergers and acquisitions
Mergers and acquisitions can be classified in three forms:

1. horizontal – involving firms engaged in similar activities
2. vertical – involving firms engaged in different stages of a production process
3. conglomerate – involving firms in unrelated lines of business.
Motives for horizontal mergers include:

 economies of scale
 access to opportunities that would otherwise be unavailable
 access to complementary resources
 the elimination of inefficient resources.

Motives for vertical mergers include:

 improved co-ordination and administration
 access to complementary resources.
Motives for conglomerate mergers include:

 utilisation of unused tax benefits
 utilisation of surplus funds
 protection against threat of takeover
 diversification
 enhancement of earnings per share
 exploitation of lower financing costs.
Behavioural finance
The field of behavioural finance relates to the psychology that underlies and drives
financial decision-making behaviour. Eight common themes include:
1. anchoring and adjustment
2. prospect theory
3. framing (and question wording)
4. myopic loss aversion
5. estimating probabilities
6. overconfidence
7. mental accounting
8. effect of options.

Financial planning
Long-term financial planning (capital budgeting) commonly looks 3 to 5 years ahead

and assesses the capital required for long-term projects. It involves the development of
business plans setting out the firm’s anticipated product development and sales
objectives. These are then converted into financial plans, which convert the business
plans into future cashflows. Sensitivity analysis should be used when developing the
plans.
Short-term financial planning (cash management) often takes the form of a 12-month
“rolling” plan and revolves around the analysis of working capital requirements. It
involves the consideration of:
 trade credit management (trade receivables and payables, ie debtors and
creditors)
 cash management
 stock and inventory policy (raw materials and finished and unfinished goods)
 non-cash elements in the projected accounts.


Chapter 6 Solutions
Solution 6.1
Tangible assets are assets that physically exist (eg machinery and buildings) whereas
intangible assets are assets that do not (eg goodwill, trademarks and brand names), but
can nevertheless be exploited by the company to generate profits.
Solution 6.2
Working capital usually refers to the company’s short-term assets and short-term
liabilities. In practice, it is sometimes interpreted as the difference between short-term
assets (cash, short-term securities, stocks and trade receivables or debtors) and short-
term liabilities (trade payables or creditors, tax and dividends due).
Fixed capital refers to long-term assets that are used to produce goods and services on
an ongoing basis, eg machinery, plant etc. They are mainly tangible assets.
Solution 6.3
The financing decision relates to the question of how the cash required for investment
should be raised. The main parties involved in the financing decision are usually the
treasurer, the financial controller and the board of directors.
Solution 6.4
Agency costs are incurred when:

 managers (as agents) do not attempt to maximise the value of the company
 shareholders (as principals) incur costs monitoring the managers and attempting
to influence their actions.

Solution 6.5
The interests of a company’s management can be aligned with those of the shareholders
by linking the management’s remuneration directly to the performance of the
company’s shares. One way of doing this is by giving the managers a stake in the
equity of the company, eg via a share option scheme.
Solution 6.6
Economies of scale refers to the situation in which long-run average costs decrease with
the level of output. Economies of scale may arise from factors such as the spreading of
fixed costs (eg research, marketing), specialisation in the production process and the
ability of larger enterprises to obtain finance more cheaply.
Solution 6.7
Economies of scale may arise if the merger enables the two companies to share some
common functions that are common to all types of enterprise, such as general
management, accounting and marketing.
Solution 6.8
It might be argued that a company definitely shouldn’t merge purely to achieve

diversification on behalf of its shareholders. This is because the divisibility of financial
securities means that it will usually be much quicker, easier and cheaper for the
shareholders to obtain diversification within their share portfolios than it is for the
company to diversify via a series of possibly lengthy and costly merger processes.
Solution 6.9
The two alternatives are of course identical in that they both offer an equal chance of
winning either $30 or $10. However, experimental evidence based on similar choices
suggests that people can and do view identical alternatives differently depending on
how they are framed or worded. Thus, the proportion of people selecting each choice
typically differs greatly from 50%.

Solution 6.10
The consequence of requiring a pension fund to report its financial position annually
rather than triennially might be to force the fund to invest in less volatile assets in order
to reduce the risk of having to report a poor financial position. It might therefore force
the fund to invest less heavily in equities, and possibly also less heavily in long-term
bonds.
This assumes that assets are valued using market values.
Solution 6.11
Only you will know how you answered this. However your answer probably reflected
behavioural issues as much as an objective assessment of your true chances. This is not
an entirely satisfactory example as some people may in fact be under confident as
regards their chances of passing the exam. Either way, it is quite possible that the
percentage of you answering “yes” is very different to the 40–50% which may turn out
to be the case in practice!
Solution 6.12
Standard financial economic theory suggests that you should be indifferent between the
two outcomes because they both result in no net gain or loss. In practice, however, you
might have chosen one or the other. When asked about scenarios of this nature in
experiments, there is typically a very strong majority preference for one or other of the
scenarios described.
Solution 6.13
The eight common themes found in research on behavioural finance are:

1. anchoring and adjustment
2. prospect theory
3. framing (and question wording)
4. myopic loss aversion
5. estimating probabilities
6. overconfidence
7. mental accounting

8. effect of options.
Solution 6.14
Financial covenants are restrictions placed on a borrower, typically an issuer of long-

term debt, which require that the borrower meets specified financial criteria, eg with
regard to interest and asset cover on that debt.
Solution 6.15
The main classes of current assets include:

 stocks of raw materials, finished and partly finished goods
 trade receivables or debtors
 cash
 short-term securities held (eg Treasury bills, commercial paper, bills of
exchange).
The main classes of current liabilities include:

 trade payables or creditors
 outstanding dividend and tax payments
 short-term borrowings and loans.
Solution 6.16
Other possible costs involved in holding buffer stocks include:

 storage costs
 spoilage costs – due to physical deterioration in the raw materials or finished or
unfinished goods
 obsolescence – of the raw materials or finished or unfinished goods.

Solution 6.17
The main advantage for the company of holding cash is that it enables the company to
cope with unexpected eventualities, ie unforeseen expenditures.
The main disadvantage is that by holding cash the company foregoes the higher returns
that could be obtained from investing either in financial securities or in its own main
line(s) of business.





the course.

ST5-07: Regulation of financial services Page 1
Chapter 7
Regulation of financial services
Syllabus objectives
(g) (i) Describe the principles and aims of market conduct regulatory regimes.
(ii) Demonstrate a knowledge of the principles underlying the legislative and

industry.
0 Introduction
Like many markets, an unregulated market for financial services may not produce an
economically efficient outcome, in which all investors make the best investment
decisions and risk is allocated optimally throughout the economy.
The most important cause of market failure in financial services markets is likely to be
the lack of (perfect) information enjoyed by private investors, in particular concerning
the financial services that they are buying.
As a result, the market for financial services is usually subject to some form of
regulation. Indeed, given the nature of financial services – ie their complexity, their
often long-term nature and the potentially large sums of money involved – the extent of
regulation within the financial service sector is often much greater than that found in the
markets for other goods and services.

Page 2 ST5-07: Regulation of financial services
This material was covered in full detail in Subject CA1. This chapter highlights
the key conclusions, in order to recap the framework that gives context to the
discussion of the detailed areas in the following sections:
 the aims of regulation

 possible regulatory regimes
- unregulated markets
- voluntary codes of conduct
- self-regulation
- statutory regulation
- mixed regimes

1 The aims of regulation
1.1 Introduction
The financial markets of all developed economies are regulated to a greater or

lesser extent. The principal aims of regulation are:
 to correct market inefficiencies and to promote efficient and orderly
markets
 to protect consumers of financial products
 to maintain confidence in the financial system
 to help reduce financial crime
These aims are, of course, related.
The market for financial services may be inefficient in the sense that consumers of
financial services make inefficient, ie incorrect, choices. In practice, the main cause of
this is likely to be a lack of information and expertise on behalf of consumers with
regard to the often complex financial services traded. This is because an individual who
doesn’t understand the different financial services between which they are choosing
may well make the wrong choice.
There may be separate regulations applying to different sectors within the market for
financial services, in addition to separate regulatory bodies enforcing the different sets
of regulations. A particular distinction might be made between the regulations applying
in the wholesale market, ie to institutional investment, and the market for personal
investment, the retail market.
Question 7.1
How might these aims typically be met in practice?

1.2 The costs of regulation
Regulation has a cost. Regulators must attempt to develop a system which can
achieve the aims specified above at minimum cost so that the benefits, which are
difficult to measure, outweigh the costs.
In economic terms, the optimal level of regulation should be such that the marginal
benefits of regulation are equal to the marginal costs. The benefits of regulation arise
from meeting the aims outlined above. The costs are of two main types – direct costs
and indirect costs.
Direct costs
Direct costs arise in administering the regulation.
The regulator will incur costs operating the regulatory framework, eg collecting and
examining the information provided by market participants and otherwise monitoring
their activities. Likewise the regulated firms will incur costs in complying with the
regulation, eg in maintaining appropriate records, collating the requisite information
and supplying it to the regulator and/or the investor.
In practice, most of these direct costs are borne ultimately by the investor in the form of
either higher taxation to fund the regulator and/or higher charges and fees for the
financial services that are purchased.
Indirect costs
Indirect costs arise from changes in behaviour, both of consumers and regulated
firms, to react to the regulations.
Firms may take less care with their choice of financial service/financial service
provider, as they feel that the protection afforded by regulation typically reduces the
adverse consequences of not doing so.
Other indirect costs include:

 a sense of diminished professional responsibility in intermediaries and advisors
 a reduction in consumer protection mechanisms developed by the market itself
 reduced product innovation
 reduced competition.
A regulatory regime designed by existing market participants could even be set up in

such a way as to act as a barrier to entry to deter new competition.

Question 7.2
Which is the economic term used to describe all this behaviour?
1.3 The need for regulation
The need for regulation of financial markets is seen to be greater than the need
for regulation of most other markets primarily because of the importance of
confidence in the financial system and the damage that would be done by a
systemic financial collapse.
An example here could be the collapse of a clearing bank. This could lead to a loss of
faith in the banking system as a whole and consequently a “run” on banks in which
investors attempt to withdraw all of their money.
Question 7.3
Why would a run on the banking system as outlined above cause particular difficulties?
Similar problems could arise from the failure of an insurance company or pension
scheme, leading to a loss of faith in the sector as a whole. More generally, a widespread
attempt to withdraw funds from financial institutions that are solvent is likely to lead to
problems, as the assets held to back liabilities may not be sufficiently liquid.

2 Types of regulatory regimes
2.1 Forms of regulation
There are several different types of regulatory regime, the most important of which are
self-regulation and statutory regulation. Within each type of regime, the regulation
itself can take a variety of forms.
Prescriptive
Regulation can be prescriptive, with detailed rules setting out what may or may
not be done.
In general, a prescriptive regime is likely to control tightly the activities of the parties
affected, thereby reducing the likelihood that things go wrong, but often with greater
costs, both direct and indirect, than the other possible approaches.
Question 7.4
Give three examples of possible prescriptive rules that might be enforced.
Freedom of action
Alternatively, it can involve freedom of action but with rules on publicity so that
third parties are fully informed about the providers of financial services.
In other words, the firm can do pretty much what it wants provided that it publishes
sufficient information for the regulator (or any other interested parties) to check that it
is being properly managed. This is essentially the “freedom with publicity” approach
adopted with regard to insurance companies in the UK. UK insurance companies have
a great deal of freedom with regard to their financial management, provided that they
publish sufficient information to demonstrate to both the regulator and any other
interested parties that they are in a sound financial position.
Outcome-based
Finally, the regime can allow freedom of action but prescribe the outcomes that
will be tolerated.
In contrast with a prescriptive regime, which says what can, cannot and/or must be
done, an outcome-based regime is concerned with the end result – eg has the investor
made a well-informed decision appropriate to her individual circumstances?

The rest of this section discusses various possible regulatory regimes. The first four
possibilities are listed in order of the increasing degree of regulation involved. In
practice, however, regulatory regimes may involve a mixture of the systems described
below.
2.2 Unregulated markets
It has been argued that the costs of regulation in some markets, especially those
where only professionals operate, outweigh the benefits. Consequently, for
wholesale markets, in which the parties involved are sufficiently well-informed, the best
option may involve no specific regulations. Even here though, the participants will
normally still be subject to the general trading and other laws applicable in the
particular legal jurisdiction in which they operate.
2.3 Voluntary codes of conduct
These operate effectively in many circumstances but are vulnerable to a lack of

public confidence or to a few “rogue” operators refusing to co-operate, leading
to a breakdown of the system.
Question 7.5
What are the main advantages of a voluntary code compared to statutory regulation?
What is the main disadvantage?
2.4 Self-regulation
A self-regulatory system is organised and operated by the participants in a

particular market without government intervention. The incentive to do so is the
fact that regulation is an economic good that consumers of financial services are
willing to pay for and which will benefit all participants. An alternative incentive
is the threat by government to impose statutory regulation if a satisfactory self-
regulatory system isn’t implemented.
Stock and option trading exchanges are often private sector companies. They provide
various services for which they are able to charge fees thereby generating profits.
Prominent amongst these is the regulation of the activities of their members.

2.5 Statutory regulation
In statutory regulation the government sets out the rules and polices them.
Advantages
This has the advantage that it should be less open to abuse than the alternatives
and may command a higher degree of public confidence. Although even here,
there may be concerns that the regulatory body takes greater heed of the views of those
it is regulating, than those of the general public. This may reflect the greater political
influence of the former.
Also, economies of scale can be achieved, eg with separate departments monitoring

different aspects of financial services provision, such as capital adequacy, product sales
and security trading, across all financial markets within the jurisdiction.
Disadvantages
Statutory regulation can be more costly and slower to respond to changing market
circumstances. Some say that the market participants themselves are in the best
position to devise and run the regulatory system. Outsiders may impose rules that are
unnecessarily costly and may not achieve the desired aim.
2.6 Mixed regimes
In practice many regulatory regimes are a mixture of all of the systems described
above, with codes of practice, self-regulation, and statutory regulation all
operating in parallel. Even a regime that is self-regulatory in name is likely to
have statutory aspects. Regulations are often developed by market-driven
private institutions (such as stock exchanges) as well as by governments.
For example, in the UK, the Financial Reporting Council is an independent

regulator responsible for promoting high quality corporate governance and
reporting to foster investment.
Question 7.6
Outline in one sentence the basic difference between statutory regulation and self-
regulation.

Question 7.7
List the advantages and disadvantages of self-regulation.


Chapter 7 Summary
Aims of regulation
The principal aims of regulation are:

 to correct market inefficiencies and to promote efficient and orderly markets
 to protect consumers of financial products
 to maintain confidence in the financial system
 to help reduce financial crime
Types of regulatory regime
The possible forms of regulation include:

 prescriptive regimes, with detailed rules as to what may or may not be done
 “freedom with publicity”
 outcome-based regimes, which focuses on achieving suitable outcomes
The main types of regulatory regime include:

 unregulated markets, where no financial services specific regulations apply,
market participants are instead subject to the normal laws of the land
 voluntary codes of conduct, drawn up by the financial services industry itself
 self-regulation, organised and operated by the participants in a particular market
without government intervention
 statutory regulation, in which a government body sets out the rules and policies
them.
In practice, many regulatory regimes are a mixture of some or all of these systems.


Chapter 7 Solutions
Solution 7.1
These aims might be met by:

 the provision of information, eg quotation systems (to ensure that the market
operates in an efficient and orderly way) and product literature (to ensure that
customers understand what they are buying)
 authorisation of financial service providers
 subsequent supervision of the authorised firms, eg checking solvency, enforcing
strict accounting information requirements
 ensuring sufficient liquidity in the marketplace, eg in the money market
 the provision of settlement systems – again to ensure that trades are carried out
in an efficient and orderly way
 schemes to compensate investors for breaches of the regulations.
Solution 7.2
They are all examples of moral hazard.
Solution 7.3
A run on the banking system could prove calamitous because banks hold cash reserves
equal to only a fraction of the value of the deposits placed with them by the customers –
precisely because they do not expect everyone to withdraw their money at once. (Note
that this same principle also applies to some extent to other financial institutions. )
Banks could then react to a shortage of deposits by calling in loans to borrowers –
eg overdrafts – leading to widespread bankruptcies.

Solution 7.4
Examples might include constraints on three from the following:

 the types of investment or contract that are offered by the institution
 the types of service provided
 the levels of charges that may be levied for a particular investment, contract or
service
 the types of investment that may be included within a collective investment
vehicle or a pooled investment vehicle, such as a life contract
 required levels of capital adequacy
 the types of investment in which a financial institution may itself invest
 who may control the institution – ie fit and proper person rules.
Solution 7.5
The main advantages are likely to be the reduced cost of regulation and the fact that the
rules are set by those with greatest knowledge of the industry. The main disadvantage
is likely to be the greater incentive to breach the voluntary code, which will have no
legal backing and in all likelihood less severe penalties – if any – than with statutory
regulation.
Solution 7.6
Within a statutory regulation system the government sets out the rules and polices them,
whereas a self-regulatory system is organised and operated by the participants in a
particular market without government intervention.

Solution 7.7
Advantages of self-regulation
 The regulatory system is implemented by the people with the greatest
knowledge of the market, who are therefore able to max the benefits and
minimise the costs. In addition they also have the greatest incentive to achieve a
soundly financial services industry.
 Self-regulation should be able to respond rapidly to changes in market needs.
 It may be easier to persuade firms and individuals to co-operate with a self-
regulatory organisation than with a government bureaucracy.
Disadvantages of self-regulation
 The closeness of the regulator to the industry it is regulating, which lead the
regulator to side with the industry
 Consumers may lack of confidence in the regulator.
 Self-regulatory organisations may inhibit new entrants to a market.





the course.

ST5-08: Applications of the legislative and regulatory framework (1) Page 1
Chapter 8
Applications of the legislative and regulatory
framework (1)
Syllabus objectives
(g) (ii) Demonstrate a knowledge of the principles underlying the legislative and
industry.
 trust law
 corporate governance
 role of the listings authority
 environmental and ethical issues
 competition and fair trading controls
 monopolies regulators
 investment restrictions in investment agreements
0 Introduction
The primary objective of this chapter is to introduce you to the key considerations for,
and regulation of, parties involved in investing funds. In this chapter we consider:
 the role of trustees, the principles they should follow and the factors that affect
their decisions
 the areas of the market that may be regulated and the principles underlying such
regulation
 the detail likely to be included in investment agreements between clients and
investment managers.

Page 2 ST5-08: Applications of the legislative and regulatory framework (1)
The layout of the chapter is as follows:
 Section 1 describes the concept of trusts and the key principles underlying the
operation of trusts.
 Section 2 defines corporate governance, and outlines how good corporate

governance can be achieved.
 Section 3 considers the role of the regulators when a company wants to issue
new shares.
 Section 4 describes the impact of the move towards socially responsible

investment on the parties involved in making investment decisions.
 Section 5 considers the role of the regulators in relation to competition and

monopoly issues on company merger.
 Section 6 outlines the likely content of the investment agreement that will be set
out between the client and the investment manager.

1 Trust law
1.1 Introduction
Trusts are a peculiarly Anglo-American concept – a relationship between

persons in which one has the power to manage property and the other has the
privilege of receiving the benefits from that property.
Trusts could exist in many different situations; examples include:

 unit trusts – a trustee can act to oversee the selection and management of assets
 pensions – in many countries it is a requirement that a company pension
scheme’s assets are segregated from the company’s assets. Appointed trustees
are responsible for safeguarding the assets, selecting investment managers and
generally ensuring the smooth running of the scheme.
 charitable bodies – whose trustees determine how funds raised can best be used
 trust funds for children – a fund may be set up for a child to provide money
when that child reaches a certain age, eg 21.
There is no precise equivalent to the trust in civil-law systems, although some

civil-law systems have created an institution like a trust. This has normally been
done by adapting trust ideas from the Anglo-American system.
Civil law systems are those inspired by Roman Law, the primary feature of which was
that laws were written into a collection; codified, and not determined, as is common
law, by judges. Civil law systems prevail in most western European states, including
Scotland.
In contrast, common law systems, which rely heavily on precedent, operate in England,
Wales and Northern Ireland, most Commonwealth countries, the United States and the
Republic of Ireland.

1.2 Legal and beneficial ownership
Fundamental to the notion of the trust is the division of ownership between legal
and equitable. The legal owner of the property (the trustee) has the right to
possession, the privilege of use and the power to convey those rights and
privileges. The beneficial owner (the beneficiary) receives all the benefits of the
property. The trustee has the fiduciary duty to the beneficial owner to exercise
his rights, privileges and powers in such a way as to benefit the beneficiary, not
himself.
The trust therefore results in a clear separation between the ownership of the assets and
the benefits received from the assets. Fiduciary duty simply the means the
responsibility placed upon the trustees to look after someone else’s (ie the
beneficiaries’) money in a correct way.
Example
In a company pension scheme set up under trust the trustees have responsibility for:
 exercising control over the investment and management of assets
 the payment of benefits to the beneficiaries (the members of the scheme)
 ensuring compliance with the trust deed and rules and pension legislation
 exercising discretionary powers in the interest of the members
 ensuring the smooth running and administration of the scheme.
The trustees may delegate the tasks, eg to specialist investment managers and
administrators, but the trustees retain responsibility.
The divisions between legal and beneficial ownership are normally created by an
express instrument of trust (usually a trust deed or a will). The trust deed will
specify the purposes of the fund and how it is to be administered.
Question 8.1
A bond indenture trust is operated by a trustee (for example a bank) representing the
bondholders in dealing with bond issuers. Outline the areas you think would be covered
in the trust deed.

1.3 Trustees
Trustees are appointed to carry out these provisions, and must operate solely
within the provisions of the deed (although they may be allowed some discretion
in this respect). The beneficiaries will also have been specified (by name or by
class) in the original deed.
A unit trust for a child will specify the beneficiary by name. A pension scheme will
specify the beneficiaries by class (eg active members or pensioners) because the
membership of the scheme changes frequently.
Common law requires trustees to act in the best interests of the scheme’s
beneficiaries. The standard of care required is that of the ordinary prudent man
of business acting in the management of his own affairs. Subject to the terms of
the trust deed, common law also requires trustees to exercise proper care when
investing trust funds.
Question 8.2
List the main concerns of the trustee in carrying out his duties.
However, the standard of care which a trustee is obliged to take with regard to
investment decisions is likely to depend on whether or not he holds himself out
as being a professional trustee. A professional trustee will be assessed by a
higher standard of care and must exercise the special skill and care which he
professes to have.
Many institutions provide trustee services as a commercial business. These institutions

are staffed by professional trustees who provide trustee services in return for a fee.

1.4 Collective representation and protection
Trusts are a means of segregating assets for the protection of beneficiaries, thus
insulating them from any consequence of the settler’s actions subsequent to the
settlement. Another function is to provide a mechanism for the collective
representation and protection of members of a group of people linked by a
common interest.
Good examples of such a mechanism are the unit trust and the bond or
debenture trust deed. Under these, the individual interests of substantial
numbers of holders are channelled into the trust and held and protected by the
trustees for the benefit of all holders, so providing the collective mechanism
without which efficient administration would be impossible. This mechanism is
valuable even where there is no trust property in the normal sense, merely an
aggregation of personal rights.
Example
Company XYZ runs a pension scheme for its members. The pension scheme is set up
under trust and the scheme’s assets are segregated from those of the company. If
Company XYZ (the settler) should become bankrupt, then its creditors are unable to
claim the assets of the pension scheme when seeking recompense.
Operating as a trust will also have other advantages. For example, the trustees provide
a powerful lobby for the pension scheme in representing views to the company, for
example regarding the distribution of any surplus, or the level of funding.

2 Corporate governance
2.1 Background
Historically most companies were small and privately owned (typically family-run).
This resulted in the same people owning and managing the company. However there
has been a major shift in company structure. Now many large companies are in public
hands and there is scope for conflicts of interest between those who own the company
(the shareholders) and the management running the company. In this context, you may
recall the discussion of agency problems and costs in Chapter 6.
The topic of corporate governance tackles this potential conflict of interest. Corporate
governance also addresses wider conflicts of interest between the company’s
management and other interested parties, eg employees.
Until the end of the last war governments did not see it as their place to interfere
with the running of private enterprise except to ensure that the public were not
abused. However, the growth of national, international and global
conglomerates over the last 50 years or so has forced governments around the
globe to tighten the reins of accountability. There is now a requirement to
monitor and enforce public governance in order to try to maintain a suitable
balance between the state, the community and private enterprise.
2.2 Basic idea
Corporate governance refers to the high level framework within which

managerial decisions are made in a company.
Typically, the governance of a company is the responsibility of its board of directors.

The board is collectively responsible for promoting the success of the company by
directing and supervising the company’s affairs.
A board of directors will typically include amongst its members:

 executive directors – drawn from the senior management of the company and
including the chief executive officer (CEO)
 non-executive directors – one of whom will act as Chairman, in which role he
will be responsible for the successful operation of the board.
Non-executive directors who have no (current or past) relationship with the company
other than as board members are sometimes referred to as independent directors.

The aim of good corporate governance is that a company should be managed in

order to best meet the appropriate requirements of its stakeholders – the
shareholders, employees, pensioners, customers, suppliers and others who may
be affected by the company’s operations whilst not having any contractual
relationship with the company at any time.
Good corporate governance requires management to make decisions based on

the interests of relevant stakeholders rather than on their own personal interests.
An example would be promoting a takeover bid that is in the directors’ interest rather
than that of the stakeholders.
Good corporate governance can be enhanced by ensuring that remuneration

incentivises management to act in the interests of stakeholders. Share options
may be seen as part of this, though the lack of sufficient downside for
management can limit how well share options perform this function.
The general aim here is the interests of management should be aligned as closely as
possible with those of the shareholders in particular. The most obvious way to do this is
by giving the management shares in the firm, as is often the case in a private company.
An alternative is to provide share options. However, any incentive package needs to be
carefully managed. There have been many examples of directors leaving companies
after poor performance with healthy bonus packages.
In the UK over recent years, bonuses paid to the bosses of failing major banks have
caused controversy, sometimes public outrage.
Example
In late 2008, Sir Fred Goodwin officially announced his resignation as Chief Executive
of RBS, just one month before RBS announced that its 2008 loss totalled £24.1bn, the
largest annual loss in UK corporate history. Following the February 2009 disclosure of
his approximately £700,000 pa pension award from RBS he was the subject of
widespread public, political and media criticism.

2.3 Non-executive directors
Non-executive directors are also often part of a structure aimed at good

corporate governance.
As an example, the UK’s Financial Reporting Council has issued a Corporate

Governance Code setting out the principles, structure and processes of good
practice in corporate governance.
The role of the non-executives in corporate governance is to provide an impartial view

and represent the shareholders’ interests. In practice, this is likely to involve:
 challenging and contributing to the development of strategy
 monitoring the performance of management
 playing a leading role in setting the remuneration for executive directors’ pay
 playing a leading role in the nomination and appointment of new board members
 playing a leading role in the audit committee. This committee aims to monitor
the financial reporting of the company, together with its financial and risks
controls and will meet with external auditors with no members of the executive
present.
Separate committees for each of the remuneration, nomination and audit functions may
be set up consisting exclusively of non-executive directors.

3 Role of the listings authority
3.1 Definition
A listings authority is responsible for ensuring that any new issue of shares is
conducted in an orderly and fair way, and that the conduct of the company
remains consistent with the listing of the shares after the issue. This would
include an initial offering of shares in a company that was previously privately
held.
Question 8.3
Give reasons why a privately held company would wish to publicly offer shares.
3.2 Information
A listed company’s shares may be bought and sold by any member of the public,
without any direct negotiations with a current holder. The negotiation when the
shares are sold is purely a matter of price and, unlike a transaction for the sale of
a share in a private company, no financial information is disclosed as part of this
process. It is therefore important that a reasonable amount of financial
information is in the public domain.
Information in the public domain will include:

 current and historical share price
 audited company accounts
 interim reports
 forecasts and profit warnings
 interest by potential takeover parties
 analysts’ comments.

3.3 Role of listing authorities
Listing authorities are normally concerned with:
 the production of relevant business and financial information on the issue

of shares.
This will be presented in the share prospectus. The prospectus will include:
– details of the number of shares on offer and the offer price
– details of the number of shares (if any) currently in circulation
– the underwriters of the issue (if there are any)
– details of how shares will be allocated if the offer is over-subscribed
– how the money raised will be used
– the company’s intended dividend policy
– audited financial statements
– an outline of the aims and objectives of the company and any special
factors
– details of the senior management and board directors and their salaries.
 the process by which shares are offered to potential shareholders and the
price is set for the issue of shares.
Investment banks often lead the issue of shares for their clients (ie the
companies looking to raise equity finance). The higher the price set, usually the
higher the fee income generated.
 the continuing production and dissemination of business and financial

information on a timely basis on companies with listed securities.
For example, companies listed on a stock exchange are typically required to
make certain accounting information available each year.
 the continuing conduct of the market in listed securities with a view to

ensuring that the market is fair to all participants, and that the pricing
process is fair and reasonable.
 rules to ensure that companies with listed securities and connected

parties continue to behave in a manner that does not conflict with other
objectives of the listing authority.
For example, market makers in the UK must be prepared to deal up to the
normal market size at the prices they display on SEAQ, the Stock Exchange
Automated Quotation system.

4 Environmental and ethical issues

Ethical investment is big business and an expanding area of the investment market.
Government, advocacy groups and the preferences of individual participants in

investment markets have acted to ensure that the concern felt by the public on
the environment and ethical issues impacts the behaviour of financial markets.
For example:
 listed companies now have to produce information on how they manage
their behaviour on environmental and ethical issues. This is often
referred to as Socially Responsible Investment (SRI).
 SRI requires fund managers to consider a company’s ethical stance before
deciding to invest in its shares.
 UK pensions disclosure legislation requires pension trustees to disclose their
social, environmental and ethical considerations in their Statement of Investment
Principles. (This has been the main factor leading to the increase in the size of
the UK ethical funds market. )
Companies that want to be attractive to the widest possible universe of investors

will want to be attractive to investors for whom environmental and ethical issues
are part of the investment process and decision making.
Operators of savings products (insurers, asset managers) have promoted

products which aim to enhance the effect of the investment process on
environmental and ethical issues. Products are sold which have a “socially
responsible overlay” and the investment managers commit to engaging in a
constructive dialogue with company management to promote environmental and
ethical objectives.
There are various definitions of “ethical” designed to meet different investors’

requirements. Some funds focus on the exclusion of investment in oppressive regimes
or certain industries (eg tobacco, weapon manufacture). Other funds have a more
stringent definition of ethical extending to only including companies that actively
promote environmental and social issues, for example companies using alternative
energy or promoting good employment practice.
There is also an informal extent to which some investors will favour asset
managers who appear more friendly to environmental and ethical objectives
whilst making no formal commitments. Following the events of September 11
2001, many investors are debating larger issues such as human rights abuse and
its impact on terrorism.

In the UK and Germany, law requires that pension funds state their position on
SRI, and similar initiatives are underway in France and Sweden. The EU
Commission is considering requiring that all investment funds and financial
institutions inform their clients about any ethical or responsible investment
criteria they apply or any standards or codes to which they adhere.

5 Competition and fair trading controls, monopolies

regulators
5.1 Background
Increasing corporate consolidation has raised the profile of competition and

monopoly regulation. The pursuit of genuine economies of scale has led to
concentrations of market share.
Markets tend to go through waves of mergers – for example there was a great deal of
merger activity in the United States in the late 1990s.
Question 8.4
The primary reason for company mergers is to benefit from economies of scale. Outline
the other main reasons why companies may merge.
The process has made real pricing power, both with suppliers and customers,
accessible to many companies for the first time. This is particularly the case where
the company has a limited number of competitors. Such pricing power is of concern
to governments and other stakeholders (for example shareholders, employees and
customers).
In recent years, the accelerating trend to privatise state monopolies operating in

sectors such as utilities, telecommunications and transport (where “natural”
monopolies are likely to persist) has led to the development of new regulatory
authorities charged with the control of the pricing policies of the privatised
companies.
Question 8.5
Why are natural monopolies likely to persist in the utilities, telecommunications and
transport sectors?

5.2 Aims of regulation
Regulatory concern is mostly aimed at protection of the interests of customers

(particularly individuals) and suppliers.
The aim of the regulators is to encourage competition and prevent mergers that would
reduce competition through the exercise of market power.
Regulators are normally acting under national legislation and have

responsibilities to national constituencies. (As a result of the move to a Single
Market in Europe there are some barriers to mergers and acquisitions that apply across
borders. ) On the other hand companies are often multinational. A company may
therefore argue that a takeover resulting in a high market share in one territory
will not confer unacceptable pricing power because of the potential entry of
international competitors. It is up to the regulator as to how these arguments are
treated.
The definition of the product is generally a second area of debate for competition
decisions. A high market share in a narrowly defined product area may translate
into a much lower share of a more widely defined product category that contains
possible substitutes for the product under review.
For example, it may be acceptable for a company to have a 50% share in the market for
“chocolate-covered ice lolly sales at seaside resorts”, but not acceptable to have “50%
of the national confectionery market”.
Fair trading controls also aim to ensure that sellers do not exploit members of
the public who may be in a weak bargaining position.

6 Investment restrictions in investment agreements

Here we have in mind investment restrictions in the investment agreements between
fund managers and those who employ fund managers to manage their investments.
6.1 Mandates
Mandate is the term often used to refer to the authority given by the owner of
investments to the investment manager whom they employ to manage their investments.
Fund managers may be engaged to invest:

 in one particular asset class, for example US fixed-interest bonds (a specialist
mandate basis)
 across a range of asset classes with certain restrictions (a balanced or multi-asset
approach).
Looking at pension fund investment in particular, fund managers are

increasingly employed on a “specialist mandate” basis to invest in a single asset
class, rather than on a traditional “balanced” or “multi-asset” mandate.
However, this still requires them to make operational decisions in relation to
stock selection (unless a “passive” index-tracking approach is to be adopted).
Managers will therefore need to be given instructions regarding any restrictions
to be applied.
The instructions will be set out in the mandate.
Within balanced mandates this may include the extent to which the manager is
allowed to depart from the benchmark strategic asset allocation at any time. For
example, the mandate might specify that the US bond holding must be between 25%
and 35% of the total value of the portfolio.

6.2 Other restrictions
Other restrictions, applying to all mandates, might include:

 asset classes that are entirely prohibited
 limitations on the use of assets and asset classes, such as a prohibition
on the speculative use of derivatives
 maximum permissible holdings in individual assets or asset classes (to
ensure diversification)
 prohibitions on “self-investment” in the sponsor’s own securities
 ethical or social limitations.
Question 8.6
Why is self-investment likely to be restricted?
6.3 Regulation
In some states there may be specific requirements such as holdings in

government bonds and bills, or requirements to match assets and liabilities by
currency. This is sometimes referred to as a localisation requirement.
There may be restrictions on the choice of assets, such as a requirement that

any equities held have paid dividends in recent years.
Question 8.7
Explain the rationale behind a government requiring:

(i) the holding of government bonds
(ii) the matching of assets and liabilities by currency.
The legislative (or regulatory) framework may take the form of the specification
of “admissible” assets, so that only those holdings which conform to the
restrictions can be taken into account when demonstrating statutory solvency.
Such an approach means that the fund can invest in a wide range of investments.
However, since only a portion of the investments can be included when demonstrating
solvency these admissibility regulations are an effective way of strongly encouraging
the fund to hold the vast majority of its assets in the categories that the regulator has
deemed to be admissible. (Such regulation applies to the UK insurance industry. )

This is a prescriptive approach because it will not be in a company’s interests to

hold material amounts of inadmissible assets.
A less prescriptive approach is where the nature of any restrictions are left to the
discretion of those awarding the fund management mandates, but with the
requirement that such restrictions are set out in a “Statement of Investment
Principles” for the information (and scrutiny) of the ultimate beneficiaries. This
may include statements to highlight any departure from accepted “best practice”
and justifications for such departures.
For example, UK pensions trustees set out a Statement of Investment Principles. The
idea behind this form of regulation is that increased disclosure will enable the ultimate
beneficiary to perform the regulatory function.
Underpinning such requirements, there is likely to be some measure of the

standards against which fund management is to be judged, such as the
standards of care, skill, prudence and diligence. The sanctions available for
failure to meet these standards may range from withdrawal of authorisation to
operate as a fund manager through to liability to make good shortfalls. There
may also be provision for assets to be taken into custody or for funds to be
managed by a statutory body.
The purpose of such restrictions can be seen as threefold:

1. to protect the ultimate beneficiaries from gross incompetence or
mismanagement by fund managers
2. to encourage confidence in investment schemes and the benefits they
secure
3. to promote the accumulation of investible funds.
The first two of the above tie in with two of the three high-level aims of regulation as
discussed in Chapter 7.
Question 8.8
What were the three high-level aims of regulation as discussed in Chapter 7?

Chapter 8 Summary
Trust law
A trust is an agreement under which one party (the trustee) has legal ownership of
certain property that they must manage for the benefit of another party (the beneficiary).
The terms of the agreement will be set out in the trust deed.
Corporate governance
Corporate governance refers to the high-level framework within which managerial

decisions within a company. Good corporate governance involves managing the
company in a way that reflects the interests of the various stakeholders. It is achieved
through:
 remunerating management in such a way as to align their interests with those of
the shareholders
 a requirement to have non-executive directors, who provide an independent
voice on behalf of shareholders.
Role of the listings authority
The authority aims to ensure new issues of shares are conducted in an orderly and fair
way. To achieve this the authority regulates:
 the financial and business information that is made available to the public at
issue
 the issue process
 the financial and business information that is made available post-issue
 the conduct of the listed security market (to ensure it is fair to all participants)
 the conduct of listed companies.
Environmental and ethical issues
Environmental, social and ethical issues are an increasingly important consideration for
many investors. In order to be attractive, companies and asset managers are paying
increasing attention to environmental and ethical considerations.
Listed companies must produce information on their ethical stance (Socially

Responsible Investment (SRI)).

Competition and fair trading controls, monopolies regulators
The desire to benefit from economies of scale has led to waves of mergers.
Mergers can lead to companies having powerful control over customers and suppliers.
This is particularly the case for natural monopolies, eg utilities. The regulatory
authority aims to protect customers and suppliers, often by price controls.
Regulation is complicated by many mergers being between companies in different

countries.
Investment restrictions in investment agreements
Managers are increasingly commonly asked to invest in a single class (specialist

mandate basis). A balanced or multi-asset mandate means the manager invests in
several asset classes. In both cases stock selection is important.
Common restrictions in all mandates are:

 a prohibition on certain asset classes
 limitations on how assets are used, eg not for speculative purposes
 maximum holdings in certain assets or sectors
 restrictions on self-investment
 ethical or social limitations.
Regulation may also impose investment restrictions, eg:

 requirement to hold government bills or bonds
 requirement to match by currency
 restrictions on asset classes
 admissibility regulations.
Regulation may require a Statement of Investment Principles to be prepared.
The purpose of incorporating restrictions in investment agreements is to:

 protect beneficiaries
 encourage market confidence
 encourage investment.

Chapter 8 Solutions
Solution 8.1
The trust deed would cover:

 name and contact details of the trustee
 the aims of the bond trust
 description of any assets placed in the trust (eg a mortgage debenture)
 procedure for investors to purchase/sell investments
 restrictions on the holding of certain bonds (eg for ethical reasons)
 restrictions on purchase and sale of bonds
 requirement to carry out administration
 level of discretionary powers the trustee may exercise
 action to be taken in the case of bond issuer default
 remuneration arrangements
 arrangements for replacement of the trustee, or resignation of the trustee
 arrangements for termination of the trust.
Solution 8.2
The main concerns of the trustee will be:

 to act prudently
 to act in the beneficiaries’ interest
 to demonstrate fairness and equity between beneficiaries of the trust
 not to profit directly from action taken
 to act in line with the constraints of the trust deed and rules and any overriding
legislation.

Solution 8.3
A private company may carry out a share issue in order to:

 have access to investment capital
 enable expansion of the business
 reduce the company’s financial gearing (placing less reliance on bank finance or
debt issue)
 enable existing owners to realise capital and/or exit the business.
Solution 8.4
The other main reasons for carrying out a merger include:

 to benefit from economies of “vertical integration” – this means merging with a
supplier or customer to facilitate coordination and reduce expenses
 to benefit from complementary resources
 to optimise use of tax breaks
 if the company has surplus cash (although the company should firstly check
whether the most appropriate action is to pass the money back to shareholders).
Recall that the above and the other reasons for the different types of mergers were
discussed in detail in Chapter 6.
Solution 8.5
Natural monopolies are likely to exist since the very nature of these industries mean a
large infrastructure is required and profitability will be strongly linked to achieving
economies of scale. In addition, such companies were historically monopolies under a
state-operated system.
Solution 8.6
Self-investment is likely to be restricted to avoid a concentration of risk.

Solution 8.7
(i) The rationale behind a requirement to hold government bonds is that

government bonds (in most countries) are viewed as a secure investment. A
wide range of terms is available which should enable at least a broad match for
most liabilities.
(Such a requirement also lends itself to a ready demand for government debt!)
(ii) The rationale behind a requirement to localise assets is to provide protection

against fluctuating exchange rates.
Solution 8.8
The three high-level aims of regulation discussed in Chapter 7 were:

1. to correct market inefficiencies and to promote efficient and orderly markets
2. to protect consumers of financial products
3. to maintain confidence in the financial system.





the course.

Chapter 9
Applications of the legislative and regulatory
framework (2)
Syllabus objectives
(g) (ii) Demonstrate a knowledge of the principles underlying the legislative and
industry.
 provision of financial services
 institutional investment practices
 EU legislation
 role and responsibilities of directors
 development of international standards
0 Introduction
In this bookwork chapter, we examine a few more topics relating to the regulatory
framework for investment management and the securities industry. In particular, we
focus on the regulation of the financial services market and the principles underlying
the investment manager/client relationship.

The layout of the chapter is as follows:

 Section 1 describes the key principles intermediaries should adhere to when
providing financial services.
 Section 2 discusses the principles that should be considered when drawing up an
agreement between a client and an investment manager with regard to how
investments are to be managed.
 Section 3 outlines recent EU legislation relating to financial services.
 Section 4 discusses the roles and responsibilities of directors towards the
shareholders of a company.
 Section 5 outlines the moves to develop International Financial Reporting
Standards to ease comparison of companies across the world.

1 Provision of financial services
1.1 Introduction
The aims of financial services regulation were discussed in Chapter 7 of this course.
Question 9.1
What were the four principal aims of regulation discussed in Chapter 7 of this course?
The relationship between providers of financial services (ie financial intermediaries

such as insurance companies and financial advisers) and their clients is key in
promoting investment confidence. In particular it is important that the intermediary is
fully aware of the client’s needs and that the intermediary keeps the client fully
informed of important information that would affect decisions on an ongoing basis.
Problems associated with the asymmetry in knowledge and understanding

between the providers of financial services and their clients are often addressed
in legislation.
If investors have imperfect information about financial services, then they are likely to
make suboptimal choices when selecting financial services. The provision of
information to investors is therefore often a key area addressed by financial services
regulation.
We will now look at the approach applied in the UK to regulating this area. Many of
the underlying principles are applied in other countries too. These principles relate to
similar issues to those discussed in Chapter 7.
The key principles underlying such legislation can be summarised as follows:

 integrity
 skill, care and diligence
 market practice
 information about customers
 information for customers
 conflicts of interest
 customer assets
 financial resources
 internal organisation
 relations with regulators.

1.2 Integrity
The firm should observe high standards of integrity and fair dealing. In other
words, they should act in the best interests of their customers.
1.3 Skill, care and diligence
A firm should act with due skill, care and diligence.
1.4 Market practice
A firm should observe high standards of market conduct. It should also comply
with any code or standard as in force from time to time and as it applies to the
firm (either according to its terms or by rulings made under it).
For example, there may be a requirement that those carrying out financial practice have
certain qualifications.
1.5 Information about customers
A firm should seek from customers it advises, or for whom it exercises

discretion, any information about their circumstances and investment objectives
which might reasonably be expected to be relevant in enabling it to fulfil its
responsibilities to them.
Just as individuals need information to make well-informed choices, so advisers need

sufficient information about the circumstances and characteristics of their customers if
they are to provide appropriate advice.
Question 9.2
List the information a firm should seek when advising an individual wishing to save for
his child’s school fees.

1.6 Information for customers
A firm should take reasonable steps to give a customer it advises, in a

comprehensible and timely way, any information needed to enable him to make a
balanced and informed decision. A firm should similarly be ready to provide
customers with a full and fair account of the fulfilment of its responsibilities to
them.
As noted above, good information is key if the customer is to make a balanced and
informed decision. What is “reasonable” and hence what information is provided, will
depend in part upon the characteristics of the customer concerned.
1.7 Conflicts of interest
A firm should either avoid any conflict of interest arising or, where conflicts
arise, should ensure fair treatment to all its customers by disclosure, internal
rules of confidentiality, declining to act or otherwise.
An example of a potential conflict of interest would be an investment house that advises

both Company A and Company B being approached by Company A regarding a
takeover of Company B.
If the firm is to continue to act in cases where there is risk of a conflict of interest, the
firm should put necessary procedures in place, eg the use of Chinese walls and careful
documentation of all actions carried out.
A firm should not unfairly place its interests above those of its customers and,
where a properly informed customer would reasonably expect that the firm
would place their interests above its own, the firm should live up to that
expectation.
1.8 Customer assets
Where a firm has control of, or is otherwise responsible for, assets belonging to
a customer which it is required to safeguard, it should arrange proper protection
for them, by way of segregation and identification of those assets or otherwise,
in accordance with the responsibility it has accepted.

1.9 Financial resources
A firm should ensure that it maintains adequate financial resources to meet its
investment business commitments and to withstand the risks to which its
business is subject.
Hence the existence of capital adequacy requirements for the likes of insurance
companies and banks, which aim to ensure that customers’ investments enjoy an
appropriate degree of security. Again the exact requirements are likely to depend on the
type of firm and the particular risks it faces.
1.10 Internal organisation
A firm should organise and control its internal affairs in a responsible manner
and keep proper records. Where the firm employs staff or is responsible for the
conduct of investment business by others, it should have adequate
arrangements to ensure that they are suitable, adequately trained and properly
supervised and that it has well-defined compliance procedures.
Question 9.3
What type of risk are the requirements regarding internal organisation intended to limit?
1.11 Relations with regulators
A firm should deal with its regulator in an open and co-operative manner and
keep the regulator promptly informed of anything concerning the firm which
might be reasonably expected to be disclosed to it.
Question 9.4
Give examples of information which the firm might reasonably be expected to disclose
to the regulator.

1.12 Other factors influencing the nature of legislation
The precise nature of the legislation or regulation will need to reflect the degree
of asymmetry experienced, and so should distinguish between different classes
of investor as well as different asset classes. For example, a professional trustee
would be expected to have a greater understanding of the investment markets than a
member-nominated trustee.
Regulations may include the form of documentation used to convey the

principles and to record compliance.
Where cross-border business is concerned, there is a further complication: is

regulation and compliance to be policed on a “home” or “host” country basis (or
both)? Mutual agreement and recognition will be needed in this respect.
However, modern electronic service delivery is threatening to undermine such
agreements. For example, where is an internet company domiciled and who is
responsible for regulating it?

2 Institutional investment practices
2.1 Introduction
Here we have in mind the situation where an investor or a group of trustees is

employing an investment manager to invest money on their behalf. The following
principles are those that should be adhered to when drawing up the investment
agreement between the two parties.
The nature of the principles underlying the legislation and regulation of

institutional investment practices are summarised under the following headings:
 effective decision-making
 clear objectives
 focus on asset allocation
 expert advice
 explicit mandates
 activism
 appropriate benchmarks
 performance measurement
 transparency
 effective operations
 regular reporting.
They are written in the context of a benefit scheme with Trustees dealing with
external investment managers, but are readily adaptable to all investment
management scenarios.
Let’s look at each of these in more detail.
2.2 Effective decision-making
Decisions should only be taken by persons or organisations with the skills,

information and resources necessary to take them effectively.
In order to comply with this, trustees will need to appoint investment managers with the
required expertise to manage assets under their custody and investment managers must
have the necessary skills and experience to handle the particular investments.

2.3 Clear objectives
Recent recommendations for the principles underlying legislation and the

regulation of institutional (pension fund) investment practices can be
summarised as:
Trustees should set out an overall investment objective for the fund that:
 represents their best judgement of what is necessary to meet the fund’s
liabilities
 takes account of their attitude to risk, specifically their willingness to
accept under-performance due to market conditions.
For example, the trustees of a mature pension scheme (a scheme where a high
proportion of the membership are retired) might adopt a low-risk investment strategy
and invest mostly in government bonds. Conversely, the trustees of a less mature
scheme, perhaps one consisting of predominantly young and active members, might
invest much more heavily in equities.
Objectives for the overall fund should not be expressed in terms which have no
relationship to the fund’s liabilities, such as performance relative to other funds
or to a market index.
The first two points result from key investment principles that you have already met in
Subject CA1 – namely, the matching of assets and liabilities (by nature, term, currency
and uncertainty) and the need to maximise return given an acceptable level of risk. The
last point means the decisions made by other investment funds must not be a primary
driver behind the fund’s investment choice.
2.4 Focus on asset allocation
Strategic asset allocation is the process of determining the asset sectors that will be
invested in and the guidelines within which the investment manager should operate.
Strategic asset allocation decisions should receive a level of attention that fully
reflects the contribution they can make towards achieving the fund’s investment
objective. Asset liability modelling can be a powerful tool in helping to determine the
optimal strategic asset allocation.

Question 9.5
Why are the asset allocation decisions usually more significant than the stock picking
decisions in determining whether a fund meets its objectives?
Decision-makers should consider a full range of investment opportunities, not

excluding from consideration any major asset class. Asset allocation should
reflect the fund’s own characteristics (both the nature of the liabilities and the
appetite for risk), not the average allocation of other funds.
Again it is the fund’s own characteristics that should be the key determinant of
investment strategy and not the strategies of its competitors.
2.5 Expert advice
Contracts for actuarial services and investment advice should be opened to

separate competition. So you ought to consider employing different advisors to help
you:
 value the investment fund’s assets and liabilities.
 choose the investment strategy
and perhaps even to choose the investment managers.
The fund should be prepared to pay sufficient fees for each service to attract a
broad range of kinds of potential providers. The potential providers can then be
assessed against each other to determine the most appropriate service providers.
In addition, it might be sensible to regularly review your choice of service providers.

2.6 Explicit mandates
Trustees should agree, with both internal and external investment managers, an
explicit written mandate covering agreement between trustees and managers on:
 an objective, benchmark(s) and risk parameters that, together with all the
other mandates, are coherent with the fund’s aggregate objective and risk
tolerances
 the managers’ approach in attempting to achieve the objective
 clear time scales of measurement and evaluation (for example annual
assessment against a benchmark index).
The mandate should not exclude the use of any set of financial instruments
without clear justification in the light of the specific circumstances of the fund.
2.7 Activism
Managers should incorporate an explicit strategy on activism, elucidating the

circumstances in which they will intervene in a company, the approach they will
use in doing so and how they measure the effectiveness of this strategy. As we
saw in Chapter 8 there is a trend towards shareholders becoming more active as regards
intervening in company activity, in order to ensure good corporate governance.
2.8 Appropriate benchmarks
Trustees should:
 explicitly consider, in consultation with the investment managers, whether
the index benchmarks they have selected are appropriate. The benchmarks
may be determined through an asset liability matching exercise.
 if setting limits on divergence from an index, ensure that they reflect the
approximations involved in index construction and selection
 consider explicitly, for each asset class invested, whether active or
passive management would be more appropriate given the efficiency,
liquidity and level of transaction costs in the market concerned
 where they believe active management has the potential to achieve higher
returns, set both targets and risk controls that reflect this, giving
managers the freedom to pursue genuinely active strategies.
We return to these issues in our discussion of the risk budgeting process in Chapter 21.

Question 9.6
Why is it important that the strategy for an actively managed or a balanced fund does
allow the investment manager some scope to diverge from the benchmark?
Question 9.7
What are the arguments for following a passive rather than an active investment
strategy?
2.9 Performance measurement
Trustees should arrange for measurement of the performance of the fund and
should make formal assessment of their own procedures and decisions as
trustees.
This will include consideration of:

 any changes in the nature of the liabilities
 any changes affecting risk appetite
 the appropriateness of the performance measures imposed
 the trustees’ role and whether they are carrying out their duties to the required
standards.
They should also arrange for a formal assessment of performance and decision-
making delegated to advisers and managers.
Care needs to be taken in setting the performance benchmarks – in particular if

comparisons are to be made against other funds. The measurement should take account
of any investment constraints imposed by the trustees on the funds.
Trustees should assess:

 how the fund has performed against the benchmarks or objectives set
 how the fund manager has performed against similar funds.
For example, if the benchmark set by the trustees was a return of 6% pa and this return
was met by the managers, they will still want to review their choice of investment
manager if other managers achieved a 7.5% pa return on similar funds!

2.10 Transparency
A “Statement of Investment Principles” should set out:

 who is taking which decisions, and why this structure has been selected
 the fund’s investment objective
 the fund’s planned asset allocation strategy, including projected
investment returns on each asset class, and how the strategy has been
arrived at
 the mandates given to all advisers and managers – ie details of the
investment objective, benchmark(s), allowable risk etc as set out in Section 2.6
above
 the managers’ approach in attempting to achieve the objective
 clear time scales of measurement and evaluation
 the nature of the fee structures in place for all advisers and managers,
and why this set of structures has been selected.
Question 9.8
What is the purpose of requiring a Statement of Investment Principles to be prepared?
2.11 Effective operations
The selection of managers should also consider operational aspects, such as the
separation of front office and back office functions.
2.12 Regular reporting
Trustees should publish their Statement of Investment Principles and the results
of their monitoring of advisers and managers, and send them annually to members
of the fund. The Statement should explain why the fund has decided to depart
from any of these principles.
The principles highlighted above are further developed in the Myners’ Report:
Institutional Investment in the United Kingdom: A Review (March 2001).

3 EU Legislation
3.1 Introduction
As the preceding sections in this and the previous chapter suggest, the regulation of
investment management and financial services is a complex business, involving a wide
range of different issues. Increasingly within Europe, these issues are dealt with at
a common European level.
In particular, an integrated EU financial market is a key objective of the European

Union.
An integrated market is one in which financial institutions authorised to provide

financial services in one EU member state are also allowed to provide them in every
other member state. It is hoped that this will increase competition, ensure better quality
financial products and also boost economic growth
Much has been done to accomplish this and, in recent years, EU financial
markets and transactions across EU borders have grown and improved their
efficiency because of the removal of barriers as well as the launch of the Euro,
global deregulation and new technology.
Wholesale financial markets
Wholesale financial markets have become integrated much further and faster
than the retail financial services section. In particular:
 unsecured euro money markets: fully integrated with short-term euro
interest rates effectively identical across the euro markets.
 bonds: Government bonds are increasingly traded on a pan-European
basis with relatively small yield differentials. However, many non-
government bonds are still traded over-the-counter.
 equities: still largely traded on national exchanges due to national listing
requirements.
Question 9.9
Why are there “small yield differentials” on Government bonds within the Eurozone?
There is evidence of an increase in investment across borders, using pan-

European rather than national benchmarks, but a “home bias” remains.

Retail financial services
In the retail financial services sector, this is still segmented largely along
national lines. The ideal is for financial institutions to be authorized to provide
financial services throughout the EU, competing on a level playing field within a
consistent regulatory environment.
The main barriers include:

 type of product – some products authorized in one country cannot be
provided in others, eg interest-bearing current accounts
 cost of regulation can be prohibitive; implementation approaches differ
 tax systems may differentiate between local and foreign products
 cultural preferences, eg the mortgage market is very different in the UK
compared with mainland Europe
 regulatory systems differ between different countries.
As a consequence there have, for example, been few major retail bank mergers
across borders.
Question 9.10
List four factors that have led to the growth of financial markets and transactions across
EU borders.
3.2 Financial Services Action Plan
To address these issues the European Commission launched the Financial

Services Action Plan, which consists of a wide range of measures to provide a
legal and regulatory environment which supports the integration of EU financial
markets. In particular:
 a single wholesale market
 an open and secure retail market
 prudent rules and supervision.
The FSAP comprises a wide range of measures designed to achieve specific objectives
within the wholesale and retail markets.

The specific objectives of the FSAP with regard to a single wholesale market include:
 enabling companies to raise finance on competitive terms on an EU-wide basis
 providing investors and intermediaries with access to all markets from a single
point of entry
 allowing investment service providers to offer their services across borders
without encountering unnecessary barriers
 establishing a sound and well-integrated prudential framework for investment by
fund managers
 creating a climate of legal certainty so that securities trades and settlement are
safe from unnecessary counterparty risk.
The specific objectives with regard to an open and secure retail market include:
 giving consumers the information and safeguards they need to participate in the
single financial market
 removing unjustified barriers to the cross-border provision of retail financial
services
 creating the legal conditions for electronic commerce on a pan-European scale
 enabling consumers to make small-value cross-border payments without
excessive charges.
The wholesale measures included in the FSAP relate to:

 securities issuance and trading
 securities settlement
 accounts
 corporate restructuring.
In contrast, the retail measures relate to:

 insurance
 savings through pension funds and mutual funds
 retail payments
 electronic money
 money laundering.
In addition, there are other measures relating to financial supervision, corporate

insolvency and cross-border savings.

The measures include:

 the Markets in Financial Instruments Directive effective from 1 November
2007 – covers the organisation and conduct of business of investment
firms and how markets operate. In particular, it covers:
- pre and post trade transparency
- execution policies
- client classification
- conflicts of interest
- conduct of business of investment firms
 the Transparency Directive, effective from January 2005 – establishes
minimum requirements for financial reporting and disclosure
 the Market Abuse Directive 2003 (implemented in the UK from 1 July 2005)
– harmonises rules on the prevention of insider dealing and market
manipulation
 the Prospectus Directive 2003 (implemented in the UK from 1 July 2005) –
enables an issue of securities to be sold across the EU, once that issue
meets the prospectus requirements in one country
 the Fair Value Accounting Directive 2001 – updates EU directives on the
valuation of assets at methods other than purchase price and cost
 endorsement of International Financial Reporting Standards – including a
proposal that a single set of international financial reporting standards will apply
to all listed companies across the EU.
 the European Company Statute enabling companies to set up under a
single European charter, so that they do not need to register in a number of
different countries
 updated solvency requirements for insurers, policyholder protection and
reinsurance supervision
 the Insurance Mediation Directive 2002 – regulation of intermediaries
selling insurance products. This also covers the authorisation and
capitalisation of intermediaries and brokers.
 the Pensions Fund Directive 2003 regulating cross-border pension
schemes based on mutual recognition of home state regulation
 extension of anti-money laundering legislation
 the Taxation of Savings Income Directive 2003 – to prevent cross-border
tax evasion by individuals. This requires member states to exchange
information on interest income paid to non-residents or (in Austria, Belgium and
Luxembourg) to tax that income at source.

4 Role and responsibilities of directors

Directors are responsible for the overall direction of the company, primarily for
the benefit of shareholders (but see Chapter 8 on Corporate Governance). It is
ultimately the responsibility of directors to ensure a company meets all its legal
obligations and to be responsible for the solvent trading of the company.
As such it is the responsibility of directors to:

 arrange that accounts are produced in time giving a true and fair view of the
company, in line with financial reporting standards.
 appoint the management
 approve dividend payments.
They may also be responsible for other matters such as taking reasonable steps to:
 safeguard the assets of the company
 prevent and detect fraud and other irregularities.
There is no necessity for directors to have any executive position, full or part
time, in the company. Shareholder pressure groups have been active in
ensuring directors use their power for the benefit of shareholders. In recent years
many directors have suffered uncomfortable times at the annual shareholder meeting!
Specific problems have arisen in connection with the principle of agency under
which directors act on behalf of shareholders.
Recall the potential for agency problems discussed in Chapter 6. Agency problems may
arise when the interests of directors and shareholders do not coincide.
There have been many examples of directors abusing their position of trust as
managers or agents of the company’s assets. A response has been to propose a
legal framework of governance for executive and non-executive directors with
the aim of trying to protect the shareholders and stakeholders from director
abuse.
Here we specifically have in mind the proposals included in the Higgs Review of the
role of non-executive directors in the UK (Higgs D. (January 2003), Review of the role
and effectiveness of non-executive directors).

Such a framework might include:
 The establishment of formal audit committees to ensure that the financial

accounts give a “true and fair” view.
 Independent remuneration committees to monitor the pay and benefits

packages of senior executives. It is proposed that the membership of both of
these committees would be drawn solely from the company’s non-executive
directors.
If the proposed extension of directors’ liability comes about it is likely that

shareholders will be able to sue directors for any failure to act in accordance
with their moral, ethical and fiduciary duties.
You may be interested to know that the Higgs Review was combined with a number of
previous reviews of corporate governance into the Combined Code of Corporate
Governance (July 2003).
Question 9.11
What is the main role of non-executive directors?

5 Development of International Financial Reporting

Standards
5.1 The need for International Financial Reporting Standards
The globalisation of capital markets has intensified the need for International
Financial Reporting Standards (IFRS) – one set of financial reporting standards
acceptable to all listing authorities in the major financial centres and which all
investors use.
This will make it easier for companies to obtain listings on different stock
exchanges as they would not have to produce multiple sets of accounts, and it
will also help investors making comparisons between companies listed on
different exchanges.
In part the drive to IFRS was also motivated by the economic and financial crisis which
began in 1998 in the Asian markets. This is because it has been suggested that a
perceived lack of transparent and reliable financial information exacerbated the loss of
confidence experienced in these markets and so led to the crisis being worse than need
otherwise have been the case.
Having consistent and reliable information helps investors to make informed choices,
and hence reduces the risks they face. This reduction in risk should ultimately reduce
the cost of capital to companies.
The aims of the IFRS are:

 to encourage reliable and consistent accounting data
 transparency of accounting data
 to have a single set of standards world-wide that enables access to financial
markets and prevent companies having to produce results on several bases.
The main areas of difference across the world relate to the treatment of:
 assets and derivatives
 provisions
 the funding of employee benefits (eg pensions)
 income taxes.

All listed UK companies must use International Financial Reporting Standards

for consolidated accounts. It is expected that many other companies will elect to
use the international standards in place of the UK ones and so these are the
ones likely to be met in practice. (The relevant Core Reading in Subject CT2
reflects the terminology and format from the international standards.)
5.2 International financial reporting in practice
IFRS is close to UK GAAP – both are based on similar frameworks of principles –

but there are a number of differences which may impact on earnings and net
assets, including the revaluation of assets and liabilities to reflect the concept of
“fair value” (broadly, market value).
The fair value of an asset is generally taken to be the amount at which a willing seller
and a willing buyer, both with full information, would trade the asset. It is typically
taken to be the market value where this is available. Alternatively, it is the present
value of future cashflows from the asset, calculated at market rates of interest. As such
fair values are typically more volatile than the book values and discounted cashflow
values that have traditionally appeared in accounts for certain items.
In particular, for institutions trading in investments, IFRS 9 requires:

 investments to be shown at fair value in the statement of financial
position
 any resultant profit or loss on revaluation to be shown in the statement of
comprehensive income
This has proved controversial, with institutions arguing that their investments
are part of a longer-term portfolio and so their values should not be viewed on
one particular day, with resultant fluctuations in the asset and income figures.

6 End of Part 2
What next?
of Chapters 6 to 9.
of your revision.
Time to consider – “learning and revision” products
Face-to-face Tutorials – If you haven’t yet booked a tutorial, then maybe now is the
time to do so. Feedback on ActEd tutorials is extremely positive. Here are a few
comments made by past students:
“I find the face-to-face tutorials very worthwhile. The tutors are really
knowledgeable and the sessions are very beneficial.”
You can find lots more information, including demos, on our website at
www.ActEd.co.uk.

Chapter 9 Summary
Provision of financial services
The key principles underlying legislation of financial services are:

 Integrity  Conflicts of interest
 Skill, care and diligence  Customer assets
 Market practice  Financial resources
 Information about customers  Internal organisation
 Information for customers  Relations with regulators
Institutional investment practice
The key principles underlying regulation of institutional investment are:

 Effective decision-making  Activism
 Clear objectives  Appropriate benchmarks
 Focus on asset allocation  Performance measurement
 Expert advice  Transparency
 Explicit mandates  Effective operations
 Regular reporting
EU legislation
An integrated EU financial market is a key objective of the European Union. So far,

wholesale financial markets have become integrated much further and faster than the
retail financial services section.
The main barriers to integration in retail markets include:

 different types of product
 prohibitive cost of regulation
 tax systems may differentiate between local and foreign products
 different cultural preferences.

The Financial Services Action Plan consists of a wide range of measures to provide a
legal and regulatory environment that supports the integration of EU financial markets.
These measures include:
 the Markets in Financial Instruments Directive
 the Transparency Directive
 the Market Abuse Directive 2003
 the Prospectus Directive 2003
 the Fair Value Accounting Directive 2001
 the endorsement of International Financial Reporting Standards
 the European Company Statute
 updated solvency requirements for insurers, policyholder protection and
reinsurance supervision
 the Insurance Mediation Directive 2002
 the Pensions Fund Directive 2003
 the extension of anti-money laundering legislation.
 the Taxation of Savings Income Directive 2003
Role and responsibilities of directors
Directors are responsible for:

 the solvent trading of the company and compliance with regulations
 the production of accounts
 the appointment of management
 approving dividend payments.
Care needs to be taken to ensure directors act in shareholders’ interests. This is

achieved through:
 formal audit committees
 independent remuneration committees
 a proposed extension of directors’ liability.

Development of international financial reporting standards (IFRS)
The growth in multinational companies and global markets has increased the need for
International Financial Reporting Standards (IFRS).
The principles behind UK GAAP are close to IFRS, but there are a number of
differences that may impact on earnings and net assets, including the revaluation of
assets and liabilities to reflect “fair value”, which broadly corresponds to market value.
In particular, IFRS 9 requires that:
 investments are shown at fair value in the balance sheet
 revaluation profits and losses are shown in the income statement.


Chapter 9 Solutions
Solution 9.1
The three principal aims of regulation discussed in Chapter 7 were:

1. to correct market inefficiencies and to promote efficient and orderly markets
2. to protect consumers of financial services
3. to maintain confidence in the financial system.
4. to help reduce financial crime.
These aims are, of course, related.
Solution 9.2
The information should cover:

 how much the client is able/willing to pay
 how much the school fees will be, when the fees will be required, the number of
years fees are required for and how they will increase
 client’s attitude to risk/other sources of income/capital
 the security of the client’s future income
 the client’s other short-term liabilities
 the client’s tax position
 any special requirements, eg ethical investment.
Solution 9.3
These requirements are intended to limit operational risk, which later in this course is
defined as the risk of losses due to fraud or mismanagement within the intermediary
itself.
An alternative definition that is widely used is the risk of losses due to failed or
inadequate people, processes or systems and external events.

Solution 9.4
Information that could reasonably be expected to be disclosed includes:

 any breaches of regulations
 any significant events, eg merger of firms
 concerns regarding clients, eg money laundering
 procedures for dealing with customer complaints.
Solution 9.5
Asset allocation is more significant because there is less correlation between the returns
on assets in different sectors than between returns on assets in the same class.
Solution 9.6
This gives the investment managers the scope to add value through asset sector
selection.
Over time the relative prices of different asset sectors move and so, even if the
investment manager did nothing, the proportions invested in different sectors will vary!
The correct strategic asset selection is not known with certainty – it is spurious accuracy
to set fixed rates.
Solution 9.7
The arguments for a passive investment strategy are:

 the approach focuses on minimising risk of under-performance (relative to that
of a particular market)
 dealing costs are lower
 a well-diversified portfolio is held if a well-diversified index is tracked.
Whether an active or passive approach is most appropriate depends upon the skills of
the active investment manager, ie whether he or she is able to generate a higher net (of
expenses) return than could be achieved by a purely passive approach.

Solution 9.8
The requirement to have a Statement of Investment Principles ensures:

 the investment manager, trustees, and investors have a clear understanding of the
investment strategy
 trustees focus on their responsibilities towards investment
 trustees and investment managers understand and explain deviations from the
strategy.
Solution 9.9
As the Government bonds are all issued in the same currency within the Eurozone, so
Government bond yields should in principal be the same in each Eurozone country.
However, small yield differentials persist due to differences in the market’s perceptions
with regard to the credit risk and liquidity of the bonds issued by different governments.
Solution 9.10
Cross-border growth of EU financial markets and transactions has been helped by:
 the removal of barriers
 the launch of the Euro
 global deregulation
 new technology.
Solution 9.11
The main role of the non-executive directors is to provide an impartial view on the
board of directors and in particular to represent the interests of the shareholders.





the course.

ST5-10: Fundamental analysis Page 1
Chapter 10
Fundamental analysis
Syllabus objective
(d) Demonstrate a knowledge of the principles of fundamental analysis of equities

and bonds.

investment strategy.
• credit rating an entity
0 Introduction
In this chapter we outline the basic idea and methodology of fundamental analysis,
which is one important means by which investors assess the value of investments and so
determine whether or not to buy or sell them. (Later in the course we consider the
alternative approach offered by technical analysis.) Fundamental analysis has
traditionally played a key role in making the short-term tactical decision as to which
assets to hold.
The basic idea is to assess the “true” or “fundamental” value of an asset, which can then
be compared to the price at which it can be bought or sold, so as to determine whether
the asset is cheap or dear at that price. If the fundamental value differs from the market
price, then this may indicate that asset is mispriced in the market and so presents a
trading opportunity. Of course, the use of fundamental analysis to identify price
inefficiencies relies on the existence of an inefficient market.
In Section 1 we consider fundamental analysis of equities. In Section 2 we consider

fundamental analysis of bonds, or credit analysis for bond investment. In Section 3 we
examine the impact of the trade cycle on the price earnings ratios of shares. The
chapter concludes with a past exam question that examines the quantitative techniques
learnt in Subject CT2.

Page 2 ST5-10: Fundamental analysis
1 Fundamental analysis of equities

Equity fundamental analysts use a variety of techniques to try to determine
whether a share is over- or under-valued by the market. Most methods involve
an attempt to obtain a better estimate of future earnings or dividends, either by
the use of a superior model or by the use of information which hasn’t been taken
into account by the market.
The process can be considered as consisting of two stages.
1. The first is the construction of a model of the company which allows

future cash flows and earnings to be estimated.
2. The second involves the use of the output from the first stage to
determine whether the company’s securities are over- or under-valued by
the market. In practice, a wide range of techniques is used and the degree
of sophistication employed varies greatly.
We can therefore think of fundamental analysis as consisting of the following two steps:
1. Construct an appropriate financial model of the company and use it to project
the future stream of earnings that it will produce. Depending upon the
methodology employed, these predictions relate to the future stream of
dividends that you expect to receive from owning the shares of the company.
Equally they might be based on some definition of earnings, such as profit
before interest and tax and/or economic value added (EVA).
2. Use these predictions to assess the relative cheapness or dearness of the shares.
This second step might involve:

 estimating the “true” value of the share and comparing it to the actual market
price, eg using the discounted dividend model.
 calculating an appropriate ratio, the value of which might be compared to that
of other similar shares or to a “normal” value, eg the price earnings ratio (PER).

1.1 Factors affecting equity prices
The price of an individual company’s shares is affected by the level of supply

and demand for those shares. The key factors affecting relative demand for
individual shares are investors’ expectations of:
 future dividend payments
 future capital growth
 the risks of the business
and thus the uncertainty of estimates of the above.
Factors that drive expectations for capital and dividend growth are estimates of
profits, free cashflow, and total enterprise value.
You may recall from Subject CA1 the discounted dividend model, which is sometimes
used to place a value on individual shares. As its name suggests, this model values a
share as the discounted present value of the future stream of dividends that it is
expected to yield. Expectations of dividend growth are therefore of the utmost
importance in the valuation of shares.
The discounted dividend model calculates a fundamental value of a share based on the
predicted pattern of future dividends, which will normally be estimated following a
detailed analysis of the fundamental characteristics of the company in question. As
such it is an example of a numerical valuation methodology used in the second stage of
fundamental share analysis.
Question 10.1
Write down the two formulae for the discounted dividend model that appear in the Core
Reading for Subject CA1.
Changing economic factors affect different companies to different extents and

possibly in different ways and so alter their relative share prices.
For example, a company that sells luxury goods (like expensive motor cars) may be
more sensitive to the state of the economy than one that sells a necessity (eg a food
retailer). Risk generally refers to the statistical variability of the returns yielded by a
security. In financial economic theory, it is often interpreted as the variance or standard
deviation of investment returns. In this respect, cyclical companies like the car
manufacturer are likely to be more risky than defensive companies such as the food
retailer.

The study of the economic and financial factors affecting a company’s share price is
known as fundamental analysis.
More specifically, fundamental share analysis is sometimes defined as the analysis of a

company’s share value and potential for future profit and dividends, based on
accounting and economic information. It is based upon the idea that every share (and
the market as a whole) has an intrinsic, fundamental or true value, which the investor
can estimate. This value depends upon the underlying or fundamental characteristics of
the company (quality of management and products, turnover, cashflow, profitability and
so on). Analysis of these characteristics enables the investor to produce estimates of
both the return that she can expect to achieve by purchasing shares in the company, and
also the risk involved – in terms of the variability of those returns. She can then
combine the resulting risk and return profiles and use one of a number of possible
methods to determine the fundamental value of the share in question.
It is important to note that:

 the value of any company’s shares will reflect a combination of the
macroeconomic influences that affect all companies to some extent, industry-
specific influences and factors specific to that particular company
 the application of fundamental analysis is extremely subjective and requires
much skill and experience. Consequently, different investors will usually
produce differing estimates of the fundamental value of a share – even if they
have access to identical information, which may not always be the case.
Fundamental analysis can be applied at an industry and economy level as well at

the individual company level. Indeed it is necessary to undertake a fundamental
analysis of the economy as a whole and of a particular industry before assessing
the prospects for an individual company. Increasingly, as enterprises and
markets globalise, a global analysis will be required, at least in broad terms, in
order to make a sensible assessment of the prospects for a single company.
Issues regarding the financial management of organisations, introduced in the

Core Reading for Subject CT2, are of particular relevance here.

One way of generating ideas in an exam about the factors that influence a particular
company might therefore be to think in terms of the:
 global economy
 domestic economy
 industry
 specific firm.
Fundamental analysis can be applied equally to other types of financial security,

tangible assets such as property and also to entire investment markets – to determine if
the market as a whole appears to be undervalued or overvalued.
Question 10.2
For which types of company will an international approach to fundamental analysis be

particularly important?
We now discuss these two steps in the following two sections of this chapter. The
discounted dividend model, which is sometimes used to value shares was discussed in
Subject CA1. The Price Earnings Ratio and other ratios used in fundamental share
analysis were discussed in detail in Subject CT2.
Question 10.3
Define the price earnings ratio (PER).
1.2 Modelling the company
The key factors driving the profits of a particular company will need to be
identified and analysis focussed on them. The analyst will therefore need to
have a good understanding of the company’s business. In some cases a
cashflow model may be used to examine the impact of various economic
scenarios on profits.

Estimating future cashflows and earnings
The ability of a company to generate profits is a vital factor in determining the value of
its shares, so profit forecasting is often the starting point for valuing shares.
One approach involves forecasting future sales and costs for the company, building in
wage and price inflation and the state of the national and international economies.
Income statements (profit and loss accounts) for future years can then be drawn up.
Estimates will have to be made about rates of interest on overdrafts and any new loan
stock issues. Where a company carries out separate operating divisions (eg brewing and
hotel ownership) it would be normal to carry out separate projections for each operating
division.
This may require a considerable amount of time and effort in order to achieve accuracy
– though even then the analyst must be wary of spurious accuracy results. Even the
most detailed analysis is unlikely to produce entirely accurate estimates of future
cashflows, particularly beyond the next year or two.
Many of the techniques employed by fundamental analysts to predict the future

performance of a company are similar to those used by the company’s own
management. However, the investment analyst does not have access to the
detailed information available to the company managers.
In other words, the external investment analyst does not have access to the inside
information enjoyed by internal management. Consequently, the level of analysis that
can be carried out is much more limited in scope.
Factors affecting the relative market price of a share
Each company needs to be considered individually, but some important general

factors are:
 management ability – if the company’s management is highly-regarded,

investors will have more confidence in the profit prospects of the company. This
is because the management typically have a key influence over the success or
otherwise of a company.
 quality of products – a company with a good range of products should be able to

maintain and increase future profitability, although the current level of profits may
already fully reflect the quality of products. More generally, different valuation
might be placed on two otherwise similar companies, one of which has a range of
successful products, whereas the other is heavily dependent on a particular
product.

 prospects for market growth – these will influence the potential growth rate of
the individual companies within the industry. A large company in a mature
industry may have lower growth prospects than a small company in an
expanding industry.
 competition – which will determine market share and perhaps also both
turnover and profit margins. For example, where the market believes that the
industry in which the company operates will become more competitive, the PER
for the company will be lower.
 input costs – analysts might have a view that the cost items (rent, interest,
wages) for a particular company may grow more (or less) quickly than prices, so
reducing (increasing) profit margins and hence profits.
 retained profits – a low payout ratio may mean that a company is (sensibly)
retaining profits to finance future growth or alternatively that the management is
less confident of future growth prospects.
 history – the recent trend in performance will influence how the current
performance is interpreted. For example, a current profit of $10m may be
interpreted more favourably if last year’s profit was $6m compared to if last
year’s profit was $12m.
In order to form a view on these factors, a fundamental analyst will investigate:

 the financial accounts and accounting ratios
 dividend and earnings cover
 profit variability and growth (by looking at all sources of revenue and
expenditure) – profit is a relatively small number calculated as the difference
between two larger numbers and so can vary greatly
 the level of borrowing
 the level of liquidity
 growth in asset values
 comparative figures for other similar companies
Some of the more important investment and accounting ratios used in fundamental
share analysis were discussed in Subject CT2.

Question 10.4
Can you remember the formula for each of the following investment and accounting
ratios, which appear in Subject CT2?
1. interest cover
2. capital cover
3. net asset value per share
4. dividend yield
5. dividend cover
6. return on capital employed
7. current ratio
8. quick ratio.
With most of these ratios, the trends from year to year are usually more important than
the absolute values obtained for any particular company, as it is the changes over time
that will indicate changes in the fundamental profitability of the company. The absolute
values themselves may depend upon the accounting policies adopted by the company.
Comparison with other similar companies is also of use, though this may also be
complicated by differences in accounting policies.
Sources of information
It will be necessary to use all the available sources of information. The primary
source is likely to be the company’s published accounts but there are many
other sources of information which include:
 the financial press and other commercial information providers
 the trade press
 public statements by the company
 the exchange where the securities are listed
 government sources of statutory information that a company has to
provide – ie information provided to the regulator
 visits to the company
 discussions with company management
 discussions with competitors
 stockbrokers’ publications
 credit ratings if they are available.

Analysts need to take care that the use of information obtained from private
discussions or visits to the company does not contravene insider trading
regulations.
Information obtained from most of the above sources will be common knowledge to the
majority of investors with an interest in any particular share. This will be especially
true for shares in the largest companies. However, some information concerning each
company will not be public knowledge – it may be available only to those in certain
positions either inside or outside the company itself. Trading on the basis of such
privileged information is known as insider trading – in many countries this is illegal.
In addition, it is necessary to consider the objectivity of the person providing the

information. For example, the management of a company will generally try to present
their company in a favourable light, so as to encourage investors to buy the shares and
thereby maintain the share price.
Question 10.5
You have been asked to analyse two companies in the food retailing sector and to
recommend one of them for investment. List the factors relating to the companies that
you would investigate when assessing the ability of the management teams of each
company.
1.3 Valuation
Estimates of future earnings or other relevant factors obtained from a

fundamental analysis of a company can be used to calculate a value for the
shares using methods such as the discounted dividend model or a comparison
of price earnings ratios. The fundamental share value obtained can be compared
with the market value and a decision made on whether the share is a candidate
for buying or selling. It should be noted that a particular analyst’s fundamental
value may differ from the market value even if the share is correctly priced by the
market. This will occur if the analyst’s required rate of return is different from
that of the market.
Recall that the price earnings ratio (PER) is defined as:
ordinary share price

earnings per share

One way of using the PER to assess whether a particular share is cheap or dear is
simply to compare its value to that of other similar companies. A higher/lower than
industry average PER perhaps indicating that the share is over-priced or under-priced.
If, say, the share appears to be under-priced, it may be possible to make short-term
profits by purchasing it ahead of the anticipated market correction that will occur once
other investors realise that it is under-priced. Conversely, a fundamental value less than
the market price may imply a decision either not to buy or instead to sell existing
holdings.
Another approach is to avoid making a full valuation but to compare some

fundamental factor (such as anticipated earnings) with the market’s consensus
estimate. If the analyst’s estimate is more optimistic than the market’s then he
or she might regard the share as good value.
Note that if an analyst uses this method she is explicitly accepting the market’s view of
all the other factors affecting the share’s value (eg riskiness, growth prospects).
Question 10.6
Why might the PER of a share be higher than that of another apparently similar share
for a company in the same industry?
Determination of the current market price
Fundamental analysis can therefore have an important influence upon the investment
decisions of the investor as regards a particular share, though other factors – for
example, technical analysis, which we discuss later in the course – may also have a
bearing. It is the interaction of all of these individual decisions that produces the
aggregate demand for the share in question, which in turn determines the current share
price.
Consequently, the share price will reflect the estimates of fundamental value by the
marginal investor – who is indifferent between buying and selling the share at its
current price. For the marginal investor, the fundamental value will equal the current
share price. For all other investors, the fundamental value of a share will differ from its
current price. For example, to those who hold a share, its fundamental value will be at
least as great as its market price (otherwise they would not hold it).

2 Credit analysis for bond investment

Credit rating involves a thorough investigation of the financial condition of an entity in
order to assess the likelihood that the entity will fail to the meet the interest payments
and the repayment of principal under a financing agreement – usually the issue of debt.
As discussed in Chapter 3, credit risk is a key consideration when investing in corporate
bonds.
2.1 Purpose
This relates to the purpose for which the loan is required.
What does the company do and why do they need to borrow? Possible reasons
for seeking finance include:
 organic growth – ie expanding the existing operations, perhaps by recruiting
additional staff and purchasing additional materials in order to expand the
existing operation
 acquisition – ie taking over another company
 investment in an associated company – ie acquiring sufficient shares to
obtain influence over another company, but without buying a controlling stake
 capital expenditure – eg investing in a new factory or office
 dividend / share buy-back – although companies don’t often borrow
specifically to finance a share buy-back or a dividend payout in practice.
When rating credit, it is important to consider how the raising and subsequent spending
of the monies raised may affect the financial strength of the company.
2.2 Payback
This relates to the ability to repay the loan.
What is the expected source of repayment? Is there a secondary source?

Issues to consider include:
 cashflow / profit profile (over time) – ie whether future internal cashflows will
be sufficient to repay borrowings when they fall due
 possible sale of assets and / or businesses
 refinancing – ie by raising further funds in the future.

2.3 Risks
This relates to the character and ability of the borrower and its ability to repay.
What risks (quantitative and qualitative) could jeopardise debt servicing in

future? Factors to consider include:
 macro considerations:
– industry analysis and competitive trends – ie the growth prospects for
the industry as a whole and how the total market will be split between the
different companies operating within the industry.
– regulatory environment – which might change in a way that affects the
financial position of the company
– sovereign macroeconomic analysis – in order to assess the state of the
economy in which the company operates. This will often include an
assessment of the “creditworthiness” of the particular country in order to
obtain a rating for its sovereign (ie government) debt. (Problems with
sovereign debt may be indicative of problems with corporate debt. )
 company-specific issues:
– qualitative analysis – of factors such as the company’s management,
technology, range of goods and services, etc
– financial performance – eg the trends in its financial ratios
(profitability, liquidity, etc), both the historical trends over recent years
and projections of future trends over the next two or three years
– market position – relative to its competitors, as reflected in its market
share.
2.4 Structure
Does the bond structure reflect the risks and protect investors’ interests
(Structure, Status, Safeguards, Pricing)?
In other words, what are the terms and conditions of the particular bond issue?
Question 10.7
What particular terms and conditions might we wish to consider when assessing a bond
issue?

2.5 General approach to credit rating
The fundamentals of the rating agencies’ approach to rating companies will

focus on:
 fundamental risks of the company’s industry – which will reflect the type of
industry in which the company operates; for example, cyclical or defensive,
global or predominantly domestic
 competitive position (relative to peers)
 downside risk vs. upside potential
 quality of profitability vs. EPS growth – ie we need to consider the
security/stability of profits as well as the projected growth rate
 cashflow generation vs. book profitability – ie whether the company is
actually getting the cash in
 forward looking analysis – ie projecting the possible future experience of the
company
 strategy, management track record and risk appetite – ie business plans and
the character and ability of management
 capital structure and financial flexibility.
Ratings will be formally evaluated at least once every 12 months and following any
significant event. Significant events might include a merger or takeover, the launch of
a new project, a rights issue or a bond issue.
The formal review is based on comprehensive information, both public and

private (background and supplemental rating questionnaires). An important
component is frequent meetings and discussions between rating analysts and
company management, providing crucial information and understanding of the
company’s operations, financial condition, competitive market position and
future business plans.
Rating opinions are based on an evaluation of a company’s financial strength,

operating performance and market profile. Quantitative evaluation will typically
involve assessment of performance over at least 5 years, using a battery of
financial tests.
Examples include the following financial factors under the headings of:
 financial strength
 operating performance
 market profile.

Financial strength
This can be assessed in terms of:

 operating leverage
 financial leverage
 asset leverage (quality, market value and diversification of assets,
exposure to investment and credit risk)
 capital structure (including holding company capital structure, where
relevant)
 liquidity (quick and current ratios, operational and net cashflows).
Operating leverage can be measured as:

sales - variable costs
profit before interest & tax
It gives an indicator of a company’s level of fixed operating costs.
The term financial leverage is often used to refer to income gearing, which can be
measured as:
interest payments
and gives an indication of the level of fixed financing costs.

Asset or capital leverage is typically measured as either:
debt debt
or
debt + equity equity
based on balance sheet values.
Capital structure just refers to the financial structure of the company, ie the balance
between debt and equity (and also anything else eg preference shares, short-term
borrowings etc)

Operating performance
The operating performance of a company can be assessed by considering its:

 profitability (sources, trends) – ie which goods and services generate its profits
 revenue composition – ie sales of necessity/defensive goods, sales of
luxury/cyclical goods, revenue from overseas subsidiaries, income from
investments, exceptional items etc.
Market profile
The company’s market profile in terms of:

 market risk (systematic and specific) – ie the risks relating to the market
sector as a whole. These will reflect the experience of both the economy as a
whole (systematic risk) and that of the particular sector (specific risk)
 competitive market position – within the sector
 spread of risk – across different markets
 event risk – ie exposure to specific events, such as takeover.
Qualitative factors will include assessment of management experience and

objectives, particularly with regard to the achievement of future business plans.
Discussions with the management will be especially important here in order to assess
what their aims and objectives are.
Question 10.8
Explain briefly what are meant by operating leverage and financial leverage.
2.6 The role of credit rating agencies
Bond issuers have found that they are more successfully able to raise funds if
they maintain credit ratings with a recognised ratings agency. Currently there
are three major global ratings agencies: Fitch Ratings, Moody’s Investor
Services and Standard & Poor’s. The cost of obtaining a rating is met by the
issuer.

Ratings agencies apply a mix of qualitative and quantitative analysis in carrying

out their assessments, and also have direct access to senior officers of the
issuer. Having carried out their analysis, they form a view and provide an issuer
rating and a bond rating (which can be higher or lower than the issuer rating, and
differ from other bonds from the same issuer). Ratings agencies provide
significant amounts of detail on their methodologies, however they do not
provide detailed supporting information relating to their specific assessments.
Historically, many bond investors have tended to place significant reliance on

issuer and bond credit ratings, rather than carry out their own credit analysis
independently. For smaller investors, this may be appropriate on the grounds of
lower costs relative to buying independent research or building an internal team
of credit experts. However, for larger investors these factors are less compelling
and it is generally considered desirable to obtain or carry out independent
research in addition to monitoring ratings.
During the Financial Crisis of 2008-–2009, ratings agencies came under criticism
for the fact that they had underappreciated the extent of systemic risks across
the fixed income universe, primarily within the financial sector and particularly
for structured credit issues. Whilst this was arguably rectified as the crisis
unfolded as evidence accumulated about the deteriorating creditworthiness of
individual bonds or loans, a number of bonds were subject to multiple
downgrades within very short periods. In most cases, bond prices had fallen
significantly before downgrades were announced, implying that ratings were
lagging indicators of weakening creditworthiness compared to observable bond
prices.

3 The impact of the trade cycle

Changes in the economic environment affect companies in different ways. For
example, using historic price/earnings ratios (PERs), the valuation of some
companies varies relative to others over the course of the trade cycle.
The fortunes of some companies are very closely linked to the state of the economy.
When the economy is booming, their profits are high. When the economy is flat, their
profits are low. These are known as “cyclical” companies (eg construction companies).
The share price of cyclical companies relative to the rest of the market will therefore
depend on the current state of the economy and the extent to which the stock market has
discounted expected future changes in the economy.
The standing of cyclical companies relative to defensive companies such as food

retailers (ie ones that are relatively immune to the state of the economy) is usually as
follows.
Economy moderately buoyant, no real prospects of rapid growth or

recession
If the economy is moderately buoyant and profits are fairly stable, both defensive
and cyclical companies might be similarly rated, ie have similar PERs. The range
of PERs might be quite narrow.
Economy starts to move into recession
As the economy starts to move into recession, PERs for cyclical companies are
likely to fall as the market starts to anticipate a drop in profits, while those of
defensive companies will remain stable or may even rise slightly.
Economic recession: “bumping along at the bottom”
At the bottom of the cycle PERs of cyclical companies will probably have risen
from their low point as earnings have fallen, but defensive stocks will still be
more highly rated (ie higher PERs). A company that has made exceptionally low
profits might have a very high PER. No PER is given for companies that make losses.
Green shoots of recovery
As the economy starts to recover, the PER of cyclical companies will rise as the
price increases in anticipation of future earnings growth. PERs of defensive
companies may be below those of cyclical companies.

Capital expenditure will start to recover. This may take a year or two to work through
to the profits of some companies, but the market will start to buy shares in highly
cyclical stocks in anticipation of very good profits. Prices will move before earnings
recover so the PERs go very high.
The defensive stocks now appear to be dull and boring. The PERs will be much the
same as before (ie lower than for the other stocks). The prices of defensive shares
might even fall as investors switch into more exciting shares.
As growth continues, the earnings of cyclical companies will catch up with the
share price and PERs will fall back.
Sudden changes to market prices
From time to time, there may be a sudden movement in the price of an individual share.
This will reflect new information, with important consequences on the future
profitability of the company, which produces a sudden correction of views on future
profitability. For example, losing or winning an important contract or a legal battle, a
takeover being announced, and so on.
Question 10.9
Classify each of the following companies as either defensive or cyclical:

1. telecommunications company
2. property development company
3. general insurance company
4. clearing bank.
Question 10.10
Summarise the aim of fundamental share analysis in a single sentence.

4 Quantitative analysis
Actuaries are expected to be able to evaluate various types of investments and
determine appropriate ratios. A good example is ST5 September 2006,
Question 5.
The following question now forms part of the ST5 Core Reading. You should
attempt to answer it yourself before looking at the solution. This question involves
calculating a large number of investment ratios, most of which are described in Subject
CT2. Many of the relevant ratios were quite easy, and a calm student should have been
able to generate most of them through applying common sense, and using all the
information available in the question.
Question 10.11 (Subject ST5, September 2006, Question 5)
An investment trust provided the following information to shareholders:
Balance Sheet £m £m
Investments 130 Shareholder Funds 110

Cash 10 Debenture 2016 (nominal value) 30
Total 140 Total 140
Income Statement £m £m
Dividends 5.0 Interest Expense 2.4

Interest Income 0.5 Management Expenses 0.9
Other Expenses 0.3
Dividends Paid 1.9
Total 5.5 Total 5.5
The current share price is 170 pence per share and there are 55 million shares in issue.
(i) Calculate appropriate accounting ratios for the above trust and comment briefly
on them. [7]
In the recent past many trusts have been paying off their long-term debt.
(ii) Calculate the effect that paying off this trust’s debt might have on the results in
(i). You may assume that there are no restrictions to paying off the debt. [7]
[Total 14]


Chapter 10 Summary
Fundamental share analysis
The price of an individual company’s shares is affected by the level of supply and
demand for those shares. The key factors affecting relative demand for individual
shares are investors’ expectations for:
 future capital and dividend growth – which will depend upon both the internal
characteristics of the company and external economic influences
 risk.
The study of the economic and financial factors affecting a company’s share price is
known as fundamental share analysis.
Fundamental analysis can be applied at the industry and economy level as well as at the
level of the individual company. It can equally be applied to other types of investment
and consists of two stages:
1. construct a model of the company to estimate future cashflows and earnings
2. use the output from the first stage to determine whether the company’s securities
are over-valued or under-valued by the market.
A wide range of techniques is used in practice, the choice of which may be influenced
by the availability of information. Each company needs to be considered individually,
but some important general factors to consider are:
 management ability
 quality of products
 prospects for market growth
 competition
 input costs
 retained profits
 history.

In order to form a view on these factors, a fundamental analyst will investigate:

 the financial accounts and accounting ratios
 dividend and earnings cover
 profit variability and growth (by looking at all sources of revenue and
expenditure)
 the level of borrowing
 the level of liquidity
 growth in asset values
 comparative figures for other similar companies.
The main sources of information will normally be the company’s accounts. Other
possible source of information include:
 the financial press and other commercial information providers
 the trade press
 public statements by the company
 the exchange where the securities are listed
 government sources of statutory information that a company has to provide
 visits to the company
 discussions with company management
 discussions with competitors
 stockbrokers’ publications
 credit ratings.

Fundamental analysis of bonds
Credit rating is a four-step process involving an assessment of:

 the reason for the borrowing (purpose)
 the expected source of repayment (payback)
 the risks that could jeopardise the repayment (risks)
 the structure of the borrowing (structure).
Ratings are:
 reviewed annually and following significant events
 based on a quantitative and qualitative evaluation of a company’s financial
strength, operating performance and market profile.
Financial tests assess:

 financial strength – operating leverage, financial leverage, asset leverage, capital
structure, liquidity
 operating performance – profitability, revenue composition
 market profile – market risk, competitive market position, spread of risk, event
risk.
Trade cycle
Changing economic factors will affect different companies to different extents and
possibly in different ways and so alter their relative share prices. One example of this is
the way in which the valuation of some companies, as measured by historical price
earnings ratios, varies relative to others over the course of the trade cycle.


Chapter 10 Solutions
Solution 10.1
The general formula for the discounted dividend model is:
P = Â Dt v(t )
t
where:
 Dt is the dividend payable at future time t
 v(t ) is the discount factor for future time t
Alternatively if we assume that the discount rate i and the dividend growth rate g (< i)
are both constant and that dividends are payable annually, then we have:
D
P=
i-g
where D is the dividend payable in 1 year’s time.
Solution 10.2
An international approach will be necessary for those companies whose profitability

depends upon economic conditions in more than one country. These might include:
 multinational companies – with operations in several countries
 exporters – the demand for whose output is derived primarily from overseas
markets
 companies which either sell imported goods domestically, or whose own output
relies heavily upon factor inputs imported from abroad
It will generally be more important for larger companies.

Solution 10.3
The PER is defined as:
share price
PER =
earnings per share
Reported PER values are typically calculated on an historical, net earnings basis,
allowing for the most recent profit figures – perhaps updated in respect of any interim
figures or recent public statements by the company in question. Though note that in
practice analysts often use prospective PER values.
Solution 10.4

1. interest cover =
annual interest on debt
total assets - current liabilities - intangibles

2. capital cover =
balance sheet value of debt
ordinary shareholders' funds - intangibles

3. net asset value per share =
number of issued ordinary shares
dividend per share

4. dividend yield =
price of ordinary share
earnings per share

5. dividend cover =
dividends per share

6. return on capital employed =
share capital & reserves + long - term debt
profit before tax

or return on capital employed =
share capital & reserves
current assets
7. current ratio =
current liabilities

current assets - inventories

8. quick ratio =
current liabilities
Of course:
 you may also need to remember what insight each of these ratios gives us into
the financial condition of the company and/or the values of its securities.
 this list of ratios is not exhaustive.
Solution 10.5
Factors to consider when assessing the ability of management teams in the food
retailing sector:
 trend and level of profit margins
 trend and level of turnover
 trends and levels of the main cost items (rent, salaries)
 indication of efficient use of resources (sales and profit per unit of retail space,
sales and profit per employee)
 efficiency also shown by speed of turning over stock (eg average stock held as a
proportion of sales)
 price earnings ratio relative to other food retailers
 indication of sound financial controls, (eg average amount of credit obtained on
purchases).
Solution 10.6
The PER may be higher because the:

 shares are thought to be low risk
 dividends of the company are believed to have a high growth rate
 recent earnings have been depressed or exceptionally low for a particular one-off
reason
 shares are over-priced.

Solution 10.7
We might wish to consider:

 term of bond and the level and frequency of its coupons (structure)
 its ranking relative to other bonds issued by the company (status)
 the provisions for further bond issues (safeguards)
 any limits on income and asset cover (safeguards)
 the quality and value of the assets (if any) on which it is secured (safeguards)
 the borrower’s ability to vary the assets on which it is secured (safeguards)
 the price and yield at which it is to be issued, and in particular the yield margin
over similar risk-free government bonds (price).
Solution 10.8
Operating leverage refers to the level of a company’s fixed operating costs. Thus, a
company with high fixed operating costs and low marginal costs is said to have high
“operational” leverage, so that a small change in sales gives a big change in profits.
Financial leverage refers to the level of company’s fixed financing, ie interest costs. A
company with lots of fixed interest borrowing is “highly-leveraged”, so that a small
change in the profits before interest and tax can have a very large proportionate impact
on the profits for shareholders.
Solution 10.9
1. Defensive.
2. Cyclical.
3. Probably defensive, as insurance is required regardless of the state of the

economy.
4. Again probably defensive, though provision for bad debts and even very small
changes in the margins between the interest rates at which they borrow and lend
may cause large reductions in profits during a recession.

Solution 10.10
Fundamental share analysis aims to assess the “true” value of a share by analysing all
of the factors that influence the future returns yielded by investment in that share, and
hence aims to determine whether or not it is under-priced or over-priced.
Solution 10.11 (September 2006, Question 5)
(i) Accounting ratios
shareholders ' funds 110m

Net Asset Value (NAV) per share = = = £2
number of shares in issue 55m
This indicates that the market value of the underlying investments attributable to equity
shareholders, when divided between the shareholders, has a value of £2 per share as at
the last valuation.
200 - 170
The share price is therefore at a discount to the NAV of = 15% .
200
This is quite a high discount and indicates that:

 the management are not well respected as fund managers
 the fees are large, and the annual fees are being discounted in the share price
 the balance sheet valuation is out-of-date and that the prices of the underlying
investments have since fallen.
debt £30m
Gearing = = = 27%
shareholders ' funds £110m
debt £30m
Alternative definition: = = 21%
debt + shareholders ' funds £30m + £110m
The higher the gearing, the more volatile and risky the trust is. Investment trusts in the
UK typically have gearing in the region of 0% to 10%, so this seems a little high.
dividends 5.0
Dividend yield on underlying investments = = = 3.8%
value of investments 130
This may be considered quite high and may limit the scope for capital growth. Perhaps
the investments are value-based equity shares.

0.9m
Annual Management Charge (%) = = 0.64% and total expenses constitute
140m
£0.9m + £0.3m
= 0.86% pa . These figures are relative high for an investment trust
£140m
where charges are typically in the region of 0.5% pa.
This may be contributing to the discount to NAV discussed above.
1.9m
Dividend yield on trust shares = = 2.0%
55m ¥ £1.7
This seems quite low, and reflects the large deductions for expenses that are made prior
to paying the dividends. There are no retained earnings – this may be as determined by
the mandate for the trust, making this an income rather than accumulation trust.
£2.4m
Interest on debt = = 8% .
£30m
This is quite high relative to current bond yields – government bond yields are around
2.0% but would have been around 4% at the time, and good quality corporate bonds are
perhaps 0.5% above this. The bond would stand at a price above par.
£0.5m
Interest on cash = = 5% pa .
£10m
This seems quite high, but this may be because the cash balance is a year-end figure,
and may have varied over the year.
(ii) The effect of paying off debt
As the yield on the debenture is likely to be lower than the 8% coupon rate, the debt
will stand at a price above par. In addition, to repay the debt, the company may have to
offer a premium. If we say that the company requires to repay the debt at a yield
equivalent to government debt, then it would cost:
£0.08 a 10 + £1 v10 for each £1 nominal of debt.
Evaluating at an interest rate of (say) 4.5% and assuming interest is payable annually in
arrears, this equals:
£0.08 ¥ 7.913 + £1 ¥ 0.6439 = £1.2769 .

Therefore paying off the debt would cost £38.31m.
If the company were to sell £38.31m of investments and repay the debt, the gearing
would fall to zero, the remaining investments would have value £91.69m, and the
income statement would look as follows:
Dividends (1) 3.53 Interest Expense 0.00

Interest Income 0.50 Management Expenses (2) 0.65
Other Expenses (3) 0.30
Dividends Paid (4) 3.08
Total 4.03 Total 4.03
where:
91.69
(1) dividends have been apportioned down by
130
101.69
(2) management charges have been apportioned down by
140
(3) other expenses are assumed to be fixed
(4) dividends paid is the balancing item to make the income and outgo equal.
The dividends paid out to investors have risen from £1.9m to £3.08m, which equates to
3.08m
a dividend yield for trust investors of = 3.3% . This is a considerable
55m ¥ £1.7
improvement.
The result of this increase in yield to shareholders would be to reduce the discount to
£110m - £8.31m
NAV. The NAV would become = £1.8489 , assuming that the
55m
additional £8.31m required to repay the debt was taken as a cost to shareholders’ funds.
On the other hand, because the gearing is reduced to zero, the investors are less exposed
to the market, and will benefit less if equity prices rise.
While these ideas are fresh in your mind, you should also look at Subject ST5 April
2010, Question 3, which is a very similar style of question.





the course.

ST5-11: Valuation of investments (1) Page 1
Chapter 11
Valuation of investments (1)
Syllabus objectives
 fixed income analytics and valuation (including interest rate swaps and
futures)
 arbitrage pricing and the concept of hedging
 empirical characteristics of asset prices
0 Introduction
The primary objective of this chapter and the following chapter is to describe how to
value several different types of interest rate derivative, ie derivatives whose payoff and
hence value depends on an interest rate or a bond price. The derivatives valued include:
 forward rate agreements
 interest rate swaps
 interest rate caps and floors
 swaptions.
The layout of the chapter is therefore as follows:
 Section 1 introduces some of the yield definitions necessary to value derivatives

and then describes how to value forward rate agreements and interest rate swaps.
 Section 2 describes the arbitrage approach to pricing derivatives and discusses

how futures may be used to hedge asset values against market risk.
 Section 3 looks at some of the models used for asset prices and returns, and
considers some of the departures from the assumptions that have been identified
by empirical studies.

Page 2 ST5-11: Valuation of investments (1)
This chapter is rather technical. It therefore contains more self-assessment questions

than usual in order to help you get to grips with the ideas being discussed.
You should be familiar with some of the terminology, which you will have met
previously in the earlier subjects. However, we will remind you of any important
definitions along the way.
Students will be expected to have prior knowledge from CT1 and CT2. In
particular, they will be expected to be able to understand and manipulate
accounting information as covered in subject CT2.

1 Fixed income analytics and valuation (including

interest rate swaps and futures)
1.1 Introduction
The use of financial mathematics for the analysis and valuation of fixed income
securities will be familiar. We now need to consider how these techniques may
be extended to the valuation of more complex instruments.
Before doing so, we review some price and yield definitions.
1.2 Price of a bond
The “clean” price of a bond per 100 face value is given by:
È ˘ È ˘
Í ˙ Í rate ˙
Í ˙ ÍN 100 ¥ ˙ Ê
redemption freq rate A ˆ
Price = Í
Í Ê
ÁË N - 1+
DSC ˆ
˜
˙+Í Â
˙ Í n =1 Ê
ÁË n -1+
DSC ˆ
˜
˙ - Á 100 ¥
˙ Ë
¥
freq E ˜¯
Ê
Í 1+ yld ˆ E ¯
˙ Í Ê yld ˆ E ¯
˙
Á 1 +
ÎÍ Ë freq ˜¯ ˚˙ ÎÍ Ë
Á freq ˜¯ ˚˙
where:
 rate = coupon rate pa
 yld = redemption yield pa
 redemption = redemption value
 freq = number of coupon payments pa
 DSC = number of days from settlement to next coupon date
 E = number of days in coupon period in which the settlement
date falls
 N = number of coupons payable between settlement date and
redemption date
 A = number of days from beginning of coupon period to
settlement date.
The clean price of a bond is the price excluding accrued interest – the interest that is
deemed to have accrued to the bondholder since the date of the last coupon payment.
This is the quoted market price that actually appears on dealing screens. The dirty price
(the sum of the clean price and the accrued interest) is the price at which the bond is
actually traded.

Example
Suppose that a particular bond pays an annual coupon of 6%, has a quoted (ie clean)
price of 98% and that it is 355 days since the last coupon was paid. The accrued
interest at that time is equal to:
355
¥ 6 = 5.836
365
giving a dirty price of:
98 + 5.836 = 103.836
The day-count convention may vary, as may the convention of quoting yields in
nominal or effective form.
For example:
 the number of days E in the above formula might:

– be the actual number of days between two coupon payments or
– simply be taken to be 180 days or 360 days, in the case of semi-annual or
annual coupons respectively.
 In the UK, where coupons are usually payable twice-yearly, yields are
commonly quoted as semi-annual rates – ie as rates compounded twice-yearly
rather than as effective rates.
Throughout the remainder of Section 1 we will in fact assume that all interest rates and
yields are compounded continuously, ie are forces of interest, unless explicitly stated
otherwise.

1.3 Yields
Zero-coupon spot yields
When we discount the individual payments under a bond by the appropriate

zero-coupon spot yields, we obtain the theoretical price of the bond.
Question 11.1
What is meant by the n-year zero-coupon spot yield?
Example
Consider a 2-year bond with 5% annual coupons. If the 1-year and 2-year spot rates are
6% pa and 7% pa respectively, then the theoretical price of the bond is equal to:
5e -0.06 + 105e -0.07¥ 2 = 95.99
Zero-coupon spot yields are also sometimes referred to as zero-coupon rates, or spot
rates, or simply as zero rates.
Bond yields
If we discount the same sequence of payments at a single interest rate to give

the market value, this single rate is the bond yield. This yield is also referred to as
the gross redemption yield.
Question 11.2
Write down an equation that can be used to determine the yield on the bond in the
above example given that the market price is indeed 95.99. Hence calculate the yield.
Par yields
Also, we can determine the coupon rate that would be required to make the
theoretical value of the bond equal to its nominal value under the prevailing
pattern of zero-coupon interest rates – this is the par yield.

Question 11.3
Write down an equation that can be used to determine the par yield for 2-year bonds in
the above example and hence find the par yield.
Derivation of zero-coupon yield curve: bootstrapping
The zero-coupon yield curve can be constructed from the observed prices of
coupon-bearing bonds by the technique of bootstrapping – that is, we build up
the pattern of zero-coupon yields that is consistent with the market prices of the
conventional bonds, using linear interpolation between observed values, where
necessary.
Bootstrapping involves finding the zero-coupon yields recursively. Having first

determined the zero-coupon yield for the bond with the shortest outstanding term, we
then use that information to determine the spot yield for the next shortest bond and so
on. The technique, which implicitly assumes that bond markets are arbitrage-free, is
best explained by means of an example.
Example
Term to maturity Principal Annual coupon Price ($)

(years) ($) ($)
1 100 0 94.00
2 100 0 89.00
3 100 5 97.50
4 100 6 101.00
Table 11.1: Bond data for bootstrapping example
The data in the above table can be used to calculate the continuously-compounded zero-
coupon yields at terms t = 1, 2, 3 and 4 years as follows.

We first find the 1-year zero-coupon yield. Given that the 1-year bond has no coupons,
the 1-year zero-coupon yield can be found from:
94 e s1 = 100
ie s1 = 0.061875
The 2-year bond likewise has no coupons and so the 2-year zero-coupon yield is given
by:
89 e 2¥ s2 = 100
ie s2 = 0.058267
The 3-year bond pays coupons of 5% annually in arrears. The coupons at times 1 and 2
can be valued using the 1-year and 2-year zero-coupon yields already calculated. If we
denote the 3-year (continuously-compounded) zero-coupon yield by s3 , then the
present value of the 3-year bond can be written as:
5e - s1 + 5e -2¥ s2 + 105e -3¥ s3 (1)
But we know that this must be equal to the market price of 97.50. Thus, substituting the
known 1- and 2-year zero-coupon yields into (1) and equating to the market price gives:
5e -0.061875 + 5e -2¥0.058267 + 105e -3¥ s3 = 97.50
This can be solved to give the 3-year zero-coupon yield as s3 = 0.057551 .
Question 11.4
Show that the 4-year zero-coupon yield is s4 = 0.055281 .

A plot of the zero-coupon yields obtained by bootstrapping is known as the zero curve.
The zero curve for the above example is shown below.
spot yield
% pa
0 1 2 3 4 5 term, years
Figure 11.1: Zero curve
By convention, it is assumed that the zero curve is:

 linear between the points determined using bootstrapping
 horizontal for terms shorter than the first point and longer than the last point
found by bootstrapping.
1.4 Forward rates
Question 11.5
What is a forward rate?
We can also use the zero-coupon yields to determine the pattern of forward rates
that are consistent with them. (A forward interest rate is the interest rate implied
by current zero-coupon rates for a specified future time period. )

So the term structure of forward rates can be found directly from the term structure of
zero rates as the following example shows. Likewise, the term structure of zero rates
can be found directly from the term structure of forward rates.
Example
1-year forward rate for nth

Term to maturity Zero-coupon rate,
year
(years) ( sn , % pa) ( f n , % pa)
1 6.00 6.00
2 6.45 6.90
3 6.50 6.60
4 6.75 7.50
Table 11.2: Zero-coupon rates and forward rates
In the above table, the 1-year forward rate for the nth year is the rate at which the
investor can agree now to lend or borrow over the 1-year period ending at time n. The
forward rate for the 1st year is just the 1-year zero-coupon rate.
The forward rate for the 2nd year is found as follows. The present value of a 2-year
zero-coupon bond can be found using the 2-year zero-coupon rate as:
100e -2¥ s2
Assuming markets are arbitrage-free, it can also be found by discounting over each of
the two years individually using the forward rate for the 2nd year ( f 2 ) and the 1-year
zero-coupon rate. It must therefore also be equal to:
100e - s1 e - f 2

Thus, equating the two expressions gives:
100e - 2¥ s2 = 100e - s1 e - f 2 (2)
 100e - 2¥0.0645 = 100e -0.06e - f 2
 2 ¥ 0.0645 = 0.06 + f 2 (taking logs)
This gives f 2 = 0.069 .
Note that Equation (2) above simplifies to:
2s2 = s1 + f 2
or:
f 2 = 2 s2 - s1
which can also be written as:
2 ¥ s2 - 1 ¥ s1
f2 =
2 -1
Provided that the rates involved are all compounded continuously, this formula can be
generalised as follows.
If R1 and R2 are the zero-coupon rates for maturities T1 and T2 respectively, and
RF is the forward interest rate for the period between T1 and T2 , then:
R2T2 - R1T1
RF =
T2 - T1
Question 11.6
Derive the values of the forward rates for Years 3 and 4 as shown in Table 11.12.

If we add and subtract R2T1 in the numerator, this expression can be written as:
R2T2 - R1T1 + ( R2T1 - R2T1 )

RF =
T2 - T1
Rearranging this, we have:
T1
RF = R2 + (R2 - R1)
T2 - T1
Thus, if the zero curve is upward-sloping (with R1 < R2 ), then RF > R2 . If the
zero curve is downward-sloping (with R1 > R2 ) then RF < R2 .
In other words, the zero curve slopes upwards (downwards) if the zero rates are
“pulled” upwards (downwards) by the forward rates. The relationship between the zero
and forward rates when the zero curve slopes upwards is shown in the diagram below.
forward rate
yield
% pa zero rate
0 term, years
Figure 11.2: The relationship between zero rates and forward rates when the zero
curve slopes upwards

In the limit, as T2 approaches T1 with a common value of T,
∂R
RF = R + T
∂T
where R is the zero rate for a maturity of T. The value of RF obtained in this way
is known as the instantaneous forward rate for a maturity of T. It represents the
forward rate applicable to an infinitesimal time interval beginning at time T.
Question 11.7
∂R
Show why RF = R + T as T2 approaches T1 with a common value of T.
∂T
1.5 Forward rate agreements
The nature of Forward Rate Agreements (FRAs) was discussed in Chapter 3.
Question 11.8
What is a forward rate agreement?
The value V of an FRA where it is specified that an interest rate RK will be

earned for the period of time between T1 and T2 on a specified principal of L can
be evaluated as:
V = L (RK - RF )(T2 - T1) e - R2T2
ie the present value of the difference between the interest payments.
In this formula:
 RK is the agreed interest rate earned for the period of time from T1 to T2
 RF is the (current) forward rate observed at time 0 for the period of time from
T1 to T2
 RK and RF are both measured with a compounding frequency equal to T2 - T1 ,

ie they are not continuously-compounded. So if the period of time between T1
and T2 is 3 months, ie T2 - T1 = ¼ , then both interest rates must be quoted as
convertible-quarterly rates.

This formula gives the value V of the FRA to the lender. The value of the FRA to the
borrower will always be equal to –V. The formula can be derived by the following
argument.
Under the FRA (and assuming that we have agreed to lend over the future time period),
the following cashflows are (in principle) payable:
 –L at time T1
 + L ÈÎ1 + RK (T2 - T1 )˘˚ at time T2 .
Typically these cashflows do not actually change hands in practice. Instead the contract
is settled at time T1 , based on the actual interest rate then prevailing. However, we can
use them to value the contract.
Now, if RK = RF , then the FRA must have a value of zero. This is because we could
agree now to borrow at the forward rate of RF over the future time period T1 to T2 and
then lend (via the FRA) over the same future time period at the same interest rate of
RK = RF .
Suppose instead that RK and RF differ and consider two FRAs, one of which promises
that the forward rate RF will be earned on a principal of L between T1 and T2 , whereas
the second promises that RK will be earned on the same principal between T1 and T2 .
In other words, the two contracts differ only in respect of the interest payments paid at
T2 . The excess value of the FRA paying RK over that paying RF must be the present
value of the excess interest payments at T2 . This is equal to:
V = L ( RK - RF )(T2 - T1 ) e - R2T2
where R2 is the continuously-compounded zero rate for a maturity of T2 . Since the

value of the FRA promising to pay RF is zero, the above expression must be the value
of an FRA that promises instead to pay RK .
This assumes that:

 the market is arbitrage-free and that it is possible to set up an FRA based on the
interest rate RK
 there are no taxes or transactions costs, a standard assumption to make when we
are valuing derivatives.

Question 11.9
Suppose that the 1-year and 2-year zero rates are 7.5% and 7% pa respectively, both
continuously-compounded.
(i) Calculate the continuously-compounded forward rate for Year 2.
(ii) Calculate the annually-compounded forward rate for Year 2.
(iii) Consider a forward rate agreement that will pay a rate of 7.1% pa compounded
annually, based on a principal of $2 million from the end of Year 1 to the end of
Year 2. Calculate the value of the forward rate agreement to the lender.
1.6 Interest rate futures
Interest rate futures are similar to FRAs except that the contracts are standardised and
exchange-tradable.
Three-month interest rate future contracts are typically available in a wide range
of currencies. The contracts trade with specified delivery months (for example
March, June, September and December) up to ten years into the future (as well
as short-maturity contracts with other delivery months). The variable underlying
the contract is the relevant market interest rate applicable to a specified period
(eg a 90-day period beginning on the third Wednesday of the delivery month).
For example, the payoff on delivery of an interest rate future with a delivery date of
June 20th is based on a 3-month interest rate relating to the period from June 20th to
September 18th.
Most interest rate futures contracts have a contract size of 1 million currency units.
Thus by entering into a long/short position involving a single Eurodollar contract, the
investor is effectively agreeing to lend/borrow a principal amount equal in value to
about $1m. Interest rate futures prices are, however, quoted per 100 nominal. As a
result, the actual (contract) price or principal paid or received differs from the quoted
price. For a 3-month future, the following formula can be applied.
If Z is the quoted price for a futures contract, the contract price is:
10,000 ÈÎ100 - 0.25 (100 - Z )˘˚

Example
The quoted price for a 3-month Eurodollar interest rate future is 95.00. Applying the
above formula, the actual price paid is:
10, 000 ÈÎ100 - 0.25 (100 - 95)˚˘ = $987,500
A change of one basis point, ie 0.01, in a Eurodollar futures quote corresponds

to a contract price change of $25. Thus the tick size is 0.01 and the tick value is
equal to $25.
Question 11.10
Explain why a change of one basis point in a Eurodollar futures quote corresponds to a
contract price change of $25.
To standardise these contracts, the actual period is 90 days, rather than exactly
3 months. When the third Wednesday of the delivery month is reached and the
actual interest rate for the 90-day period is known, the contract is settled in cash.
If Z is a Eurodollar futures quote, then (100 - Z ) % is the Eurodollar futures interest

rate for a 3-month period beginning on the third Wednesday of the delivery month. So,
if the quoted price is Z = 95.00 say, then the futures interest rate is 5% pa. This rate is
a percentage interest rate convertible quarterly.
If the actual 90-day Eurodollar interest rate on the settlement date (ie the third
Wednesday of the delivery month) turned out to be R say, then the final marking to
market would set the futures price equal to Z = 100 – R. This price would then be
compared to the quoted price when the contract was first agreed to determine the profit
or loss on the contract (although in practice this would already be reflected in the
variation margin payments).
For example, given the tick value of $25 per basis point, if the price at settlement is 10
basis points higher than that when the contract was agreed, then the profit (loss) to the
long (short) party will be $250 per contract.

Question 11.11
Suppose that you had originally purchased a Eurodollar interest rate future based on a
90-day Eurodollar interest rate of 5.24% (compounded quarterly).
(i) Calculate the equivalent annually-compounded interest rate.
(ii) If the quarterly-compounded interest rate at the settlement date turns out to be
5.11%, what cash payment will you receive or make on settlement?
1.7 Relationship between forward and futures prices
As forward and futures contracts are in many respects similar, so we would expect there
to be a close relationship between the prices for FRAs and interest rate futures.
The main difference between (OTC) forwards and (exchange-traded) futures is

that, for a forward, there is no cashflow until the maturity. For a future, there are
daily marking-to-market and settlement of margin requirements.
If interest rates are constant (ie fixed) then the values of the cashflows are equal
and, hence, the prices must also be equal.
This result, which can be shown using an arbitrage argument, also applies if interest
rates are a known function of time.
When interest rates vary unpredictably, forward and futures prices are no longer
the same because of the daily cashflows from settlement and the interest earned
on cash received (or paid on borrowing).
When the price of the underlying asset is strongly positively correlated with
interest rates, a long futures contract will be more attractive than a similar long
forward contract and futures prices will tend to be higher than forward prices.
Suppose that the underlying asset price is strongly positively correlated with interest
rates. If the asset price increases, then an investor with a long futures position makes an
immediate gain because of the daily margining procedure of marking to market. As
such gains tend to happen when interest rates are high, this gain will tend to be invested
at higher than average interest rates. Likewise, decreases in the asset price, which lead
to an immediate loss to an investor with a long futures position, will tend to be financed
at lower than average interest rates.

In contrast an investor with a long forward position will not be affected in this way by
interest rate movements. Thus, all else being equal, a long futures contract will be more
attractive than the equivalent long forward contract. Futures prices will therefore tend
to be slightly higher than forward prices.
The reverse holds true when the asset price is strongly negatively correlated
with interest rates. Asset prices are typically negatively correlated with interest rates
in practice.
Question 11.12
Explain why the reverse result holds true.
The theoretical differences between forward and futures prices for contracts that
last only a few months are, in most circumstances, sufficiently small to be
ignored – although in practice there may be other factors such as transaction costs that
do lead actual futures and forward prices to differ.
However, for long-term futures contracts, the differences between forward and
futures rates are likely to become significant, in which case forward rates cannot be
derived directly from quoted futures prices.
Short-term interest rate futures and forward rates
In the particular case of short-term interest rates, forward rates are always lower than
the corresponding futures rates.
To convert futures to forward interest rates, a convexity adjustment is applied:
Forward rate = Futures rate – ½ s 2t1t2
where:
 t1 is the time (in years) to maturity of the futures contract
 t2 is the time (in years) to maturity of the rate underlying the futures
contract
 s is the standard deviation of the change in the short-term interest rate in
one year. (A typical value for s is 1.2%. )
Note that the forward and futures rates in this expression are expressed in
continuously-compounded form, d , ie as forces of interest.

The convexity adjustment in the above formula is only one particular example of such
an adjustment, based on a particular interest rate model. The derivation of both this
convexity adjustment and the above formula are beyond the syllabus.
Question 11.13
Suppose that the current price of a 4-year Eurodollar future on a 3-month interest rate is
95 and that s = 0.01 . Calculate:
(i) the absolute value of the convexity adjustment, as given above
(ii) the continuously-compounded futures rate
(iii) the continuously-compounded forward rate.
Question 11.14
Explain why forward rates are lower than the corresponding futures rates for interest
rate forwards and futures.
1.8 Interest rate swaps
As we saw in Chapter 3, an interest rate swap can be valued as a long position in

one bond compared to a short position in another bond. The cashflows are
usually discounted using LIBOR zero-coupon interest rates (since LIBOR is the
cost of funds for a financial institution). This involves an implicit assumption that
the risk associated with the swap cashflows is the same as that associated with loans in
the interbank market.
Thus:
Vswap = Bfl - Bfix
where:
 Bfix is the value of the fixed-rate bond underlying the swap
 Bfl is the value of the floating-rate bond underlying the swap.

Here we are valuing the swap to the party that has lent money at the variable interest
rate (and so is receiving variable interest rate payments under the swap) and is
borrowing money at the fixed rate.
The fixed-rate bond is valued in the usual way:
n
Bfix = Â ke - r t
i i
+ Le - rnt n
i =1
where:
 the cashflows are k at time t i (1  i  n) and L at time t n
 ri is the continuously-compounded LIBOR zero rate for maturity ti .
The value of the floating-rate bond will be L immediately after a payment date.
Here we are implicitly assuming that the floating-rate bond pays the (variable) market
rate of interest, ie LIBOR (and not LIBOR + ¼% pa say). If this is the case, then the
same variable rates are used both to estimate the future coupon payments and to
discount them. So, unlike with fixed interest bonds, there is no discrepancy between the
market price and the redemption value.
The same idea applies to an interest-only variable-rate mortgage, where the outstanding
amount of the loan on Day 1 (the value) is of course equal to the amount of the loan (the
principal) regardless of the pattern of interest rates on that day.
We can illustrate this general result by means of the following simple example.

Example
Consider a 3-year floating-rate bond with annual coupons and a principal of 100. The
coupon paid at the end of each year is based on the value of the floating interest rate at
the start of that year.
Let:
 Rk (k = 1, 2, 3) be the k-year zero rate
 RFk (k = 1, 2, 3) be the forward rate applicable over year k.
If both series of rates are assumed to be annually compounded then the price of the
bond can be written as:
È R RF 2 1 + RF 3 ˘
P = 100 Í F 1 + + ˙
ÍÎ 1 + R1 (1 + R2 )
2
(1 + R3 )3 ˙˚
Recall that:
 RF1 = R1
(1 + R )
2
 2 = (1 + R1 )(1 + RF 2 )
(1 + R )
3
 3 = (1 + R1 )(1 + RF 2 ) (1 + RF 3 )
Using these results to substitute in for RF1 , RF 2 and RF 3 in the bond price expression
gives:
È R 1 1 1 ˘
P = 100 Í 1 + - + ˙
ÍÎ 1 + R1 1 + R1 (1 + R2 ) (1 + R1 )(1 + RF 2 ) ˙˚
2
Here the final two terms cancel. So the whole expression simplifies to 100 – ie the
principal amount. This result can be generalised to allow for any term and frequency of
coupon payments.
The same argument also applies immediately after any coupon payment during the
lifetime of a floating-rate bond (as the remaining part of the original bond can be
thought of as a new floating rate bond with a shorter term). It can therefore be used to
value such a bond immediately before a payment date.

Immediately before a payment date, its value will be L + k * , where k * is the

floating-rate payment that will be made on the next payment date due at time t1 .
That is, equal to the sum of the value immediately after the payment plus the amount of
the payment itself.
Thus the value of the bond today is its value just before the next payment date,
discounted at rate r1 for time t1 :
Bfl = (L + k *) e - r1t1
Question 11.15
Consider an interest rate swap in which Company X has agreed to:

 receive 6% pa fixed
 pay 1-year LIBOR
both on a notional principal of $50 million.
The outstanding term of the swap is currently 2½ years, and the current LIBOR zero
rates for ½, 1½ and 2½ years are 5.7%, 5.75% and 5.85% pa respectively, all
compounded continuously. Interest payments are made annually, with the next due in
6-months’ time.
If the 1-year LIBOR rate was 5.72% pa (compounded annually) six months ago,
calculate the value of the swap to Company X.
1.9 Valuation of a swap as a series of forward rate agreements
Alternatively, the swap can be valued as a series of forward rate agreements.
The procedure is:
1. Calculate forward rates for each of the LIBOR rates that will determine
swap cashflows. This is done using the formula described in Section 1.4.
2. Calculate swap cashflows on the assumption that the LIBOR rates will
equal the forward rates. In other words, we assume that the forward rates will
actually be realised.
3. Set the swap value equal to the present value of these cashflows. Here the
cashflows are discounted using the appropriate LIBOR zero rates.

Example: Part 1
Consider the swap in Question 11.15.
In 6 months’ time, the company will receive a fixed interest payment of 6% pa and pay
a floating-rate payment based on the 1-year LIBOR rate at the last payment date of
5.72% pa, both payments based on the principal of $50 million. The net present value
of the cashflows then payable (discounting using the 6-month zero rate) is thus equal to:
50 ¥ (0.06 - 0.0572) e -0.057¥½ = 0.13607
In order to calculate the net present value of the cashflows in 18 months’ time, we need
to determine the amount of the floating-rate payment at that time. This first requires
that we calculate the forward rate applicable over the 1-year period starting in
6 months’ time.
Question 11.16
Show that the 1-year forward rate for the period starting in 6 months’ time is equal to
5.945% pa (annually compounded).

Example: Part 2
So the floating-rate payment in 18 months’ time is 50  0.05945 and the net present
value of the cashflows exchanged at that time is:
50 ¥ (0.06 - 0.05945) e -0.0575¥1½ = 0.02523
Similarly, to value the cashflows payable in 2½ years’ time we first need to find the
forward rate for the year ending at that time. This turns out to be 6% pa compounded
continuously, or 6.1837% pa compounded annually. The net present value of the
interest payments exchanged in 2½ years’ time is therefore:
50 ¥ (0.06 - 0.061837) e -0.0585¥ 2½ = - 0.07933
We do not need to consider the principal here as it is not exchanged in practice.
The total value of the swap is therefore:
0.13607 + 0.02523 – 0.07933 = $0.082 million
as before.
Question 11.17
Show that the annually-compounded 1-year forward rate for the period starting in 18
months’ time is equal to 6.1837% pa.

2 Arbitrage pricing and the concept of hedging
2.1 Introduction
Any two assets (or asset portfolios) that provide identical payoffs in all future
times and conditions must have the same price. If this was not the case, then
there would be opportunities for arbitrage – by selling the more expensive
portfolio and buying the cheaper portfolio with the proceeds, an investor could
produce an unlimited return without capital expenditure.
As investors attempt to take advantage of this position, the demand for the
cheaper portfolio will increase (causing its price to rise) and demand for the
more expensive portfolio will fall. Equilibrium will be restored when the prices of
the two portfolios are equal.
(Note that we are making many assumptions here about tax, transaction costs,
access to borrowing, divisibility of assets, investors’ knowledge, etc. )
The pricing of most derivatives is based on the assumption that markets are arbitrage-
free, which is often a reasonable, if not exact, assumption in practice.
Arbitrage pricing of forward contracts
We can apply the no arbitrage concept to derive the price, F0 , of a forward

contract in terms of the spot price S0 . No arbitrage requires that:
F0 = S0e rT
where T is the time when the forward contract matures and r is the risk-free rate of
interest (for an investment maturing at time T). If this equality did not hold,
arbitrage possibilities would exist.

Question 11.18
Complete the next section of notes yourself, by filling in the missing words and
mathematical expressions for the amounts involved. You may wish to use a pencil in
case you need to change your answer. (The passage relates to an asset with no
associated cashflows – eg a non-dividend-paying share. )
If F0 < S0e rT the investor can _____ the asset short at the current spot price ___, invest
the sale proceeds risk-free (to accumulate a sum _______ ), and, at the same time, enter
into a _____ forward contract to buy the asset at time T at price ___.
This will generate a risk-free profit of __________ for no initial outlay, at time T.
Similarly, if F0 > S0e rT unlimited profit can be made from a strategy of _________ S0
now to buy the asset and entering into a ______ forward contract to sell the asset at time
T for ___.
At that time the loan and accumulated interest of ______ will be repayable, leaving the
investor with a risk-free profit of _________.
The only price for the forward, F0 , that eliminates the arbitrage opportunities is
_______.
Core Reading
The section of notes you completed above was based on a section of Core Reading. We
give the full Core Reading overleaf for the sake of completeness.

If:
F0 < S0e rT
the investor can sell the asset short at the current spot price S0 , invest the sale
proceeds risk-free (to accumulate a sum S0e rT ), and, at the same time, enter into a
long forward contract to buy the asset at time T at price F0 . This will generate a
risk-free profit of S0e rT - F0 for no initial outlay, at time T.
Similarly, if:
F0 > S0e rT
unlimited profit can be made from a strategy of borrowing S0 now to buy the asset
and entering into a short forward contract to sell the asset at time T for F0 . At that
time the loan and accumulated interest of S0e rT will be repayable, leaving the
investor with a risk-free profit of F0 - S0e rT . The only price for the forward, F0 ,
that eliminates the arbitrage opportunities is S0e rT .
Question 11.19
Consider an 18-month forward on a zero-dividend preference share with a current price

of 82. Find the current price of the forward if the risk-free rate is 4% pa (compounded
continuously) over the next 18 months.
Where an asset will provide income with a present value of I during the lifetime of a
forward contract, then:
F0 = (S0 - I ) e rT
If the income is in the form of a known (continuous) yield, q, then:
F0 = S0e (
r - q )T
These results can be derived using similar arbitrage arguments to those described above.

Question 11.20
Suppose instead that the above preference share pays a dividend of 5 every 6 months
and that the last dividend payment was 2 months ago. Find the revised current price of
the forward if the risk-free rate is 4% pa (continuously compounded) over the next 18
months.
2.2 Hedging
A hedge is defined as a trade to reduce market risk.
Market risk is the risk of losses due to unpredictable changes in the market values of
assets. Market risk is a problem in any investment strategy that involves buying and/or
selling assets at market prices that cannot be predicted in advance.
Thus, an investor that knows she is due to sell an asset at a particular time can
hedge by taking a short futures position (known as a short hedge).
In other words, she can eliminate the effect of price movement by selling futures
contracts and thereby effectively agreeing to sell the asset at a fixed price at an agreed
future date. In practice, any loss on the actual sale of the asset would be offset by a
cash profit when the futures position is closed out by going long in an equal and
opposite future at a lower price.
If the price of the asset goes down, the investor does not fare well on the sale of
the asset, but makes a gain on the short futures position. If the price of the asset
goes up, the investor gains from the sale of the asset but takes a loss on the
futures position.
Similarly, an investor that knows she is due to buy an asset in the future can
hedge by taking a long futures position (known as a long hedge).
If the price of the asset goes up, the extra cost to the investor of buying the asset will be
offset by a gain on the long futures position. If the price of the asset goes down
however, the investor gains from the purchase of the asset but takes a loss on the futures
position.
It is important to recognise that futures hedging does not necessarily improve the
overall financial outcome. What it does is reduce the risk by making the outcome
more certain.

Question 11.21
(i) What is the basis of a futures contract?
(ii) What is basis risk?
Basis risk may arise if:

 The asset whose price is to be hedged is not exactly the same as the
asset underlying the futures contract.
 The hedger is uncertain as to the exact date when the asset will be bought
or sold.
 The hedge requires the futures contract to be closed out well before its
expiration date.
Note that:
 Basis risk may arise if any or all of the above applies.
 The first of the above points is sometimes referred to as cross hedging.
 For investment assets, arbitrage means that the basis risk tends to be fairly small.
Basis risk and cross hedging are discussed further in Chapter 22.
The optimal hedge ratio, h, (expressed as the ratio of the size of the position taken
in futures contracts to the size of the exposure) is given by:
sS
h=r
sF
where:
 s S is the standard deviation of DS , the change in spot prices over the life
of the hedge
 s F is the standard deviation in DF , the change in futures price over the
life of the hedge
 r is the correlation coefficient between DS and DF .
For example, if r = 1 and DS = DF , the optimal hedge ratio is 1.

The above result can be derived by considering the change in the value of the hedged
portfolio over the life of the hedge. If the hedge involves a long position in the asset
and a short position in the future then this change is:
DS - h DF
If the hedge is the opposite way around then the change is h DF - DS .
Question 11.22
Finish off the derivation of the formula given for the optimal hedge ratio by writing
down an expression for the variance of the change in the value of the hedged portfolio
and minimising it with respect to h.
We discuss hedging further in Chapter 22.

3 Empirical characteristics of asset prices
3.1 Assumptions
Most models used to price assets are based on strong assumptions concerning the
patterns of the investment returns generated by those assets. This is usually done in the
interests of mathematical tractability. For example, in much financial economic theory,
equity returns are assumed to be the increments in a random walk, with share prices
themselves following a geometric Brownian motion if we work in continuous time.
Although this is not the most accurate model of reality, it has the key advantage of
keeping the maths involved relatively(!) simple.
Question 11.23
State a formula showing how the share price at time u is related to that at time t < u
according to the continuous-time lognormal model of security prices as described in
Subject CT8.
Empirical studies of asset prices and interest rates have identified departures in
price and returns data from the assumptions commonly used in asset models.
These assumptions include:

 normality of increments in (log) asset prices
 independence of increments in asset prices
 constancy of parameters – eg drift ( m ) and volatility (s ) .
While there has been some debate about:

 this empirical evidence,
 the statistical validity of the tests
 the economic meaning of the results
the issues raised need to be understood if the standard modelling assumptions

are used.

3.2 Normality
Most studies of equity return distributions and other financial data find them to
be leptokurtic as compared with the normal distribution. This means that the
return distributions are peaked at the mean and fat-tailed compared with the
normal distribution.
Question 11.24
Interpret what this means in the context of daily share price movements.
The distribution of price changes becomes more normal as the horizon over
which these are measured is increased. Thus, annual returns are closer to
normal than monthly returns. This “fat-tailed” feature of returns can be modelled
by using a heteroscedastic model.
Question 11.25
What is a heteroscedastic model? What is the “opposite” of a heteroscedastic model?
3.3 Independence of increments
Other studies of equity returns have found that the variance of price changes for
longer horizons does not increase linearly (as would be expected if equity prices
follow a random walk). The variance was found to grow at a slower-than-linear
rate, suggesting that equity values exhibit long-run mean reversion.
This contradicts the assumption that the increments in equity prices are independent.
Studies of equity returns, interest rates and foreign exchange rates have also
found significant non-linear dependence, with absolute values of returns and
squared returns significantly autocorrelated. These studies generally do not find
evidence of serial correlation in the prices themselves.
3.4 Constancy of parameters
The non-linear dependence of squared returns suggests that the returns series
could be heteroscedastic, and not homoscedastic as the random walk model
assumes. Studies of stock market volatility over long periods of time in a
number of markets suggest that financial market volatility varies in certain
systematic ways.

For example, volatility of equity markets has tended to increase in recessions

and financial crises and to be lower in bull markets than in bear markets. This
latter phenomenon is usually explained by the effect of leverage, where negative
shocks result in proportionally higher volatility. Markets also exhibit volatility
“clustering”, where large and small shocks tend to be clustered together. This
feature of asset returns is indicative of non-linear dependence in the returns
series.
Although models have been developed that capture some of these features, they tend to
be relatively difficult to develop, use and interpret.
3.5 Relationships between variables
A contentious issue is the relationship between equity values, dividend growth

rates and inflation. Time series analysis of equity returns suggest that there is
little direct correlation between rates of equity growth for share price indices and
the rate of inflation. Indeed, there is some evidence that equity share returns are
negatively related to inflation, using year-on-year data.
Perhaps this is because governments often respond to high inflation by increasing

interest rates, with a negative impact on equity market levels. However, there may be a
positive relationship over longer time periods.
These studies need to be interpreted with care to determine whether equity

values and inflation indices are “co-integrated” (ie move together) even though
the rates of growth in these indices exhibit no significant cross-correlation.
Since equity assets are often used as an inflation “hedge”, the nature of this
relationship is fundamental for ALM and strategic asset allocation.
This is because it would make less sense to invest in “real” assets such as equities and
property to match real liabilities, if they did not actually provide a reasonable match.
Question 11.26
What are the main departures in price and returns data that have been identified by
empirical studies from the assumptions commonly used in asset models?

Chapter 11 Summary
Yields
The zero-coupon spot yield (or zero rate) is the (continuously-compounded) rate of
return on a zero-coupon bond.
The bond yield is the single interest rate such that the discounted present value of the
payments on a bond is equal to the market value of the bond.
The par yield is the coupon rate that would be required to make the theoretical value of
the bond equal to its nominal value under the prevailing pattern of zero-coupon interest
rates.
The zero-coupon yield curve can be constructed from the observed prices of coupon-
bearing bonds by the technique of bootstrapping.
A forward interest rate is the interest rate implied by current zero-coupon rates for a
specified future time period. Forward rates can be calculated from zero rates using:
R2T2 - R1T1
RF =
T2 - T1
The instantaneous forward rate for a maturity of T can be defined as:
∂R
RF = R + T
∂T
Forward rate agreements (FRAs)
The value, V, of a FRA can be evaluated as the present value of the difference between
the interest payments:
V = L ( RK - RF )(T2 - T1 ) e - R2T2
Interest rate futures
Three-month interest rate futures contracts are typically available in a wide range of
currencies. If Z is the quoted price for a futures contract, the contract price is:
10, 000 ÈÎ100 - 0.25 (100 - Z ) ˘˚

Relationship between forward and futures prices
To convert futures to forward interest rates, a convexity adjustment is applied:
forward rate = futures rate – ½s 2t1t2
Interest rate swaps
Vswap = B fl - B fix
where:
n
B fix = Â ke- r t ii + Le - rntn
i =1
B fl = ( L + k *) e - r1t1
Arbitrage pricing
Any two assets (or asset portfolios) that provide identical payoffs in all future times and
conditions must have the same price. If this was not the case, then there would be
opportunities for arbitrage.
The arbitrage price of a forward is:
 F0 = S0erT – if underlying asset provides no income
 F0 = ( S0 - I ) erT – if underlying asset provides income with a present value I
F0 = S0e(
r - q )T
 – if underlying asset provides a known, continuous yield q.

Hedging
A hedge is defined as a trade to reduce market risk.
Basis risk may arise if:

 The asset whose price is to be hedged is not exactly the same as the asset
underlying the futures contract.
 The hedger is uncertain as to the exact date when the asset will be bought or
sold.
 The hedge requires the futures contract to be closed out well before its
expiration date.
The optimal hedge ratio is given by:
sS
h=r
sF
Empirical characteristics of asset prices
Empirical studies of asset prices and interest rates have identified departures in price
and returns data from the assumptions commonly used in asset models.
These assumptions include:

 normality of increments in (log) asset prices
 independence of increments in asset prices
 constancy of parameters – eg drift ( m ) and volatility (s ) .


Solution 11.1
The n-year zero-coupon spot yield (or spot rate) is the rate of return earned on an n-year
zero-coupon bond. Thus, if a 5-year zero-coupon bond has a price of $78.35%, then the
(continuously-compounded) 5-year zero-coupon spot yield s5 is equal to 4.88% pa
since:
78.35 e5¥ s5 = 100
ie s5 = 0.04880
Solution 11.2
The equation is:
5e - y + 105e -2 y = 95.99
where y is the bond yield.
We can solve this using the quadratic formula to obtain y = 6.98%. Notice that this
value lies between the spot yields of 6% and 7%, but is heavily weighted towards 7%
because the redemption payment at Year 2 dominates the equation.
Solution 11.3
The equation is:
Ce -0.06 + (100 + C ) e -0.07¥ 2 = 100
where C is the par yield. Solving this gives the par yield of 7.21% pa.

Solution 11.4
The present value of the payments provided by the 4-year 6% bond with annual
coupons is:
6e - s1 + 6e -2¥ s2 + 6e -3¥ s3 + 106e -4¥ s4
ie 6e -0.061875 + 6e -2¥0.058267 + 6e -3¥0.057551 + 106e -4¥ s4
Given the market price of 101.00, we have:
6e -0.061875 + 6e -2¥0.058267 + 6e -3¥0.057551 + 106e -4¥ s4 = 101
 5.6400 + 5.3400 + 5.0486 + 106e -4¥ s4 = 101
 s4 = 0.055281
Solution 11.5
A forward rate is the rate at which two parties can agree to lend and/or borrow a
specified principal over a specified future time period.
Solution 11.6
Forward rate for Year 3, f 3
The present value of a 3-year zero-coupon bond can be written as:
100e -3¥ s3 = 100e -3¥0.065
It can also be written as:
100e - s1 e - f 2 e - f3 = 100e -0.06e -0.069e - f3
Equating these then gives f3 = 0.0660 .

Alternatively, you can start from the equation:
100e -3s3 = 100e -2 s2 e - f3
Or you can use the result in the Core Reading:
3s3 - 2 s2 3 ¥ 0.065 - 2 ¥ 0.0645

f3 = = = 0.0660
3- 2 3- 2
Forward rate for Year 4, f 4
The present value of a 4-year zero-coupon bond can be written as:
100e -4¥ s4 = 100e -4¥0.0675
which equals:
100e - s1 e - f 2 e - f3 e - f 4 = 100e -0.06e -0.069e -0.066e - f 4
Equating these then gives f 4 = 0.0750 .
Alternatively:
100e -4 s4 = 100e -3s3 e - f 4
will give the same answer. As does the result in the Core Reading:
4s4 - 3s3 4 ¥ 0.0675 - 3 ¥ 0.065

f4 = = = 0.0750
4-3 4-3

Solution 11.7
We saw that:
T1
RF = R2 + ( R2 - R1 )
T2 - T1
This can be rearranged to give:
Ê R - R1 ˆ
RF = R2 + T1 Á 2
Ë T2 - T1 ˜¯
As T2 Æ T1 , with a common value of T, so R2 Æ R1 with a common value of R and

Ê R2 - R1 ˆ ∂R DR
ÁË T - T ˜¯ Æ ∂T . (You can think of this ratio as DT , where DR and DT represent
2 1
small changes in R and T. )
So:
∂R
RF Æ R + T
∂T
A partial derivative is used here because our interest rate model may consider R to be a
function of other variables, as well as the term T.
Solution 11.8
A forward rate agreement (FRA) is a forward contract where the parties agree that a
specified interest rate will apply to a specified principal amount during a specified
future time period.

Solution 11.9
(i) Continuously-compounded forward rate for Year 2
Here the formula:
R2T2 - R1T1
RF =
T2 - T1
2 ¥ 0.07 - 1 ¥ 0.075
gives: RF = = 0.065
2 -1
ie 6.50% pa
(ii) Annually compounded forward rate for Year 2
This is found from:
1 + R = e RF
 R = e0.065 - 1 = 0.06716
ie 6.716% pa
(iii) Value of the forward rate agreement (to the lender)
Here we can use the formula from the Core Reading:
V = L ( RK - RF )(T2 - T1 ) e - R2T2
where:
L = 2,000,000 T1 = 1
RK = 0.071 T2 = 2
RF = 0.06716 R2 = 0.07
Thus:
V = 2, 000, 000 (0.071 - 0.06716)( 2 - 1) e -0.07¥ 2 = + $6, 678
ie the lender is currently looking at a profit of $6,678.

Alternatively, we can calculate the value from first principles.
From the point of view of the lender, the notional cashflows involved are:
 $2m paid at time 1
 $2m  1.071 received at time 2
So, discounting these payments using the spot rates given in the question gives the
value of the FRA as:
( )
$2, 000, 000 ¥ -e -0.075 + 1.071 e -2¥0.07 = + $6, 678
Note that the value of the FRA to the borrower is –$6,678, ie the borrower is currently
looking at a loss.
Solution 11.10
Using the formula, we see that a change of one basis point, ie a change in Z of 0.01, in a
Eurodollar futures quote will change the contract price by:
$10,000  0.25  0.01 = $25
Solution 11.11
(i) Equivalent annually-compounded interest rate
The equivalent annually-compounded interest rate i, ie the effective annual rate, is

given by:
4
Ê 0.0524 ˆ
1 + i = Á1 + ˜
Ë 4 ¯
ie i = 5.344% pa
(ii) Cash payment on settlement
The original quoted price for the future was 100 – 5.24 = 94.76 and so the contract price
was:
10, 000 ÈÎ100 - 0.25 (100 - 94.76) ˘˚ = 986,900

The contract price at settlement is:
10, 000 ÈÎ100 - 0.25 (5.11) ˚˘ = 987, 225
As the interest rate has fallen and the contract price increased, you have made a profit
and so will receive a cash payment equal to:
987,225 – 986,900 = $325
Solution 11.12
Suppose that the underlying asset price is strongly negatively correlated with interest
rates. If the asset price increases, then an investor with a long futures position makes an
immediate gain because of the daily margining procedure of marking to market. As
such gains tend to happen when interest rates are low, this gain will tend to be invested
at lower than average interest rates. Likewise, decreases in the asset price, which lead
to an immediate loss to an investor with a long futures position, will tend to be financed
at higher than average interest rates.
interest rate movements. Thus, all else being equal, a long futures contract will be less
attractive than the equivalent long forward contract. Futures prices will therefore tend
to be lower than forward prices.
Solution 11.13
(i) Convexity adjustment
Here, s = 0.01 , t1 = 4 and t2 = 4.25 . So the absolute value of the convexity

adjustment is given by:
½s 2t1t2 = ½ ¥ 0.012 ¥ 4 ¥ 4.25 = 0.00085

(ii) Continuously-compounded futures rate
A price of 95 implies a futures rate of 5% pa convertible quarterly.
So:
4
dÊ 0.05 ˆ
e = Á1 + ˜
Ë 4 ¯
ie d = 4.969% pa
(iii) Continuously-compounded forward rate
forward rate = futures rate – convexity adjustment
ie forward rate = 0.04969 – 0.00085 = 4.884% pa
Solution 11.14
Interest rate forward and futures prices are negatively correlated with interest rates. So
in accordance with the discussion in Section 1.7, forward prices will be higher than the
corresponding futures prices. Consequently, forward rates must be lower than the
corresponding futures rates.
Solution 11.15
The value of the swap to Company X, which is receiving 6% pa fixed in return for
paying 1-year LIBOR is given by:
Vswap = B fix - B fl
The general expression for the value of the fixed bond is:
n
B fix = Â ke- r t
ii + Le - rntn
i =1
which in this case is equal to:
B fix = 3e -0.057¥0.5 + 3e -0.0575¥1.5 + 53e -0.0585¥ 2.5 = 51.4567

The general expression for the value of the floating-rate bond is:
B fl = ( L + k *) e - r1t1
which in this case is equal to:
B fl = (50 + 50 ¥ 0.0572) e -0.057¥0.5 = 51.3748
Thus:
Vswap = 51.4567 - 51.3748 = + $0.0820m
Solution 11.16
The continuously-compounded 1-year forward rate for the period starting in six months’
time is found using the usual formula:
R2T2 - R1T1
RF =
T2 - T1
Here we have:
0.0575 ¥ 1½ - 0.057 ¥ ½
RF = = 0.05775
1½ - ½
The annually compounded forward rate R is thus given by:
1 + R = e RF = e0.05775
which gives the required value of R = 0.05945 .
Solution 11.17
The continuously-compounded 1-year forward rate for the period starting in 18 months’
time is found using the usual formula:
R2T2 - R1T1
RF =
T2 - T1

Here we have:
0.0585 ¥ 2½ - 0.0575 ¥ 1½
RF = = 0.0600
2½ - 1½
The annually compounded forward rate R is thus given by:
1 + R = e RF = e0.06
which gives the required value of R = 0.061837 .
Solution 11.18
If F0 < S0erT the investor can sell the asset short at the current spot price S0 , invest the
sale proceeds risk-free (to accumulate a sum S0erT ), and, at the same time, enter into a
long forward contract to buy the asset at time T at price F0 .
This will generate a risk-free profit of S0erT - F0 for no initial outlay, at time T.
Similarly, if F0 > S0erT unlimited profit can be made from a strategy of borrowing S0
now to buy the asset and entering into a short forward contract to sell the asset at time T
for F0 .
At that time the loan and accumulated interest of S0erT will be repayable, leaving the
investor with a risk-free profit of F0 - S0erT .
The only price for the forward, F0 , that eliminates the arbitrage opportunities is S0erT .

Solution 11.19
This is a direct application of the formula:
F0 = S0erT
Here we have S0 = 82, r = 0.04, T = 18 12 . Thus:
F0 = 82 e0.04¥18 12 = 87.07
Solution 11.20
Here we use the formula:
F0 = ( S0 - I ) erT
in which:
( )
I = 5 e -0.04¥ 4 12 + e -0.04¥10 12 + e -0.04¥16 12 = 14.51
So:
F0 = (82 - 14.51) e0.04¥18 12 = 71.66
Solution 11.21
(i) Basis
The basis of a futures contract is defined as the difference between the spot price of the
asset to be hedged ( S0 ) and the futures price of the contract used to hedge ( F0 ) .
It provides a measure of the discrepancy between the elements involved in a hedge. If

there is no basis the hedge is perfect and all market risk is eliminated. In practice, this
rarely happens.

(ii) Basis risk
Basis risk is the risk that the basis cannot be predicted in advance with complete
certainty – except at the settlement date, when it should be zero if the asset to be hedged
and the asset underlying the futures contract are identical (and ignoring transaction
costs).
The basis risk for an investment asset (ie financial securities, currencies and precious
metals) arises primarily from uncertainty regarding the level of the risk-free rate and the
asset’s future yield.
Solution 11.22
Whether we consider the change as DS - h DF or h DF - DS , its variance v is equal to:
v = s S2 + h 2s F2 - 2h rs Ss F
where:
s S2 = Var ( DS )
s F2 = Var ( DF )
Covar ( DS , DF )
r=
s Ss F
So:
∂v
= 2hs F2 - 2 rs Ss F
∂h
∂ 2v
Setting this equal to zero, noting that 2
= 2s F2 > 0 (so that we have a minimum) and
∂h
solving for h then gives the required result.

Solution 11.23
According to the continuous-time lognormal model of security prices:
log( Su ) - log( St ) ~ N [ m (u - t ),s 2 (u - t )] , u > t
where:
 Su and St are the security price at times u and t , u > t
 m and s are the (constant) drift and volatility parameters

 returns over non-overlapping intervals are assumed independent of each other.
Solution 11.24
Interpretation of leptokurtic
This means that:

 market crashes and jumps appear more often than one would expect from a
normal distribution (fat tails)
 days with no change, or very small change, also happen more often than the
normal distribution suggests (ie the actual distribution is more peaked).
Solution 11.25
A heteroscedastic model is one in which the volatility of the time series being modelled
varies in some way. For example, in an autoregressive conditional heteroscedastic
model, the volatility parameter is modelled as a time-varying process in its own right.
The “opposite” of a heteroscedastic model is a homoscedastic one (eg lognormal model
of security prices) in which the volatility is modelled as a constant parameter.
Solution 11.26
The main departures in price and returns data from the assumptions commonly used in
asset models that have been identified from empirical studies include:
 a lack of normality of increments in (log) asset prices
 a degree of dependence between increments in asset prices
 a lack of constancy of parameters – eg drift ( m ) and volatility (s ) .





the course.

Chapter 12
Valuation of investments (2)
Syllabus objectives
 introduction into fixed income option pricing
 evaluating a securitisation (including CBO’s and MBS’s)
 evaluation of a credit derivative
0 Introduction
The primary objective of this chapter, which is again rather technical, is to describe how
to value several further types of derivative including:
 interest rate caps and floors
 swaptions
 credit derivatives.
We also consider how to evaluate a securitisation.
The layout of the chapter is therefore as follows:
 Section 1 describes a general formula that can be used to price derivatives and
then applies it to the pricing of bond options, interest rate caps and floors and
swaptions. These are all interest rate derivatives, whose payoffs depend in
some way on interest rates and/or bond prices.
 Section 2 describes the factors that need to be considered when evaluating a

securitisation.
 Section 3 considers the evaluation of credit derivatives and also discusses a

model that can be used to price corporate debt allowing for credit risk, based on
the information contained in the company’s share price.

1 Introduction to fixed income option pricing
1.1 Introduction and general pricing formula
The use of the Black-Scholes formula for valuing options on shares was
considered in Subject CT8. Here, we consider the extension of this approach to
bond options, interest rate caps and floors and swaptions – derivatives whose
payoffs are dependent in some way on the level of interest rates. These are
more difficult to value than equity derivatives, since:
 the behaviour of an individual interest rate is more complicated than that
of a stock price. The key reason for this is that interest rates vary by term,
which must be incorporated as an extra dimension.
 for the valuation of many products, it is necessary to develop a model
describing the behaviour of the entire yield curve. This is in contrast to the
Black-Scholes model of share option prices, which is based on a model of a
single share price only.
 the volatilities of different points on the yield curve are different
 interest rates are used for discounting as well as for determining payoffs
from the derivative.
The main classes of yield curve models were introduced in Subject CT8. Recall
that these included the Vasicek and Cox-Ingersoll-Ross models. A key attribute of such
models was that they modelled movements in the entire yield curve in such a way that
arbitrage opportunities were excluded.
Question 12.1
Define arbitrage opportunity in this context.
Black’s model for valuing European options
The model we discuss here is often referred to as Black’s model. It was originally
developed in the context of share options, but can be used to value a wide range of
European options if we assume a lognormal distribution for the value of the underlying
asset.
Note that you should not rely on being given this and the following formulae in the
exam. Instead you will be expected either to remember each formula, or to “tweak” the
Black-Scholes option pricing formula that appears on page 47 of the gold Formulae and
Tables book. Either way, you will need to identify the underlying asset to which the
option relates, the relevant strike price and whether the option is a put or a call.

More generally you ought to be aware of exactly which formulae are given in the gold
tables.
Call option
We consider a European call option on a variable whose value is V. Recall that

the payoff from any financial derivative is linked to the value of some variable, often
the price of an “underlying” asset.
Defining:
● T: Maturity date of the option
● F: Forward price of V (for a contract with maturity T)
● F0 : Value of F at time 0
● X: Strike price of the option

● P (t , T ) : Price at time t of a zero-coupon bond paying 1 at time T, assumed
to be risk-free
● VT : Value of V at time T
● s: Volatility of F, sometimes known as the forward volatility of V.
Then, assuming that:

 VT has a lognormal distribution with standard deviation of ln VT equal to
s T
 the expected value of VT is equal to F0
the value of the option c at time 0 is given by:
c = P ( 0, T ) ÎÈ F0 F(d1) - X F(d 2 ) ˚˘ (1)
where:
 F( x ) is the cumulative standard normal distribution function,
 d1 = Á
0 (
Ê ln (F / X ) + s 2T / 2
) ˆ˜
Á s T ˜
Ë ¯
 d2 = Á
0 (
Ê ln (F / X ) - s 2T / 2
) ˆ˜
Á s T ˜
Ë ¯

This formula is similar to the Black-Scholes formula for options on shares, but is in fact
slightly more general. For a non-dividend-paying share, F0 would equal S0 e rT – the
current share price accumulated at the constant risk-free rate. If you substitute this in
the above formula, then you get the more familiar Black-Scholes formula, albeit it with
slightly different notation.
Question 12.2
What is the option payoff at time T?
Question 12.3
What can you say about the parameter s in the case of options on non-dividend-paying
shares?
The rationale behind this Core Reading formula is as follows. It can be shown that,
given the assumption that VT has a lognormal distribution, the expected option payoff at
time T is:
E ÈÎ(VT )˘˚ F(d1 ) - X F(d 2 )
where:
 d1 = Á
T (
Ê ln ( E [V ] / X ) + s 2T / 2 ) ˆ˜
ÁË s T ˜¯
 d2 = Á
T (
Ê ln ( E [V ] / X ) - s 2T / 2 ) ˆ˜
ÁË s T ˜¯
Substituting in the assumption that E [VT ] = F0 and discounting at the risk-free rate
from T back to time 0 using P (0, T ) then gives the required result.
Note that whilst the model assumes that VT has a lognormal distribution at time T, it
does not assume that either V or F follows a geometric Brownian motion.

Put option
The value p of the corresponding put option is given by:
p = P (0, T ) [ X F( -d 2 ) - F0 F( -d1)]
with d1 and d 2 defined as before.
The put formula can be found from each corresponding call formula throughout this
chapter by:
 “switching around” the X F(.) and F0 F(.) terms
 reversing the signs on d1 and d 2 .
Payoff at a later date
Where the payoff is made at some later time T * than the time at which the
variable V is evaluated, we simply allow for this in the discount factor P (0, T *) .
In other words:
c = P (0, T *) [ F0 F(d1 ) - X F(d 2 )] (2)
p = P (0, T *) [ X F( - d 2 ) - F0 F( - d1 )] (3)
with d1 and d 2 are exactly as before.
We will use this idea when we value interest rate caps and floors later on in this chapter.
Approximations
When interest rates are stochastic, this model appears to involve two
approximations:
1. The expected value of VT is assumed equal to its forward price F0 . This

assumption is true in a risk-neutral world, when the risk-free rate is assumed to
be deterministic.
2. The stochastic behaviour of interest rates is not taken into account in the
way the discounting is done.
It can be shown, however, that these two assumptions have exactly offsetting
effects, when the model is being used to value the derivatives we consider in this
chapter. Showing this is, however, beyond the syllabus.

1.2 Pricing bond options
Assuming that bond prices at the maturity of the option are lognormally
distributed, the equations in Section 1.1 above can be used to price European
options on bonds with F0 equal to the forward bond price.
s T is the standard deviation of the logarithm of the bond price at the maturity
of the option. In other words, the standard deviation of ln VT is equal to s T as in
the earlier section.
Question 12.4
State the formula for the price of a European call option on a bond.
To allow for income, F0 can be calculated as:
B0 - I
F0 =
P (0,T )
where:
 B0 is the bond price at time zero
 I is the present value of the coupons that will be paid during the life of the
option.
Note that F0 , B0 and X should all be expressed as “dirty” prices ie allowing for
accrued income.
Recall that:
 dirty prices are the prices actually paid for bonds, whereas the quoted prices are
often “clean” prices, excluding accrued interest
 dirty price = clean price + accrued interest.

Example
Consider a 5-year fixed interest bond that is priced at 106 and has just paid its annual
coupon of 7. Suppose that we wish to calculate the price of an 18-month call option on
this bond, with a strike price of 104. If spot yields are equal to 4% pa compounded
continuously for all terms up to 18 months, then the present value of the coupons due to
be paid by the bond between now and the option strike date is given by:
I = 7e -1¥0.04 = 6.7255
Also, the 18-month discount factor is equal to:
P (0, 1½ ) = e -1½ ¥0.04 = 0.94176
So, the current forward price of the bond (at the option strike date) is:
B0 - I 106 - 6.7255
F0 = = = 105.413
P (0, T ) 0.94176
Question 12.5
Calculate the value of a call option in the above example assuming that the forward
volatility of the bond is 0.04.
1.3 Price and yield volatilities
The volatility in the above option-pricing formula is a price volatility. In practice,

however, volatilities are often expressed as yield volatilities. To convert these to
price volatilities we use the expression:
s = D y0 s y
where:
 s is the forward price volatility
 s y is the corresponding forward yield volatility
 y 0 is the initial forward yield on this bond
 D is the (modified) duration of the forward bond underlying the option.

The modified duration is given by:
Duration
D=
(1 + y m )
where m is the frequency per annum with which y is compounded.
Question 12.6
Define the modified duration or volatility of a bond in terms of the bond price.
Question 12.7
A 6-year zero-coupon bond is priced at 74.62%.
(i) What is the duration of the bond?
(ii) Calculate the annual effective yield on the bond and hence its modified duration.
1.4 Interest rate caps
How interest rate caps work
A popular over-the-counter interest rate option is the interest rate cap, which is
designed to provide insurance against the rate of interest on an underlying
floating rate note rising above a certain level. This level is known as the cap
rate, R X .
If you have a mortgage, you may well have a similar arrangement where there is a
clause that “caps” your interest payments if the mortgage rate goes above a specified
level. So an interest rate cap is most likely to be of use if you wish to cap the variable
interest rate you are paying.
Consider a floating rate note, the interest rate on which is reset to equal LIBOR at pre-
specified time intervals, say every 3 months. The interest rate on the floating rate note
for the first 3 months is equal to initial LIBOR rate on the starting date. The interest
rate for the next three months is set equal to the LIBOR rate that applies at the first 3-
month point and so on.
The following example illustrates how an interest rate cap works.

Example
Consider a 3-year interest rate cap based on a principal amount of $1,000,000, in which
the interest rate is reset every 3 months, and with an interest rate cap of 6% pa
(compounded quarterly, as the payments are made quarterly).
If the relevant LIBOR rate at the start of a particular 3-month period was equal to 7%
pa (compounded quarterly), then the interest payment on a floating rate note would be:
0.25  0.07  1,000,000 = $17,500
If LIBOR was equal to the cap interest rate of 6% pa, the interest payment would be:
0.25  0.06  1,000,000 = $15,000
Given that the actual LIBOR rate exceeds the cap rate, the interest rate cap will make a
payment equal to the difference between the two payments, ie a payment of $2,500. If
instead, the actual LIBOR rate had been less than the cap rate, then no payment would
be made.
In practice:
 the payment, if any, occurs at the end of the 3-month period concerned (not at
the start) to coincide with the interest payment due under the floating rate note,
based on the interest rates prevailing at the start of the period
 usually no payment is made at the first reset date, even if the initial LIBOR rate
exceeds the cap rate, as the initial LIBOR rate (and hence any payment) is
known.
Thus, in this example, there would be 11 reset dates (at times 0.25, 0.50, …, 2.75) and
11 possible payment dates (at times 0.50, 0.75, …, 3.00).
Pricing interest rate caps
Suppose the interest rate RK on the floating rate note is reset every three
months to equal LIBOR. (The time between resets is known as the tenor. ) The
payoff provided by the cap will be:
L ¥ 0.25 ¥ max (RK - R X , 0)
where:
 L is the principal amount specified for the contract
 RX is the cap rate.

This payoff calculation will occur every three months during the life of the cap, T.
Note that payment of the payoff occurs at the end of the tenor period (here three
months) not at the time of calculation (the beginning of the period).
Thus the cap leads to a payoff at time t k + 1 (k = 1, 2, . . . , n) of:
L d k max (RK - R X , 0)
where t n + 1 is defined as T and the reset dates are t1, t2 , ..., t n .
Note that:
 d k = tk +1 - tk
 RK and R X are expressed with a compounding frequency equal to the
frequency of resets
 there is no reset at t0 and hence no payment at t1 .
Question 12.8
Suppose that Bank Z has sold an interest rate cap based on a principal of £50m and a
fixed cap rate of 6% pa convertible quarterly.
Calculate the payments Bank Z must make to the purchaser of the cap at the end of each
of the first six quarters if the LIBOR rate at the start of first quarter is 6.20%, and moves
to 6.03%, 6.61%, 5.99%, 6.12% and 6.20% pa in subsequent quarters.
The above expression suggests that we can think of each of the potential payments
under an interest rate cap as the payoff from a call option on the LIBOR rate.
Each payoff is a call option on the LIBOR rate observed at time t k (with the
payoff occurring at time t k + 1 ) and is known as a caplet. The cap is a portfolio of
n such options.
Recall Equation (2) in Section 1.1, which gives the general expression for the price of a
European call option as:
c = P (0, T *) [ F0 F(d1 ) - X F(d 2 )]

If the rate RK is assumed to be lognormally distributed with volatility s K , then

we can use the expression in Section 1.1 above, substituting:
 R X for X
 FK (the forward rate for the period between time t k and t k + 1 ) for F0
 t k + 1 for T*
 s K for s
to value each caplet.
(Each caplet must be valued separately. )
Once we allow for the fact that the actual cash payment will reflect both the principal L
and the tenor d k , the resulting formula is:
c = Ld k P (0, tk +1 ) [ FK F(d1 ) - RX F(d 2 )]
where:
Ê ln ( FK RX ) + s k2tk 2 ˆ
 d1 = Á ˜
Ë s k tk ¯
Ê ln ( FK RX ) - s k2tk 2 ˆ
 d2 = Á ˜
Ë s k tk ¯
 FK is the forward rate between tk and tk +1 .
The discount factor here is P (0, tk +1 ) because the payoff occurs at time tk +1 , based on
the interest rate observed at time tk .
Question 12.9
Suppose that the zero curve is flat at 7% pa for all terms and that the interest rate
volatility is 10% pa. Consider a 3-year interest rate cap, based on annual payments, a
principal of $100k and a cap rate of 6% pa. Given that all interest rates are quoted as
annual effective rates, calculate the value of the interest rate caplet in the third year.

1.5 Spot rate volatilities
As each caplet must be valued separately, one issue to be considered is whether to

use a different “spot” volatility for each caplet or to assume the same “flat”
volatility for all the caplets comprising any particular cap (but to vary this
volatility according to the life of the cap).
When a different forward rate volatility is used to value each caplet, based on the term
of that caplet, then the volatilities used are referred to as spot volatilities. If instead the
same (average) volatility is used for all caplets within a given cap, then it is known as a
flat volatility.
Spot and flat volatilities usually vary with the term of the option. In practice, a plot of
spot volatilities against term usually produces a humped curve. The flat volatility curve
is likewise humped, although typically less so, as flat volatilities are essentially
cumulative averages of spot volatilities.
Cap
volatility
spot volatilities
flat volatilities
Term of the option
Figure 12.1: Typical pattern of spot and flat volatilities

1.6 Interest rate floors
An interest rate floor contract provides a payoff when the interest rate on an underlying
floating rate note falls below a certain rate. It is otherwise identical to a cap. A floor
can therefore provide insurance against a fall in a floating rate, which might be useful if
you are receiving the floating rate.
Pricing interest rate floors
An equivalent approach (to that used to price interest rate caps) is used for an
interest rate floor contract providing payoff when the interest rate on an
underlying floating-rate note falls below a certain rate. In this case, we are
valuing a portfolio of put options
Question 12.10
State a formula for the payoff provided by a floorlet at time tk +1 (k = 1, 2, ..., n).
1.7 The relationship between caps and floors: put-call parity
Note that the cap and floor prices satisfy the put-call parity relationship:
cap price = floor price + value of swap
where:
 the cap interest rate and the floor interest rate are the same
 the swap is an agreement to receive floating and pay a fixed rate R X , but
with no payments made at the first reset date.
1.8 Interest rate collars
Caps and floors are often combined into a single instrument, the interest rate
collar (or “floor-ceiling” agreement). This is designed to guarantee that the
interest rate on the underlying floating rate note always lies between two levels.
It is usually constructed so that the price of the long position in the cap is
initially equal to the price of the short position in the floor, so that the cost of
entering into the collar is then zero.

Example
Suppose that you have sold a floating rate note (FRN) with a nominal value of £400m.
You subsequently decide to protect yourself by arranging a collar, with a long cap based
on 6% pa and a short floor based on 5% pa. The following table shows the resultant
cashflows (in £m) at the end of each quarter:
Quarter 1 2 3 4 5 6
Time 0 to 0.25 0.25 to 0.5 0.5 to 0.75 0.75 to 1 1 to 1.25 1.25 to 1.5
LIBOR
5.3% 6.1% 6.2% 5.2% 4.8% 4.9%
at quarter start
FRN payment –5.3 –6.1 –6.2 –5.2 –4.8 –4.9

Cap receipt – +0.1 +0.2 0 0 0
Floor payment – 0 0 0 –0.2 –0.1
Total net cashflow –5.3 –6.0 –6.0 –5.2 –5.0 –5.0
Thus, the collar ensures that the total cashflow always remains within the 5% to 6% pa
range required. Remember that each cashflow occurs at the end of the period based on
the interest rate at the start of the period.
The long cap position will cost money, whereas the short floor position can be sold,
thus it may be possible to achieve the above at no net cost.
1.9 Caps and floors as portfolios of bond options
Note also that an interest rate cap can be characterised as a portfolio of put
options on zero-coupon bonds with payoffs on the put occurring at the time they
are calculated.
Recall that a cap provides a payoff at time tk +1 of:
L d k max ( RK - RX , 0)
This has the same present value as a payoff at time tk of:
L dk
max ( RK - RX , 0)
1 + RK d k

Recall that RK , the floating rate, is convertible with frequency d k and so the effective
interest rate from tk to tk +1 is RK d k .
Question 12.11
Show that the previous formula can be rewritten as:
Ê L (1 + RX d k ) ˆ
max Á L - , 0˜
Ë 1 + RK d k ¯
L (1 + RX d k )
is the present value at time tk of a zero-coupon bond that pays
1 + RK d k
L (1 + RX d k ) at time tk +1 . The expression in the question box is therefore equal to the
value of a put option with an exercise date and price of tk and L respectively, on a zero-
coupon bond with a principal of L (1 + RX d k ) maturing at time tk +1 .
In the same way, a floor can be seen as a portfolio of call options on similar
bonds.
1.10 European swaptions
The nature of swaption contracts was considered in Chapter 3.
Question 12.12
Explain briefly what is meant by a swaption.
We have seen that an interest rate swap can be regarded as an agreement to

exchange a fixed rate bond for a floating rate bond, with the same principal.
Also, at the start of a swap, the value of a floating rate bond always equals the
principal amount of the swap, as we saw in Chapter 11.
Thus, a swaption can be regarded as an option to exchange a fixed rate bond for
the principal amount of the swap. If the swaption gives the holder the right to
pay fixed and receive floating, it is a put option on a fixed rate bond with a strike
price equal to the principal. If the right is to receive fixed and pay floating, it is a
call option on a similar bond, again with a strike price equal to the principal.

Question 12.13
Why can a swaption that gives the holder the right to pay fixed and receive floating, be
thought of as being equivalent to a put option on a fixed rate bond with a strike price
equal to the principal?
We do not, however, use this particular option-related argument here to value the
swaption. Instead we view the swaption as an option on the swap rate.
Swap rate
The swap rate for a particular term at a particular time is the fixed interest rate that
would be exchanged for LIBOR in a new swap with the same outstanding term. It can
therefore be defined as the fixed interest rate that makes the value of an interest rate
swap equal to zero.
Equally, if we consider an interest rate swap in terms of swapping a fixed for a floating
rate bond, then the swap rate is the fixed rate such that the two bonds have the same
present value at the start of the swap.
Example
Suppose that the 1-year and 2-year continuously-compounded spot rates are 4.6% and
4.73% pa respectively. Consider a 2-year interest rate swap, with a principal of $10m
and payments made annually in arrear, based on the spot rates at the start of the year.
Given that the value of the floating rate side of the swap at outset is equal to the
principal of $10m, the swap rate R can be found from the equation:
10 = 10 ¥ ÈÎ R e -0.046 + (1 + R ) e -2¥0.0473 ˘˚
This can be solved to obtain R = 0.0484 , ie a swap rate of 4.84% pa.
Assuming that the swap rate at the maturity of the option is lognormally
distributed, we consider a swaption with the right to pay R X and receive LIBOR
on a swap that will last n years starting in T years. We suppose there are m
payments per year under the swap and that the principal is L.

The payoff from the swaption consists of a series of cashflows equal to:
L
max (R - R X , 0)
m
where:
 R is the swap rate for an n-year swap at the maturity of the swap option
 m is both the number of cashflows each year and the frequency of compounding.
Thus, we have in effect replaced the unknown series of variable LIBOR rates with the
fixed swap rate, which is known with certainty at the strike date and which yields
payments with the same (expected) present value (at the strike date) as the unknown
LIBOR payments.
Each cashflow represents the payoff from a call option on R with a strike price of RX .
Thus, using Equation (1) from Section 1.1 above, the value of the cashflow received at
time ti can be shown to be:
L
P (0, ti ) ÈÎ F0 F (d1 ) - RX F ( d 2 )˘˚
m
where:
Ê ln ( F0 RX ) + s 2T 2 ˆ
 d1 = Á ˜
Ë s T ¯
Ê ln ( F0 RX ) - s 2T 2 ˆ
 d2 = Á ˜
Ë s T ¯
 F0 is the forward swap rate
 s is the volatility of the swap rate.
Thus, the value of the swaption is:
mn
L
Â m P (0, ti ) ÈÎF0 F (d1) - RX F (d2 )˘˚
i =1
where F0 is the forward swap rate.

Note that here there is only a single option on a single strike. However, should the
option be exercised then a series of m payments will be made in each of n years, so a
corresponding number of discount factors is required.
The previous expression can be simplified by substituting an annuity A where:
mn
1
A= Â
m i =1
P (0, t i )
Question 12.14
Use this annuity expression to simplify the expression for the value of the swaption.
Thus, if the swaption gives the holder the right to receive a fixed rate R X – ie the
payments are the opposite way around to previously – the value of the swaption is:
LA ÈÎ R X F ( -d 2 ) - F0 F ( -d1)˘˚
Question 12.15
Consider a swaption giving the option to make annual payments of 4.75% pa fixed in
return for receiving a floating rate income over a 2-year period, based on a principal of
$10m and commencing on a strike date in 3 years’ time.
Calculate the value of the swaption if the forward swap rate is 4.88% pa, the swap rate
volatility is 0.3 and the 4-year and 5-year spot rates are 4.8% and 4.85% pa respectively
(both compounded continuously).

2 Evaluating a securitisation
Evaluation of assets for securitisation concentrates more on the predictability
and sustainability of adequate cashflow than the asset’s loan to value ratio – the
aim being to check that the cashflows generated by the pool of securitised assets will be
sufficient to cover the payments promised by the asset-backed security.
Thus factors such as:

 lease terms
 rental prospects
will be considered when the underlying assets are properties.
More generally if the cashflows depend on the profit stream generated by the
underlying assets then factors such as the:
 degree of potential competition
 barriers to competitive entry
will be considered.
Agreements may include a debt service-to-EBITDA ratio covenant. The specific

factors considered will of course reflect the nature of the underlying securitised assets.
EBITDA is an abbreviation for earnings before interest, tax, depreciation and
amortisation. So a covenant of this nature aims to ensure that earnings are sufficient to
cover interest payments.
Outside the UK, and within the Eurozone, the reduction of currency exchange risk
has removed a barrier which previously inhibited pan-European securitisation,
making the pooling of assets in different countries easier (although differences in
legal systems can still make the transfer of assets located in different
jurisdictions a relatively complicated process).
The borrower’s auditors are likely to be called upon not only to undertake audits
of the assets, but also to provide various certificates concerning the assets,
cashflows, tax positions and contingent liabilities. They will therefore be required
to check and certify that the securitised assets are likely to generate a sufficient level of
cashflow.
The complexity of the securitisation structure requires a much higher degree of

reporting than under more usual banking facilities – particularly where more than
one tranche of asset-backed security is created based on a single pool of assets.

The focus of attention on cashflow volatility means that the analysis of credit
risk is a key feature when evaluating a securitisation. Techniques for evaluating
credit risk are considered in the next section.
Question 12.16
Why is the volatility of cashflow important?
Evaluation of a securitisation therefore follows the standard approach of

modelling the anticipated cashflows and discounting these at an appropriate
interest rate. The modelling of the cashflows will involve key features such as:
 statistics (early repayment experience)
 probability (default / recovery and timing)
 treasury management (payments in / payments out)
 structuring and security issuance – ie the ranking and structure (term, capital
and interest payments) of the different tranches of asset-backed securities.
A more intractable problem relates to the choice of a suitable discount rate for
each tranche of security. A common approach is to compare the risk
characteristics of each tranche with similar securities already in existence in
order to assess an appropriate credit rating for the tranche. From this, a market
interest rate can be established.
The techniques and considerations involved are therefore similar to those that apply to
the analysis of any investment or project.
Question 12.17
What are the main classes of asset-backed securities?

3 Evaluating a Credit Default Swap

The main types of credit derivative contracts were outlined in Chapter 3.
3.1 Implied prices
The price of a “plain vanilla” credit default swap (CDS) might, in theory, be
derived from the yield on an associated bond, from the same issuer and for the
same maturity, in excess of the risk-free rate.
We can illustrate the basic approach by means of an example.
Example
Consider a newly issued credit default swap which gives Bank X the right to sell a bond
issued by Company Y to Bank Z for the face value of the bond should Company Y
default on the bond. In return for this right, Bank X makes an annual payment of P to
Bank Z, which is therefore receiving P pa in return for accepting the credit risk on the
bond.
Assuming that investment markets are arbitrage-free, P should be approximately equal

to the excess yield on the bond over and above the corresponding risk-free rate.
Question 12.18
(i) If the face value of the bond is $100, the yield on the bond is 7.25% pa and the
risk-free rate is 6% pa, what is P?
(ii) What should Bank X do if P is less than this value?
(iii) What should Bank Z do if P is greater than this value?
However, in practice the “basis”, equal to the CDS price less the yield in excess
of risk-free on the bond is not zero, and can in fact be quite volatile.

This reflects a number of factors:
1. The package of a bond and a credit default swap, to protect against

default, is not in practice risk-free due to:
 counterparty credit risk on the credit default swap

This means that Bank Z would default on their agreement when
Company Y defaults on the bond.
 the no-default value of the bond may be higher or lower than face
value due to changes in interest rate
This is unlikely to be a major problem as government bonds will also
change with interest rates.
 documentation differences
This might be a subtle difference in the wording of a particular credit
event that causes Company Y to not be able to claim their full loss from
Bank Z.
2. The package of a bond plus CDS is illiquid and requires funding, and so
typically basis will be negative when funding is expensive.
So, although a bond plus a CDS is equivalent to a government bond, investors

who want government bonds will still prefer to simply buy government bonds.
This makes selling the bond plus CDS harder.
3. Different supply and demand dynamics in different markets.
3.2 Pricing credit derivatives directly
Another approach to directly estimating the price of credit risk, and hence credit
default swap premium, is to use structural models based on information from
equity derivative markets. One such approach, the Merton model, was covered
in CT8.
This model, developed by Merton for the purpose of pricing corporate debt and
appeared in:
 Merton R. (1974), “On the pricing of corporate debt: The risk structure of
interest rates”, Journal of Finance 29: pp449-70.

Suppose, for example, that the company has a zero-coupon bond outstanding,
and that the bond matures at time T. We wish to determine the value of this bond.
Let:
 Vt = the value of the company’s assets at time t
 Et = the value of equity at time t
 D = debt (principal and interest) due to be paid at time T

 s V , s E = volatility of V and E respectively.
If VT < D , it is rational for the company to default in its debt at T. The value of
the equity is then zero.
If VT > D , the company should make the debt repayment and the value of the
equity at this time is VT - D .
The value of the firm’s equity at time T, ET , is therefore:
max (VT - D , 0)
This shows that the equity is a call option on the value of the assets with a strike
price of the amount of the debt, D.
Intuitively, we can think of the shareholders as handing over the company’s assets to
the bondholders, when the bonds are first issued, but subsequently having the option to
buy back the assets by redeeming the bonds when they mature. In practice, the assets
remain owned by the shareholders but the bondholders have first claim on them in the
event of default.
The Black-Scholes formula can then be used in the usual way to give the current
value of the equity, E0 , since:
E0 = V0 F (d1) - De - rT F (d 2 )
where:
d1 =
( )
ln (V0 D ) + r + s V2 2 T
sV T
and:
d 2 = d1 - s V T

The value of the debt today is V0 - E0 , where V0 is the current value of the
company’s assets, ie the market value of its equity plus the market value of its debt and
other obligations, which may not be known.
Intuitively, the F (d 2 ) in the above formula represents a survival probability – ie the

probability that the company does not default on its debt. Thus, the risk-neutral
probability that the company will default is F ( -d 2 ) . This requires knowledge of
both V0 and s V , neither of which are directly observable. However, E0 is
observable, giving one equation in two unknowns – the above equation for E0 .
Also, from Ito’s lemma, we have:
∂E
s E E0 = s V V0 = F (d1) s V V0
∂V
The derivation of this formula appears in the original article by Merton. Merton
specifies a pair of equations, the first representing the stochastic process governing the
evolution of Vt through time and the second likewise for Et . These equations are then
differentiated using Ito’s Lemma and appropriate terms equated to obtain the previous
result.
By estimating s E and solving this second equation, the risk neutral probability
of default can be estimated. This provides an alternative figure for the
theoretical price of a CDS contract, before allowing for the factors listed above.
We have a pair of simultaneous equations that can be solved for V0 and s V . Having
found V0 and s V we can then find the value of the corporate debt allowing for the
possibility of default. In addition, F ( - d 2 ) gives us an estimate of the risk-neutral
probability of default, which may tell us something useful about the actual probability
of default.
Question 12.19
How do we find the value of the bond?

4 Evaluation of investment alternatives

Actuaries are expected to be able to evaluate various types of investments. A
good example of a practical problem faced by a company was set in the exam
paper for ST5 September 2006, Question 4, as follows.
The following question now forms part of the ST5 Core Reading. We recommend that
you have a go at it yourself before reading the solution.
Question 12.20 (Subject ST5, September 2006, Question 4)
ABC plc has a share price of 57 pence and paid a dividend of 2 pence per share in the
previous twelve months. It is considering issuing:
 a convertible debenture, with a zero coupon, which is convertible into ordinary

shares on the basis of 150 shares per £100 nominal at any time over the next five
years; or
 a zero-dividend preference share at £100 that will be redeemed in five years’

time at £138.
(i) Evaluate the returns that might be achieved from each of these investments
stating any assumptions. [5]
(ii) Explain which investors may prefer each investment giving reasons. [7]
[Total 12]

5 End of Part 3
What next?
of Chapters 10 to 12.
of your revision.
Time to consider – “revision” products
Flashcards – These are available in both paper and eBook format. Students have said:
“The paper-based Flashcards are brilliant.”
Sound Revision – These are audio CDs that can be used additionally / alternatively to
your paper-based products. Students have said:
“I loved the Sound Revision because I just had the CDs on all the time.”
MyTest – This product identifies and then focuses on gaps in your knowledge and
understanding. The results of a recent survey suggest that students who concentrate on
the areas of the course they find most difficult have significantly higher pass rates.
You can find lots more information, including demos, on our website at
www.ActEd.co.uk.

Chapter 12 Summary
Interest rate derivatives
These are more difficult to value than equity derivatives, since:

 The behaviour of an individual interest rate is more complicated than that of a
stock price.
 For the valuation of many products, it is necessary to develop a model
describing the behaviour of the entire yield curve.
 The volatilities of different points on the yield curve are different.
 Interest rates are used for discounting as well as for determining payoffs from
the derivative.
A general expression for the price of a European call option is:
c = P (0, T ) [ F0 F(d1 ) - X F(d 2 )]
where:
d1 = Á
0 (
Ê ln ( F / X ) + s 2T / 2 ) ˆ˜ (
Ê ln ( F / X ) - s 2T / 2
d2 = Á
0 ) ˆ˜
ÁË s T ˜¯ ÁË s T ˜¯
The value of the corresponding European put option is
P (0, T ) [ X F( - d 2 ) - F0 F( - d1 )]
Bond options
The above equations can be used to value bond options. Bond volatilities are often
expressed as yield volatilities. Yield volatilities can be converted to price volatilities
using:
s p = D y0 s y

Interest rate caps and floors
An interest rate cap leads to a payoff at time tk +1 (k = 1, 2, . . . . , n) of:
where tn +1 is defined as T and the reset dates are t1 , t2 , ..., tn .
Each payoff is a call option on the LIBOR rate observed at time tk (with the payoff
occurring at time tk +1 ) and is known as a caplet. The cap is a portfolio of n such
options.
Likewise, an interest rate floor leads to a payoff at time tk +1 (k = 1, 2, . . . . , n) of:
L d k max ( RX - RK , 0)
Cap and floor prices satisfy the put-call parity relationship:
cap price = floor price + value of swap
European swaptions
A swaption can be valued as an option on the swap rate, R. The payoff from a swaption
giving the holder the right to pay fixed and receive floating consists of a series of
cashflows equal to:
L
max ( R - RX , 0)
m
The value of the swaption is:
mn
L
Â m P (0, ti ) ÈÎ F0F (d1 ) - RX F (d2 )˘˚
i =1

Evaluating a securitisation
The evaluation of assets for securitisation concentrates on the predictability and

sustainability of adequate cashflow and will consider factors such as:
 lease terms
 rental prospects
 degree of potential competition
 barriers to competitive entry.
The evaluation of a securitisation is based on a discounted cashflow approach. The

modelling of the cashflows will involve key features such as:
 statistics (early repayment experience)
 probability (default / recovery and timing)
 treasury management (payments in / payments out)
 structuring and security issuance.
A major difficulty is the choice of discount rate to use.
Evaluation of a credit derivative
The payoff per annum from a vanilla credit default swap is equal to the excess return on
the bond over the risk-free rate.
The value of a total return swap is the difference between the values of the assets
generating the returns on each side of the swap.
The value of a credit spread option can be derived from the difference between the
market value of the bond and its value at the strike spread.
The value of a bond allowing for its credit risk can be found using information provided
by the company’s share price as V0 - E0 , where:
 V0 is the current value of the company’s assets
 E0 = V0 F (d1 ) - De - rT F (d 2 ) is the current value of the company’s equity
 F ( - d 2 ) is the risk-neutral probability of default.


Solution 12.1
An arbitrage opportunity arises where an investor can buy and sell a combination of
assets at zero cost, ie the purchases are funded by short selling, and at some later point
the portfolio has a positive value with certainty.
Solution 12.2
The (call) option payoff at time T is its intrinsic value of:
max (VT - X , 0)
Solution 12.3
In this case F0 = S0 erT , and if we take logs:
ln F0 = ln S0 + rT
Since we are assuming that the risk-free rate r is fixed, this tells us that ln F0 and ln S0
have the same variance. This means that s , defined as the volatility of F0 , is the same
as the volatility of the share price.
Solution 12.4
The general formula applies here, so the price of a European call option on a bond is:
c = P (0, T ) [ F0 F(d1 ) - X F(d 2 )]
where:
 F( x) is the cumulative standard normal distribution function
 d1 = Á
0 (
Ê ln ( F / X ) + s 2T / 2 ) ˆ˜ (
Ê ln ( F / X ) - s 2T / 2
and d 2 = Á
0 ) ˆ˜
ÁË s T ˜¯ ÁË s T ˜¯

Solution 12.5
Recall that:
 the 18-month discount factor is P (0, 1½ ) = 0.94176
 the forward price of the bond is F0 = 105.413
 the option strike price is X = 104

 forward volatility is s = 0.04
 the strike date is at T = 1½
Thus:
(
Ê ln (105.413 /104) + 0.042 ¥ 1½ / 2
d1 = Á
) ˆ˜ = 0.29996
ÁË 0.04 1½ ˜¯
(
Ê ln (105.413 /104) - 0.042 ¥ 1½ / 2
d2 = Á
) ˆ˜ = 0.25097
ÁË 0.04 1½ ˜¯
So:
F (d1 ) = 0.61790 F (d 2 ) = 0.59908
The call option price is therefore given by:
c = 0.94176 ¥ [105.413 ¥ 0.61790 - 104 ¥ 0.59908] = 2.67
Solution 12.6
The modified duration or volatility of a bond with price P is defined as:
1 dP
D=-
P dy
A negative sign is included in the definition so as to give a positive number, given that
P and y are negatively correlated.

Note that this formula can be written as:
1 dP y
D=-
P dy y
which can be rearranged to give:
dP dy
= - Dy
P y
It is this result that suggests that the forward price volatility s can be related
(approximately) to the corresponding forward yield volatility s y via:
s = D y0 s y
Solution 12.7
A 6-year zero-coupon bond is priced at 74.62%.
(i) Duration of the bond
Given that the duration is the weighted average of the time to the payments provided by
a bond, the duration of a zero-coupon bond must be equal to its outstanding term.
Hence, in this case it is simply 6 years.
(ii) Annual effective yield and modified duration
The annual effective yield on the bond is found from:
100
74.62 =
(1 + s6 )6
From which, s6 = 0.05 , ie 5% pa.
So the modified duration of the zero-coupon bond is equal to:
6
D= = 5.71 years
1.05

Solution 12.8
Recall that the cap leads to a payoff at the end of each quarter (except the first) equal to:
where:
 L = £50m is the principal
 d K = 1/ 4 is the tenor
 RK is the LIBOR rate at the start of the quarter
 RX = 6% pa is the cap rate.
Thus, the payments made by Bank Z at the end of each quarter are:
Quarter 1 2 3 4 5 6
LIBOR 6.20% 6.03% 6.61% 5.99% 6.12% 6.20%
max ( RK - RX , 0) 0.2% 0.03% 0.61% 0% 0.12% 0.20%
Payment * £3.75k £76.25k £0 £15k £25k
* Note in the first quarter, there is no payoff as the initial LIBOR rate is known, so any
payoff would be known and simply priced in to the cap – hence it is usually ignored.
Solution 12.9
In this instance:
 L = 100k
 dk = 1
1
 P (0, tk +1 ) = = 0.81630
1.073
 FK = 0.07
 RX = 0.06
 s k = 0.10
 tk = 2
So:
Ê ln ( FK RX ) + s k2tk 2 ˆ Ê ln (0.07 0.06) + 0.102 ¥ 2 2 ˆ
 d1 = Á ˜ =Á ˜ = 1.1607
Ë s k tk ¯ Ë 0.10 2 ¯

Ê ln ( FK RX ) - s k2tk 2 ˆ Ê ln (0.07 0.06) - 0.102 ¥ 2 2 ˆ

 d2 = Á ˜ =Á ˜ = 1.0193
Ë s k tk ¯ Ë 0.10 2 ¯
So, the value of the caplet is:
c = Ld k P (0, tk +1 ) [ FK F(d1 ) - RX F(d 2 )]
= 100k ¥ 0.81630 [0.07 ¥ F(1.1607) - 0.06 ¥ F(1.0193)]
= $869
Solution 12.10
A floorlet provides a payoff if the actual LIBOR rate RK is less than the floor rate RX .
So the payoff provided by a floorlet at time tk +1 (k = 1, 2, ..., n) is:
L d k max ( RX - RK , 0)
Solution 12.11
L dk
max ( RK - RX , 0) can be rewritten as:
1 + RK d k
Ê ( R - RX ) L d k ˆ
max Á K , 0˜
Ë 1 + RK d k ¯
Ê ( R L d - RX L d k + L - L) ˆ
= max Á K k , 0˜
Ë 1 + RK d k ¯
Ê ( L + LRK d k - LRX d k - L) ˆ
= max Á , 0˜
Ë 1 + RK d k ¯
Ê L (1 + RX d k ) ˆ
= max Á L - , 0˜
Ë 1 + RK d k ¯

Solution 12.12
A swaption provides its holder with the right, but not the obligation, to enter into a swap
agreement on specified terms on a fixed strike date.
Solution 12.13
A swaption that gives the holder the right to pay fixed and receive floating can be
thought of as being equivalent to a put option on a fixed rate bond with a strike price
equal to the principal for the following reason.
Such a swaption provides its holder with the option to receive a series of floating
payments, whose present value at the strike date is equal to the amount of the principal.
We can therefore think of the principal as being the strike price received in return for
subsequently making fixed rate payments over the term of the swap. In other words, the
principal represents the strike price we receive for selling a fixed rate bond.
Solution 12.14
The value of the swaption is:
mn
L
Â m P (0, ti ) ÈÎ F0F (d1 ) - RX F (d2 )˘˚
i =1
This expression can be simplified by substituting an annuity A where:
1 mn
A = Â P (0, ti )
m i =1
to give:
LA ÈÎ F0 F (d1 ) - RX F (d 2 )˘˚

Solution 12.15
Here:
 the principal is L = 10 m
 the number of payments pa is m = 1
2
 the annuity factor is A = Â P (0, ti ) = e -4¥ s4 + e -5¥ s5 = 1.6100
i =1
(as the two possible swap payments occur at times 4 and 5)

 the forward swap rate is F0 = 0.0488
 the fixed rate is RX = 0.0475

 the strike date is at time T = 3
 the volatility of the swap rate is s = 0.3 .
Thus:
Ê ln (0.0488 0.0475) + 0.32 ¥ 3 2 ˆ

d1 = Á ˜ = 0.3118
Ë 0.3 3 ¯
Ê ln (0.0488 0.0475) - 0.32 ¥ 3 2ˆ

d2 = Á ˜ = - 0.2078
Ë 0.3 3 ¯
So:
F (d1 ) = 0.6224
F (d 2 ) = 0.4177
The value of the swaption is therefore given by:
= L ¥ A ¥ ÈÎ F0 F (d1 ) - RX F (d 2 )˘˚
= 10m ¥ 1.61 ¥ [0.0488 ¥ 0.6224 - 0.0475 ¥ 0.4177]
= 0.170
ie $170k

Solution 12.16
The volatility of cashflow is important because the greater the volatility, the greater the
chance that the underlying cashflows will be insufficient to cover a particular coupon
payment on the asset-backed securities.
Solution 12.17
The main classes of asset-backed securities are:

 residential and commercial mortgage-backed securities (MBS)
 credit card receivables (CCABS)
Solution 12.18
(i) P
If the face value of the bond is $100, the yield on the bond is 7.25% pa and the risk-free
rate is 6% pa, then the excess yield on the bond is 1.25%. So P is equal to:
P = 0.0125  100 = $1.25
(ii) What should Bank X do if P is less than this value?
If P is less than this value, then Bank X should buy the bond and enter into the credit
default arrangement, as by doing so it can earn a higher return than the risk-free rate
without facing any credit risk.
(iii) What should Bank Z do if P is greater than this value?
If P is greater than this value, then Bank Z can earn make an arbitrage profit without
facing any credit risk by short selling the bond (if it can do so!), buying the risk-free
bond and selling the credit default swap.

Solution 12.19
The value of the bond is found as V0 - E0 .
Solution 12.20 (September 2006, Question 4)
(i) Evaluate the returns
Convertible Debenture
The conversion option converts £100 nominal of debenture into 150 shares, currently
valued at £0.57 each. Therefore at present the conversion has no intrinsic value
because:
150 ¥ £0.57 = £85.50
which is less than the repayment value of the debenture.
However, if the share rises at 10% pa over the period in capital terms, the share’s price
after five years would be £0.92 and the conversion option would be worth £138 per
£100 nominal of debenture. This represents an annual return of:
1
Ê 138 ˆ 5
ÁË ˜ - 1 = 6.6% pa
100 ¯
If the share price rises faster, then the returns will increase accordingly – a 20% pa
share price rise equates to an annual return on the debenture of 16.3%. If the shares
price does not rise above £0.67 per share, then the debenture will be repaid at par and
investors will simply get their money back. The return from the convertible is never as
great as the share if the share rises strongly, but this is to be expected since the
convertible guarantees the investor’s money back whereas the share does not.
Preference share
1
Ê 138 ˆ 5
This gives a guaranteed return of Á - 1 = 6.6% pa . This is above the dividend
Ë 100 ˜¯
2
yield on the shares themselves of = 3.5% pa .
57
It would rank below bond investors in the event of a wind up.

(ii) Which investors may prefer each investment?
Equity shares
As these have a 3.5% dividend yield, these might be attractive to many investors
seeking cashflow.
Convertible debenture
The debenture offers a money-back guarantee with the possibility of upside potential if
the company performs well, or if the equity market rises.
This might appeal to investors that want an equity investment but that are too risk-
averse to invest directly in the equity shares, for example an absolute return manager
(ie a hedge fund manager that targets an absolute positive return in all market
environments).
Pension funds may also prefer these shares as the offer real returns with a downside
protection.
1
Ê 67 ˆ 5
However, the share price does need to rise at greater than Á ˜ - 1 = 3.3% pa in
Ë 57 ¯
order to give any return on capital, and needs to rise at greater than 10% pa in order to
beat the preference share. This seems a tall order, as this has to be achieved in addition
to the dividend yield of 3.5% pa.
Preference share
The preference shares offers a fixed nominal return of 6.6% pa. It may be preferred by
investors that are looking for nominal returns to match known cashflows. Life
insurance companies or pension funds that are closed and have known liabilities might
be interested in buying it.
The preference share offers no income over the 5-year period, which may suit investors
that have no cashflow requirements.
The preference shares may appeal to investors that require a fixed nominal return
(rather than a real return).
The bond is relatively short in term and would only match shorter liabilities.
There may be tax reasons for preferring debentures to preference shares.

ST5-13: Industry classification Page 1
Chapter 13
Industry classification
Syllabus objective
major investment indices.
0 Introduction
In analysing the equity market it is often helpful to categorise shares in different ways.
The most commonly used categorisation is probably by industry.
Question 13.1
Which other features of ordinary shares might be used to categorise individual shares?
This short chapter outlines the reasons why equities are in practice typically categorised
by industry and then goes on to describe the FTSE industry classification system used
for shares in the UK. Similar systems are used in other countries.
Although this chapter is both short and straightforward, the material has cropped up
fairly often in bookwork exam questions and so needs to be learned thoroughly.

Page 2 ST5-13: Industry classification
1 Reasons for categorisation by industry

Equity analysts (and other interested parties such as credit ratings analysts) often
specialise in an industry and confine their research and advice to the relative merits of
companies within that industrial group. The main reasons why this is so fall under two
headings:
1. practicality
2. correlation of investment performance.
Practicality
It is sensible for investment analysts to specialise within particular industrial sectors

because:
 The factors affecting one company within an industry are likely to be relevant to
other companies in the same industry.
 Much of the information for companies in the same industry will come from a
common source and will be presented in a similar way.
 No single analyst can expect to be an expert in all areas, so specialisation is
appropriate.
The grouping of equities according to some common factor gives structure to the
decision-making process. It assists in portfolio classification and management.
Correlation of investment performance
Research has shown that, after overall market movements have been taken into
consideration, the share price movements of companies within industrial groupings tend
to correlate more closely with each other than with companies in other industries. The
share price movements reflect the changes that have occurred in the operating
environment. Such changes affect companies in individual industries in similar ways.
Factors affecting one company in a sector that will probably be relevant to other
companies in the same sector include:
 resources: companies in the same sector will use similar resources (eg labour,
land and raw materials), and will therefore have similar input costs
 markets: companies in the same sector supply to the same markets, and will
therefore be similarly affected by changes in demand
 structure: companies in the same sector often have similar financial structures
and will therefore be similarly affected by changes in interest rates.

As there is a degree of correlation between the shares of companies in the same sector,
investment managers construct their equity portfolios so that there is a good spread
between sectors. In doing so, they would check to ensure that they are not over
concentrated in sectors that are themselves positively correlated, eg “construction and
materials” and “industrial engineering”.
Note that the same arguments apply equally between different classes of asset –
ie bonds, equities, property, etc.
Problems with industry groupings
Whilst every effort is made to ensure that industry groupings are appropriate, there are
some difficulties in practice.
Question 13.2
Can you think of any difficulties?

2 The FTSE industry classification system

The FTSE (together with the Dow Jones) industry classification system is one
example of a stock classification system. Other systems are in use, for example
the Standard and Poor’s classification in the US and the Morgan Stanley Capital
International system for global equities.
The FTSE system classifies companies into ten industry groups, which are
further divided into supersectors, sectors and subsectors.
The aim of the system is to group individual companies into subsectors based primarily
on the company's source of revenue or where it constitutes the majority of revenue.
The industry groups and their characteristics are described below. Each group
encompasses a wide range of industries so the characteristics outlined below
can only be broad generalisations.
Oil and gas
These companies are involved in the extraction and supply of oil and gas
products used throughout the economy.
Key characteristics are:
 large companies. Many of the companies, particularly integrated companies,

will be large multinationals (eg BP Amoco) competing on the world market.
Indeed, several of the UK’s largest companies come from this group. Some
smaller firms are involved in specialist areas (eg geological surveying).
 commodity price dependent. Share prices in this sector may be more closely
related to movements in oil prices than to general stock market or economic
movements. Most commodities are priced in dollars (including oil) making
them similar to a dollar-denominated investment.
 risky. This is particularly true of smaller exploration companies. For example,

striking or failing to strike oil can have a big impact on their share price. In
other cases new technology (eg the emergence of renewable energy sources)
could have an adverse impact.
 global. In many cases, domestic sales will be a small proportion of total sales.
This makes the state of the world economy more important than the state of the
domestic economy for these companies.

Basic materials
This group includes the chemical industry and the mining industry, as well as
companies producing steel and other metals, and those engaged in forestry and
paper. As such, these companies are mainly producing “intermediate” goods.
Industrials
Industrial companies are involved in the various stages in the supply and
production of goods. Many of the goods tend to be capital items, ie aircraft,
ships, machinery, electronic and electrical equipment. This group includes
companies in the building material and construction industries, as well as
industrial transportation and industry support services.
The distinctive features are:
 dependent on the level of investment spending – the companies are

dependent on the strength of the economy and in particular the level of
economic investment, ie “capital formation”.
 cyclical – the performance of general industrials is very dependent on the state

of the economy and the trade cycle. The impact of the trade cycle can be
heightened by the accelerator principle, which you may remember from
Subject CT7.
 company profits tend to move ahead of the trade cycle – because capital
expenditure throughout the economy is usually greatest at the start of a period of
rapid economic growth. Share prices also move early in anticipation of a
recovery.
 dependent on government spending – a fairly large proportion of capital

expenditure is under the control of the government (eg building roads, schools,
hospitals), which means that general industrials may be exposed to the whims of
government expenditure.
 volatile profits – because of the volatile demand for capital goods (due to the
accelerator principle), profits can be very volatile. Also, in some cases the unit
size of production is large. In these cases, winning or losing a new contract can
have a big impact on profits.
 high profit margins when conditions are good – but when the economy
moves towards recession, general industrials need to be able to cut their costs
quickly to minimise their losses.

 low gearing because of volatile profits – recall that the stability of profits is
an important consideration when determining whether or not to invest in a
particular corporate bond.
 possibly exposed to overseas markets and competition – (eg engineering),

in other cases domestic demand is more important (eg building materials).
Consumer goods
Companies in the consumer goods groups manufacture consumer durables and

non-durables. Durables include cars, furniture, televisions and “white goods”
such as washing machines. Non-durables include food and drink and tobacco,
Generally the impact of an economic cycle is less severe on non-durable

consumer goods companies than on general manufacturers. This is especially
true for companies producing basic necessities.
Other key features are:
 increasingly capital-intensive – increasing mechanisation of production

processes is gradually increasing the proportion of added value from capital
(where previously the industry has not been seen as capital intensive), reducing
the degree of labour intensiveness in these industries.
 importance of brand names – in many cases a strong brand name allows

higher profit margins to be generated. Consequently, many firms in this sector
have large advertising budgets. Brand names can be difficult to value.
 increasingly international – as advertising and consequently brand names

become known around the world, this sector is becoming increasingly
international.
 moderate to high gearing – gearing tends to be highest where profits are most
stable, as investors are less inclined to lend at a fixed rate to riskier companies.
Generally the impact of an economic cycle is less severe on consumer goods
companies than on general industrials. The smaller unit size (of goods sold) for
most consumer goods companies (compared with general industrials) also
increases stability by reducing the dependence on individual customers.
 low profit margins – due to extreme competition.

Healthcare
This group covers healthcare providers, medical equipment and supplies, as well
as pharmaceuticals.
Consumer Services
The companies in this group include food, drug and general retailers, media
companies and companies in the travel and leisure industries, such as
passenger airlines, casinos, hotels, bars and restaurants. Once again, the
impact of the economic cycle will be greater on the cyclical industries.
Other key features are:
 labour-intensive – most services depend upon labour more than capital.

Exceptions include hotels and retailers where property costs are high.
 the more defensive companies in the group may have high gearing. Those
with stable demand (eg food retailers) or with a strong asset base (eg hotels), are
likely to have higher borrowings. More cyclical companies will probably have
lower gearing.
 the domestic market is the most important – most companies will depend
heavily on the domestic market although some (eg hotels) may operate in several
countries.
Telecommunications
This group covers the providers of fixed line and mobile telephone services.
Utilities
Utilities are involved in the supply of continuously demanded services to

households and business premises. Examples include electricity, water and gas
distribution. Most UK utilities were formerly owned by the government, having
been privatised during the 1980s. They are vulnerable to some political risk and
to changes in the regulations under which they operate.
Demand is very stable because the services that they provide are essential, or
nearly essential, and because their market share will be stable (often at 100%).
Thus, they are less affected by economic cycles than other groups.

Other points are:
 They usually require an extensive physical infrastructure. This tends to

make them capital intensive.
 Most utility companies are natural monopolies due to the high fixed costs of
setting up the infrastructure.
 They are usually subject to tight government regulation of prices and

vulnerable to other forms of political risk. The regulation is intended to
prevent abuse of their monopoly position. Often, this involves a government
watchdog imposing some restriction on their pricing policies, eg limiting price
increases to inflation less k%.
 They generally have low growth prospects; this leads to a high gross
dividend yield and a lower price earnings ratio, than for any other sector. Low
growth prospects are a result of:
– lack of potential sales volume growth due to monopoly position
– lack of profit margin growth due to regulatory control.
 Despite their stable demand and large capital requirements, gearing is low
(ie financial gearing – operational gearing may be high). This is because most of
their debt was written off by the government prior to privatisation.
 They are largely dependent on the domestic market, although some

companies are diversifying internationally. In many cases close to 100% of
sales will come from the domestic market. In the case of water and electricity
distribution, 100% of sales may be from a single region within the domestic
economy.
As a form of utility, these points also apply to some degree to telecommunications

companies. However, deregulation of telecommunications markets has made the sector
more volatile.
Financials
The financial group companies are the various industries making up the financial
services industry, eg banks, general insurance companies, life assurance
companies, investment trusts and real estate (property) companies.
The key distinctive feature of financial group companies is that they tend to be
capital intensive.

Otherwise, the features of companies in this group are quite varied between the
different sectors:
 banks are highly-geared and have volatile profits. Small changes in the
difference between saving and lending rates can have a big impact on
shareholders’ profits. Also, provisions for bad debts during a recession can
wipe out profits entirely. Note that higher interest rates have two effects on
banks:
1. their profits will tend to be reduced because they will have to increase
their provision for bad debts.
2. profits will tend to increase due to the “endowment” effect, ie they
benefit from higher interest on lending whilst the interest on some of
their borrowing (eg your current account balance) remains at zero or at
very low levels.
 general insurers also have volatile profits and virtually no borrowings.

This is because of the volatile nature of general insurance claims.
 life insurers have stable profits and low gearing (profits are realised
gradually over the life of their contracts which are long-term)
 labour costs are important for many companies in the group. For the
insurance contingent (life, composite and brokers) staff costs form a large
proportion of the total costs. Staff costs are also significant for banks if
compared with the difference between interest earned and interest paid.
However, for property companies the cost of labour should be minor.
 the domestic market is most important but there is increasing

internationalisation as capital markets are deregulated. Companies involved in
reinsurance often have a high proportion of overseas contracts.
Technology
These are the companies involved in the “new” industries of information

technology hardware, software and the provision of computer services. While
investor demand for such shares has caused share prices to increase
dramatically in the past, many of the companies have yet to make profits or pay
dividends. Dividend yields on these companies are therefore low, and their
assets can be largely intangible.

Classification summary
The table below shows the complete Industry Classification Benchmark (ICB) system
developed by Dow Jones and FTSE.
Industry Supersector Sector

Oil & Gas Producers
Oil & Gas Oil & Gas
Oil Equipment, Services & Distribution
Chemicals Chemicals
Forestry & Paper
Basic Materials
Basic Resources Industrial Metals
Mining
Construction & Materials Construction & Materials
Aerospace & Defence
General Industrials
Industrials Electronic & Electrical Equipment
Industrial Goods & Services
Industrial Engineering
Industrial Transportation
Support Services
Consumer Goods Automobiles & Parts Automobiles & Parts
Beverages
Food & Beverage
Food Producers
Household Goods
Leisure Goods
Personal & Household Goods
Personal Goods
Tobacco
Health Care Equipment & Services
Health Care Health Care
Pharmaceuticals & Biotechnology
Food & Drug Retailers
Retail
General Retailers
Consumer Services
Media Media
Travel & Leisure Travel & Leisure
Fixed Line Telecommunications
Telecommunications Telecommunications
Mobile Telecommunications
Electricity
Utilities Utilities
Gas, Water & Multi-utilities
Banks Banks
Nonlife Insurance
Insurance
Life Insurance
Financials Real Estate
General Financial
Financial Services
Equity Investment Instruments
Non-equity Investment Instruments
Software & Computer Services
Technology Technology
Technology Hardware & Equipment

The mnemonic FT MUG IS HOT may be one way to recall the industry classification
list: Financials, Technology, Basic Materials, Utilities, Consumer Goods, Industrials,
Consumer Services, Health Care, Oil & Gas and Telecommunications.
Question 13.3
“The profits of a major telephone company are unlikely to fall during a recession. ”
True or False?
Question 13.4
In which of the groupings are profits most sensitive to:

 the value of the dollar
 the state of the domestic economy
 fashion and social trends
 tax changes
 labour costs
 government regulation
Use each grouping only once.
Question 13.5
Which grouping can be most closely compared to an investment in index-linked

government bonds?

This chapter is regularly examined. A typical question is Question 8 from the ST5
September 2005 examination.
September 2005, Question 8 (updated)
(i) Explain why equities are usually analysed in industry groupings. [5]
(ii) (a) Discuss the advantages and disadvantages of this division.

(b) Suggest, with reasons, two possible alternative groupings. [5]
(iii) State the features that characterise each of the following economic groups:
 Industrials
 Consumer Goods
 Utilities [6]
[Total 16]

Chapter 13 Summary
Industry classification
The FTSE industry classification system is one example of a classification system.

Other systems are in use, for example the Standard and Poor’s classification in the US
and the Morgan Stanley Capital International system for global equities.
The FTSE system classifies companies into ten industry groups which are further
divided into supersectors, sectors and subsectors.
The key industry groups and the risk main characteristics are as follows:
 Oil and gas companies are risky, independent of the rest of the stock market and
depend upon dollar-denominated oil and gas prices.
 Basic materials companies may be significantly affected by the state of the

economy and commodity prices.
 Industrial companies tend to be cyclical.
 Consumer goods companies tend to be less cyclical but depend greatly upon
brand names.
 Health care companies tend to be non-cyclical.
 Consumer services companies are usually labour-intensive, and mainly

domestic-based.
 Utilities companies are stable, dependent on the domestic market and subject to
regulation.
 Telecommunications companies are a type of utility, but less regulated and

hence more volatile.
 Financial companies are quite mixed, although most are capital intensive.
 Technology companies tend to have low profits and dividends and largely
intangible assets.


Solution 13.1
Some of the other features include:

 marketability
 market capitalisation
 price earnings ratio or dividend yield
 gearing – the level of debt capital in relation to the overall asset value of the
company
 exposure to overseas earnings
 how sensitive the earnings of the company are to the economic cycle. The
shares of a company whose earnings are particularly sensitive to the cycle are
said to be a cyclical. If the converse is true, then the shares are described as
defensive.
In practice, many of these features are themselves closely related. For example, the
marketability of an ordinary share is determined primarily by the size of the company.
Similarly, the risk of an individual share is generally dependent upon a host of other
factors.
Solution 13.2
Two particular difficulties relate to:
1. companies that operate throughout several sectors, ie conglomerate companies.

This is becoming more of an issue as companies increasingly diversify into new
sectors by means of mergers and takeovers and leads to particular difficulties
where the sectors involved are very different. A similar issue relates to
multinational companies that may operate in several very different marketplaces.
2. the heterogeneity of companies within particular sectors. Companies may differ

greatly even within the same sector – eg due to size, or because they operate
within different niches of the market.

Solution 13.3
The statement is false.
Profits in telecommunications companies (and other utilities companies) are less

sensitive to the economic cycle than profits in other industries. However, turnover will
fall as businesses and to an extent domestic customers, make fewer calls. Costs will not
fall to the same extent because of the high fixed costs of maintaining the infrastructure,
ie marginal costs are very low.
Solution 13.4
Note that in some cases the answers are not clear-cut. Do not worry too much if you
don’t agree exactly with our answers.
 the value of the dollar: oil and gas

 the state of the domestic economy: industrials (or basic materials)
 fashion and social trends: consumer goods
 tax changes: financials
 labour costs: consumer services
 government regulation: utilities
Solution 13.5
Utilities are most like index-linked government bonds in that they are low risk, with
prices often linked to a price index plus or minus a constant.

ST5-14: Investment indices Page 1
Chapter 14
Investment indices
Syllabus objectives
major investment indices.
(i) Discuss the uses of investment indices.
(ii) Describe the principal indices in the United Kingdom, United States,
Japanese, German and French stock markets.
(iii) Explain the problems encountered in constructing property indices.
0 Introduction
Investment indices have a wide variety of uses in investment and asset management.
The Institute and Faculty of Actuaries have been instrumental in the design of some of
the indices.
The structure of the chapter is as follows:

 Section 1 provides an introduction to the construction of indices
 Section 2 introduces the uses of indices
 Sections 3 to 5 discuss the principal published indices for equities and bonds
both in the UK and internationally
 Section 6 considers property indices.

Page 2 ST5-14: Investment indices
1 Construction of indices
An investment index represents the relative changes in the share/stock prices of
the constituent companies or stocks which make up the index. The various
methods of averaging those relative price changes are dealt with below.
There are many investment indices in use throughout the world, with each index having
its own particular purpose and use. Each index will be constructed using certain
eligibility criteria to determine the constituent companies from time to time.
1.1 Weighted arithmetic indices
Most investment indices are calculated on a weighted arithmetic average basis,

the general formula being:
P
Â w i Pii,0,t
I (t ) = K i (14.1)
Âwi
i
where:
 I (t ) is the capital index at time t
 Pi ,t is the price of the ith constituent at time t

 Pi ,0 is the price of the ith constituent at time 0 – the last time at which
there was a capital change
 w i is the weight applied to the ith constituent
 K is a constant related to the starting value of the index at time 0.
For investment indices, the weights used are the market capitalisations of the
constituents, usually the market capitalisations of the constituents at time 0. In
the same way that a typical portfolio will be weighted towards the bigger companies,
the index will be weighted towards the bigger companies.
The constant K is fixed when the index is first set up. Often it is fixed so that the index
starts at a round number such as 100 or 1,000. For example, the FTSE 100 had a base
value of 1,000 when it was started on 31 December 1983.

Question 14.1
A new index is to be constructed in a share market that contains just two shares, in
Companies A and B. At the starting date of the index, time 0, there are 100 shares in
each company. Company A shares are priced at 3, whilst Company B shares are priced
at 1.
(i) What is the market capitalisation at time 0?
(ii) What are the weights to be used in the above formula?
(iii) What value of the constant K is required if the index is to have a starting value
of I (0) = 100 ?
(iv) What is the value of the index at time 1 if the share prices have by then
increased to 3.2 and 1.1 respectively?
The weights are updated each time the number of shares issued by a constituent
company changes and continuity is maintained by “chain-linking” the index on
the new capital to that of the previous index.
It is now becoming common practice to restrict the weights to reflect the level of
“free float” of shares available for purchase, thereby eliminating strategic
holdings.
The free float of a share is the proportion of the shares that are freely available for
purchase on the open market. It therefore excludes shares that are held for strategic
purposes – eg by holding companies in subsidiaries – and are thus highly unlikely to be
sold.
Chain-linking
The chain-linking process is set up so that:

 the index reflects the new market capitalisation of the constituents
 the index value is not disturbed by the change in capital structure of its
constituents.
This is appropriate because if the aim of the index is to reflect the investment
performance of its constituents, then the index value should change only in response to
that investment performance and not in response to injections or withdrawals of funds
into or out of the market itself.

Rights issues, for example, will increase both the number of shares and the total market
capitalisation. However, this does not mean that the index should be increased. After
all, the value of a portfolio of shares would not jump upwards. For a portfolio to remain
fully representative of the whole market, some of the holdings would have to be sold in
order to take up an appropriate proportion of the rights issues.
Fixed weight indices are rebalanced in a similar way. Part of the portfolio can be
notionally sold so that the new issue can be notionally bought.
After allowing for chain-linking, the formula for the investment index then
becomes:
Â Ni ,t Pi ,t
I (t ) = i (14.2)
B(t )
where:
 Ni ,t is the number of shares issued for the ith constituent at time t
 B(t ) is the base value, or divisor, at time t
 B(t ) is obtained from B(t - 1) through the chain-linking process.
A simple example will help illustrate the chain-linking process. It is most easily seen
using the above formula.
Example: Part 1
Recall that at time 0, there were 100 shares in issue in each of Companies A and B,
priced at 3 and 1 respectively. Suppose that we wish to construct an index using the
above formula such that the opening index value is again I (0) = 100 . Using the above
formula, we can find the required base value B(0) as:
Â Ni ,0 Pi ,0
I (0) =
i = A, B
=
(100 ¥ 3 + 100 ¥ 1) = 100
B (0) B(0)
This gives B (0) = 4 .

Question 14.2
Use this formula to show that the index value at time 1 is the same as you found using
the previous formula.
Example: Part 2
Suppose now that 20 new Company A shares are issued at the market price of 3.2. The
new total market capitalisation will change as a consequence. The index should not,
however, change as the increase in the market capitalisation is nothing to do with
investment performance, which is what the index is intended to measure. Thus, the
value of the divisor in the formula must be changed appropriately to ensure that this is
the case – ie to ensure that the index value remains equal to 107.5 at the time of the new
share issue.
In this case, the new divisor B(1) is given by:
I (1) = 107.5 =
((100 + 20) ¥ 3.2 + 100 ¥ 1.1)
B(1)
ie B(1) = 4.595
By making this adjustment, we make the index move in the same way as a portfolio that
stays representative of the whole market. Note that although we can do chain linking
calculations using the first formula – by changing the wi weights and the constant K – it
is normally much easier to use this second formula.
This formula is now standard for investment index construction. However the
formula, as described, only measures changes to capital values. It takes no
account of income received by the investor.
Question 14.3
List three circumstances in which chain-linking would be required.

1.2 Total return indices
In many cases, a measure of the total return, including income received, is

required on an investment class. To provide this measure, a total return index is
calculated from the capital index described above. Total returns can be
calculated using ex-dividend adjustments or yield figures.
XD adjustment
The ex-dividend or XD adjustment represents the amount of income that has been
received since the start of the year by the capital value index. It is assessed in the same
terms as the main index. For example, on 12 December 2001, the index value for the
FTSE 100 Index was 5,160.8. On the same day, the XD adjustment was 134.24
(ie 2.6% of the index value). In other words, by mid-December the dividend payments
that had been paid by the FTSE 100 companies since 1 January 2001 were equal to
2.6% of their total market capitalisation.
To allow for the effect of investment income it is necessary to make assumptions

about the time that the income is reinvested and whether it is reinvested net or
gross of tax.
An allowance may also be required for the expenses of reinvestment.
Assuming that the dividend or interest payment is reinvested back in the index
on the ex-dividend date, and that is it is added to the current market
capitalisation, the corresponding increase in the index value would be the
investment income divided by the base value, that is:
Di ,t
xd i ,t = Ni ,t (14.3)
B(t - 1)
where:
 Di ,t is the dividend per share declared by the ith constituent at time t (net
or gross, as required);
 B(t - 1) is the divisor at the close of business on the previous day after
allowing for any capital changes.
The XD adjustment is the accumulated total of each constituent over the

calendar year as each constituent company declares a dividend. It is returned to
the value zero at the beginning of the year and a new accumulation is started.

Thus, the XD adjustment in respect of any share i, which reflects the total dividends
declared by Company i over the year to date is given by:
XDit = Â xdit
t
Finally, the XD adjustment for the index itself is found by summing over all of the
individual company XD adjustments to obtain:
XDt = Â XDit
i
Question 14.4
Explain how we can use the capital value index and the XD adjustment to estimate the
total return yielded by an investment market over the period from time t to time t+1.
Total return index
To create a single index that incorporates both capital and income, we need to combine
the capital index with the XD adjustment. Using the approach developed in the answer
to the previous question, the total return from t–1 to t is:
I (t ) - I (t - 1) + XD(t ) - XD(t - 1)
TR =
I (t - 1)
This implicitly assumes that:

 dividends are subject to the rate of tax (if any) assumed in the calculation of the
index
 there are no expenses or losses incurred in reinvesting the dividends.
The figure calculated using the above expression is sometimes referred to as the holding
period return, which is more generally defined as:
P1 + d
-1
P0
where:
 P0 and P1 are the values of the investment at the beginning and end of the
period
 d is the income generated by the investment over the period.

The holding period return is sometimes used an approximation to the internal rate of
return, but is inaccurate because it fails to allow for the fact that in practice part of the
total return comes from the reinvestment of the income (d). However, by linking
successive holding period returns together we can generate a total return index series.
Thus, the total return index value at time t is related to the total return index value at
time t–1 as follows:
È I (t ) + XD(t ) - XD(t - 1) ˘
TRI (t ) = TRI (t - 1) ¥ Í ˙
Î I (t - 1) ˚
Alternative formula
The formula to obtain a total return index at time t is:
I (t )
TRI (t ) = TRI (t - 1) (14.4)
I (t - 1) - [ XD (t ) - XD (t - 1)]
where:
 TRI (t ) is the total return index;
 XD(t ) is the value of the accumulated XD adjustment at time t.
The total return between time a and b (b > a) is then given as:
TRI (b)
-1
TRI (a )
Note that in this total return formula – which is used to calculate the FTSE Share
indices in the UK – the increase in the XD adjustment is subtracted from the
denominator rather than being added to the numerator, as it was in the previous, and
more perhaps more intuitively appealing, formula. However, this difference of
approach is not important in practice, as both approaches will lead to index series that
are very similar.
For completeness, we give the argument used to justify the above formula, which is as
follows. Suppose that the market price of a share at yesterday’s close was Py and that
the share then declared a dividend of D at the start of the today. All else being equal,
the share price should fall by the amount of the dividend and so opening price of the
share today should be Py - D .

If the dividend of D is then reinvested to purchase new shares at the opening price, then
D
the number of shares purchased will be for each existing share. Thus, the
Py - D
D
holder of one share at yesterday’s close will now hold 1 + shares. Finally,
Py - D
suppose that at today’s close the share price has moved to Pt .
The total return from yesterday’s close to today’s close for an investor who held one
share at yesterday’s close is then equal to:
Pt
Py - D
ie today’s closing price divided by yesterday’s closing price less the dividend received
in the meantime, which is exactly the approach adopted in the above total return index
formula.
Question 14.5
Show that the total return from yesterday’s close to today’s close for an investor who
held one share at yesterday’s close is equal to:
Pt
Py - D
If ex-dividend adjustments are published separately the approach illustrated in

this section can be used to calculate the total return using any desired
assumptions for reinvestment frequency and tax rates. Care has to be taken to
allow for the fact that the XD figures are reset to zero at the year end.
Question 14.6
When do you assume that the dividends are reinvested?
In practice, a formula similar to Equation 14.4 but with the change in the XD
adjustment added to the numerator rather than subtracted from the denominator
is often used.

Thus, the formula used is that derived previously, namely:
È I (t ) + XD(t ) - XD(t - 1) ˘
TRI (t ) = TRI (t - 1) ¥ Í ˙
Î I (t - 1) ˚
ie the capital gain plus the income, divided by the starting value.
Because of the small size of the XD adjustment relative to the capital index the
difference between the two approaches is rarely of any practical significance.
If a published total return index is used, care should be taken to ensure that the
tax and reinvestment assumptions used in the calculation of the index are
understood.
Yield adjustment
For many published equity indices ex-dividend adjustments are not available but
figures for the net dividend yield on the index are. The yield figures can then be
used to estimate the dividend income over the period in order to calculate total
return. The income received over the 12 months prior to time t (measured in
index points) is:
I (t ) ¥ y t
where y t is the dividend yield at time t, and I  t  is the value of the index at
time t.
The income received over shorter periods can be estimated by taking the
relevant proportion of the annual amount but this will only give an approximation
to the true value as income is not generally received uniformly over the year.
Having estimated the income in this way, a total return index series can then be
calculated as described above.

1.3 Unweighted arithmetic indices
An unweighted, or price-weighted, arithmetic index is the arithmetic average of

the relative price changes of the constituents. It is unsuitable as a benchmark
for dynamic institutional portfolios.
Question 14.7
Why is it unsuitable as a benchmark?
Although such indices are rather crude and generally inappropriate for performance
measurement work, several of the world’s most famous indices are constructed using
this method, eg the Dow Jones Industrial Average, the Nikkei 225.
1.4 Geometric indices
A geometric index is based on the geometric mean of the relative price changes
of the constituents. The geometric index with n constituents is:
1
Ê Pi ,t ˆ n
KÁ ’ ˜
Ë i Pi ,0 ¯
(14.5)
where K is the index value at time 0, usually taken as 100.
An unweighted geometric index is easy to calculate as only price data is

required. It gives an indication of short-term price movements, but is totally
unsuitable as a benchmark for investment strategy or portfolio investment
measurement.
For example, if the price of one constituent falls to zero, then so does the index.
Hence, constituents need to be changed, when necessary, to avoid this
happening.
Question 14.8
Would an (unweighted) arithmetic index rise faster or slower than a geometric index in
a rising market?
Hint: consider an index with two constituents, each valued at 100 on the base date.

2 Uses of indices
Uses
The uses to which indices can be put include:
 a measure of short-term market movements
 providing a history of market movements and levels.

All of the types of index described above can be used to give at least a broad
indication of both whether the level of a particular investment market has
increased or decreased, and the extent to which it has done so.
 as a tool for estimating future movements in the market, based on past

trends.
Analysing how the investment market, as represented by the index, has moved in
the past is likely to help us to predict how it may move in the future. Such
technical analysis is discussed in detail in Chapter 21.
 as a benchmark against which to assess the investment performance of

portfolios.
We discuss how this may be done in Chapter 15 of this course.
 valuing a notional portfolio.

This was discussed in detail in Subject CA1. Recall that the fund split used
could reflect either the actual split between equities and bonds (broad
discounted cashflow approach) or an entirely notional split (notional portfolio
approach).
 analysing sub-sectors of the market.

Many market-wide indices are built up from sub-indices, each of which
represents a particular sub-sector of the total market. As an example, recall that
in Chapter 13 we described how the FTSE industry classification system breaks
down the UK equity market into ten industry groups that are further divided into
sectors.
Question 14.9
What are the ten industry groups used in the FTSE classification system?

 as a basis for index funds that track the particular market.

As the name suggests, index tracker funds aim to track or replicate the
performance of an investment index. Thus, in order to construct an index
tracker fund, we need an appropriate index to track. We discuss index tracking
and index tracker funds in Chapter 20 of this course.
 to provide the basis for the creation of derivative instruments relating to

the market or a sub-section of the market.
Many standardised derivative contracts are based on widely used indices, as
opposed to individual securities. Such contracts are particularly useful if we
wish to use derivatives to manage the risks arising from movements in an entire
investment market.
In particular for government bond indices:
 a standard against which yields on other fixed interest investments can be

assessed
Question 14.10
How are the yields on other fixed interest investments likely to compare to those on
government bonds?
 approximate valuation of a fixed interest portfolio.

The price indices can be used to obtain a quick, albeit approximate, valuation of
a fixed interest portfolio without reference to all of the individual bond prices.
 providing a picture of general yield structures of fixed interest

investments.
Yield indices provide a quick summary of the yield curve.
 Yield indices allow comparison to be made with yields on ordinary shares

as a measure of the yield gap between bonds and equities.
Again, this is because yield indices summarise the yield curve.

Relevance of indices
Indices are thus relevant to all stages of the asset management process.
 The investor’s investment objectives may be specified with reference to one or
more indices – eg track or outperform a particular index.
 Indices can be used in the development of the appropriate portfolio to best
achieve those investment objectives – by helping us to predict the future
possible returns on a particular investment market or sector.
 Indices can be used to value the portfolio and can provide a benchmark against
which to monitor its performance – as part of monitoring the investment
experience.
Question 14.11
You have been asked to devise an equity index based on quoted shares in Country X.
List all of the factors that you would need to consider in specifying the index.
Fit for purpose
When using any index it is vital to ensure that the index chosen is fit for purpose.
In particular where an index is used to model a real world situation, it is
important to ensure that the constituents of the index are a good match for the
real world situation being modelled.
This is particularly true when using indices compiled by commercial institutions.

Such indices may have been established primarily for the sponsoring
institution’s internal purposes, and later put into the public domain as a
marketing tool.
One example is that corporate bond indices produced by UK merchant banks

often have a greater exposure to debt from financial institutions than does the
bond market as a whole. Using such an index without care during the bond
market turmoil in 2008-2009 could have generated significant model risk.

3 Equity indices
3.1 FTSE UK Index Series
This is a series of indices covering the whole quoted UK equity market. All the
indices used to be calculated on a weighted arithmetic average basis with the
market capitalisations as the weights. As such they may be suitable for performance
measurement purposes.
From June 2001 the weightings of all FTSE constituents were altered to reflect
the availability of stock in the market. Where the actual “free float” is 5% to 15%,
this percentage (rounded up to the next whole number) is used. Otherwise
weightings are in bands according to the next higher of 20%, 30%, 40%, 50%,
75% and 100%.
The free float weighting of a share is the proportion of the company’s equity that is
available for trading by the public. It therefore excludes any strategic holdings by
holding companies in subsidiary companies.
Example
Hold plc holds 55% of the shares in Subsid plc. The free float percentage of Subsid
shares share is therefore 45%, whilst the free float weighting in a FTSE index would be
rounded up to 50%.
In addition to the capital and total return index numbers:

 average net dividend cover
 actual dividend yield
 price earnings ratio
 ex-dividend adjustment
are given for each of the indices in the series.
The dividend cover and dividend yield are based on the most recent year’s
profits and declared dividend figures respectively, updated for interim changes
and for any statements by companies forecasting future earnings and dividends.
A euro index value is also computed.
Data for the FTSE UK Index Series is published each day in the Financial Times. The
indices are calculated by FTSE International Limited. Note that since July 1997, the
total return index has been calculated on a net basis – ie assuming reinvestment of net
dividends.

3.2 FTSE 100 Index
This consists of the 100 largest quoted companies by market capitalisation,

accounting for about 80 per cent of the total UK equity market capitalisation. It is
the main indicator of short-term movements in the UK equity market and is used
extensively as a basis for investment products, such as derivatives and exchange-
traded funds.
The capital value is the one that is widely quoted. It was started on 31 December 1983,
with a base value of 1,000. At the close of play on 31 December 2014, the value was
6,566.10.
The index is calculated on a real-time basis, ie continuously during the day, effectively
every minute, and is based on the last trade prices. For continuity and administrative
reasons, the constituents are changed once a quarter in accordance with predetermined
rules. The index is also used as a basis for stock index derivatives, namely the FTSE
100 Index Futures and the FTSE 100 Index Options.
3.3 FTSE 250 Index
This index covers the 250 companies ranking below the top 100 companies by
market capitalisation.
Its constituents are also changed every quarter. It is calculated on a real-time basis and
is another base for stock index derivatives.
3.4 FTSE 350 Supersectors Index
This index combines the 100 and 250 indices.
The 350 Index constituents account for over 90 per cent of the total UK equity market.
Sub-indices are also calculated for high yielding and low yielding stocks.
3.5 FTSE SmallCap Index
This index covers all companies below the top 350 companies with a market
capitalisation greater than a certain limit and whose shares are actively traded. It
currently represents around 2% of the UK market capitalisation.

The number of constituents is not fixed as with the previous indices – the chain-linking
process enables the number of constituent companies to be varied. The index is
calculated at the close of each day.
3.6 FTSE All-Share Index
This comprises the 350 and the SmallCap indices. It accounts for around 98 – 99
per cent of the total overall market capitalisation, and is calculated and updated
every minute.
Sub-Indices are calculated for industrial sub-sectors in accordance with the FTSE
industry classification system described in the previous chapter.
3.7 FTSE Fledgling Index
This index consists of the remaining, sufficiently marketable, quoted companies

which are too small to be included in the SmallCap index.
As with the SmallCap index, each of the constituent companies must fulfil eligibility
requirements concerning the level of active trading in their shares.
3.8 FTSE Aim Index Series
This series of indices covers companies traded in the UK Alternative Investment

Market. These are companies which are too small or too new to apply for a
listing. The indices are calculated on a free-float basis.
Question 14.12
On 31 December 2014, the FTSE 100 closed at 6,566. What do you think its value will
be at the close of play on 31 December 2024?
3.9 USA
Dow Jones
This is the best known and most widely quoted of the New York indices.

The Dow Jones Industrial Average, commonly known as the Dow Jones index, is
made up of 30 shares. It is an unweighted arithmetic index. It is therefore
unsuitable for performance measurement calculations.
It provides a quick guide to shares in the industrial sector, but it is not

representative of the American equity market as a whole. It is, however, very
widely reported.
It is a very crude index because:

 it is based on only 30 shares
 there is no weighting by market value.
The basic principle of calculation is that you add up the share prices of all the
constituents and divide by 30. Therefore, if the price per share of the company with the
most costly share rises by 10%, it will have a disproportionate impact on the index –
even if the company happens to be the smallest of the thirty companies.
The divisor does get adjusted to reflect capital changes such as scrip issues.
Consequently, the divisor now bears no resemblance to 30. However, the basic
principle of summing the prices of the thirty shares and dividing by a constant remains.
Standard & Poor’s
The Standard & Poor’s Composite Index, sometimes known as the S&P 500, is a
weighted arithmetic index. Its constituents are 500 leading companies in the
USA representing a broad cross-section of all sectors of the market.
It is often suitable to use for performance measurement of a fund’s portfolio of

USA equities.
Both the S&P 500 and the Dow Jones Industrial Average are used as the basis for stock
index futures.
NASDAQ
There are a number of other relatively comprehensive US equity indices such as the
NASDAQ (National Association of Stock Dealers Automated Quotations).

The NASDAQ composite index includes all common stocks (ie ordinary shares) traded
on the NASDAQ market and currently includes about 5,000 different stocks. There are
various sub indices for different industrial sectors, which reflect the large number of
technologically based companies that are quoted on NASDAQ. In addition there are
indices for the NASDAQ 100 (largest non-financial companies) and the NASDAQ
Financial 100 (largest financial companies).
The NASDAQ 100 is also used as the basis for stock index futures.
3.10 Japan
Nikkei
The Nikkei Stock Average 225 is an arithmetic index. The constituents are
reviewed annually and the index is designed to reflect the overall market. It is
the most widely used indicator of short-term movements in the Japanese market.
The Nikkei is an unweighted index with 225 constituents, which are not the largest 225
companies and so only represent about 50% of the market value of the Tokyo stock
exchange.
The constituents are reviewed annually. The principle is that any illiquid stocks or
unrepresentative stocks are replaced by more liquid stocks. In practice, the index still
contains some small, illiquid and volatile stocks. Nevertheless, it is used as the basis
for a stock index future.
Topix
The Tokyo Stock Exchange First Section Index, commonly known as Topix,
comprises approximately 1,700 shares. It is a market capitalisation weighted
arithmetic index reflecting “free float” from June 2006.
The constituents represent the leading companies in the market, so the index is
much more comprehensive than the Nikkei index, and is more suitable for use in
performance measurement.
3.11 Germany
DAX
The Deutsche Aktienindex (DAX) is a real-time index of thirty leading shares. It

is a total return index.

There are other, older German indices which you may hear about from time to time
(eg FAZ Aktien, Commerzbank), but the DAX is the most widely quoted and is used as
the basis for a stock index future.
3.12 France
CAC
The main market index is the CAC General Index, comprising 250 shares. The
CAC-40 consists of 40 of the largest stocks and was introduced as the vehicle
for an index futures contract.
Question 14.13
Which index would you use to assess the performance of the German equity component
of a UK investment fund?
Question 14.14
Why might you expect the DAX to increase more rapidly than the FTSE All-Share
Index?
3.13 Europe
A number of indices have been created to measure the performance of the major
European companies. These include the FTSE Eurotop 100 and FTSEurofirst 300
(formerly Eurotop 300), their Eurobloc equivalents and the Dow Jones Eurostoxx
50.
These indices provide a set of general European equity indices that can be used to
assess European equity funds.
3.14 Volatility indices
The above indices all measure the performance of equities in price or total return
terms. Another form of equity indices measures the volatility of equities, and
such indices are typically used as an indication of the market perception of risk.

Question 14.15
Suggest two ways in which the volatility of an equity share may be measured.
The most well known volatility index is the Chicago Board Options Exchange
Volatility Index, commonly known as the VIX. This is essentially a weighted
average of prices for a range of 30 day expiry put and call options on the S&P
500 index (see Section 3.9 above).
Intuitively, the level of the index, which is quoted in annualised percentage

terms, is the risk neutral expectation of the volatility on the S&P index over a 30
day period.
The composition of VIX is quite sophisticated and uses the prices of options to
calculate the implied volatility. Specifically, a higher option price implies greater
volatility, other things being equal. Despite the sophistication, its predictive power is
similar to that of simpler measures, such as observations of past volatility.

4 International equity indices
4.1 FTSE Global Equity Index Series
Although equity market indices exist in each of the major world stock markets, in some
markets they may not be:
 sufficiently comprehensive
 calculated consistently
 calculated accurately.
The FTSE Global Equity Indices are an attempt to overcome some of these difficulties.
Construction
The FTSE Global Equity Index Series covers over 8,000 securities in 48 countries
and captures around 98% of the world’s equity markets in terms of investible
market capitalisation.
The index is divided into Developed, Advanced Emerging and Secondary

Emerging segments.
The indices are weighted arithmetic indices. From June 2001 the weightings of
constituents reflect “free float”, as above. This applied to all new constituents
from the beginning of 2000.
Coverage
Index numbers are shown for each country in US dollar and local currency
terms. The local currency index gives a measure of the underlying performance
of the particular market, and the dollar currency index shows performance
adjusted for movements in the currency concerned.
In addition to the indices in respect of each country, there are indices in respect
of market type and region, for example, the FTSE Developed All Cap Index.
Finally, there is a FTSE All-World Index comprising the Large/Mid-Cap aggregate
of around 2,700 stocks from the Global Equity Series.
The indices also include the gross dividend yield and a total returns index for each
country.

Uses
Question 14.16
What you do think are the two main uses of the indices?
Stocks not available to foreign investors are not included in the indices. This is
not the case for most local indices, so the Global Index Series are often more
suitable for performance measurement purposes than local indices. They also
have the advantages of consistency between countries and are easier to obtain
than some local indices.
4.2 Morgan Stanley Capital International Indices
These are a widely used series of international equity indices covering both
developed and emerging markets. They are calculated on a market capitalisation
weighted arithmetic basis and total returns are published both gross and net of
withholding tax.
The MSCI ACWI (All Country World Index) Index is a free float-adjusted market
capitalization weighted index that is designed to measure the equity market
performance of developed and emerging markets. As of May 2015, the MSCI ACWI
consisted of 46 country indices, comprising 23 developed and 23 emerging market
country indices.

5 Bond indices
5.1 FTSE Gilts Index Series
The indices cover conventional and index-linked gilts. Price, total return and
yield indices are published, with the indices being subdivided according to term.
The index numbers are calculated using dirty prices, ie inclusive of accrued
interest.
The latter is the amount of gross income which has arisen on the index for the
calendar year to date.
Details of construction
The principle of construction is to replicate the market value of a market portfolio of

gilts. This assumes that the portfolio is rebalanced whenever there are changes to the
market constituents.
Price indices are constructed as weighted arithmetic indices, the weights being
the market capitalisations of the stocks, dirty prices being used. The indices are
chain-linked to allow for new issues, redemptions and movements of stocks
between categories.
Question 14.17
State what would happen to the following FTSE Gilt Index Series index figures on the
day when a gilt goes ex-dividend:
 the price index
 the accrued interest index
 the ex-dividend adjustment.
UK yield indices
The yield indices are published each day in the Financial Times.

Basis for construction
For conventional gilts, each yield index is constructed by fitting a curve to the
gross redemption yields of the stocks in the particular category. All the
irredeemable stocks are included in each coupon band to give stability to the
long end of the curves. Where a stock has optional redemption dates the earliest
or latest date is used, whichever gives the lower redemption yield.
For index-linked gilts, each yield index represents the average yield of the stocks
in that category.
Question 14.18
Briefly outline the main features and uses of the FTSE Gilt Index Series.
5.2 International bond indices
FTSE global bond index series
These are a series of fixed income indices covering the principal bond markets,
including, France, Germany, the US and Japan and global emerging markets.
The series comprises four homogenously constructed bond families:
 FTSE Global Government Bond indices comprising central government

debt from 22 countries denominated in the domestic currency (or Euros
for Eurozone countries). Sub-indices are segmented by maturity band.
 FTSE Covered Bond indices which consist of securitised issues. These

include Jumbo pfandbrief from Germany and Obligations Foncieres from
France.
The Jumbo Pfandbrief index was introduced in 1995 to attract international investors to
the German bond market. By 2007, both France and Spain were issuing more jumbo
covered bond bonds than Germany. The bonds are often issued by syndicates rather
than individual institutions so each issue must be heavily insured (minimum €1bn).
 FTSE Corporate Bond indices covering investment grade bonds from

corporate entities. Sub-indices are available by maturity band, by industry
group and by credit rating.
 FTSE Euro Emerging markets Bond indices of Euro-denominated

government bonds from emerging countries. Indices are published in US
dollars, Euro, sterling, yen and local currency versions.

Markit iBoxx fixed income indices
These indices cover Euro, Sterling, Asian, US dollar and European High Yield
bond markets. These indices comprise liquid investment grade bond issues in
six categories:
1. sovereigns
2. sub-sovereigns
3. collateralised
4. corporates
5. financials
6. non-financials.
They are based on bid and ask bond prices supplied throughout the trading day
by leading investment banks. From these, consolidated bid and ask prices are
calculated and used for index calculation. Geographic, rating, sector and
maturity sub-indices enable multi-dimensional analysis.
Other international bond indices
Investment banks such as Barclays Capital, Merrill Lynch, Saloman and J P

Morgan also produce indices covering all aspect of the fixed income market
including inflation-linked and swaps indices. These are published as:
 global / multicurrency and
 regional / single currency benchmarks
and a large number of standard sub-indices are available within each index
family.
(Prior to 2008, Lehman Brothers benchmark indices were also widely quoted.
These have now been rebranded as Barclays Capital indices. )
These other indices include:

 Salomon Smith Barney World Government Bond Index, which covers
government bonds in sixteen different countries, broken down by maturity.
Indices are produced for different maturities in each country.
 JPMorgan EMBI (Emerging Markets Bond Index), which tracks total returns on
bonds in emerging markets
The market for Japanese corporate bonds is covered by the Nikko Bond
performance index.

5.3 Credit derivative indices
In addition to corporate bond indices, there are indices of credit default swaps
(CDS). Whereas corporate bond indices blend interest and credit risk, CDS
indices can be used by analysts and investors to monitor more directly the price
of credit risk.
A CDS is an OTC credit derivative, whereas a CDS index is a completely standardised

credit security and may therefore be more liquid and trade at a smaller bid-offer spread.
This means that it can be cheaper to hedge a portfolio of credit default swaps or bonds
with a CDS index than it would be to buy many single name CDS to achieve a similar
effect.
There are currently two main families of CDS indices, the iTraxx and the CDX.
iTraxx
The most well known index in Europe is the Markit iTraxx Europe index (often
referred to as iTraxx Europe Main). Different index series are established each
six months, and the constituents of the index are the top 125 names in terms of
CDS volume traded in the six months prior to this. The index is quoted for 3, 4,
5, 7 and 10-year maturity CDS and the index is the unweighted average of the
CDS premium for the constituents.
The constituents of the indices are changed every six months, a process known as
"rolling" the index. The roll dates are March 20 and September 20 each year. For
example, Series 13 was launched on March 20 2010, with a maturity of June 20 2015
for the 5-year contract.
There are also a number of sub-sector indices for different industries.
This means that it may be possible to invest in a CDS index for a basket of bonds issued
by pharmaceutical companies, say.
CDX
The corresponding US indices are the CDX family. CDX indices contain North
American and Emerging Market companies and are administered by CDS Index
Company.

6 Property indices
6.1 Problems in constructing property indices
There are two key problems encountered when constructing property indices:
1. the lack of reliable and up-to-date data on property prices
2. the heterogeneity of properties.
The root of the problem is therefore mainly a lack of reliable data on prices.
Lack of price data
The production of reliable indices requires knowledge of the market values of the
constituents of the indices at frequent intervals. There are a number of problems
in obtaining such information for property:
 Each property is unique.
 The market value of a property is only known for certain when the
property changes hands.
Just because a property sells for X on a given day does not mean that an identical
property next door will also achieve X on an immediate sale.
 Estimation of value is a subjective and expensive process.
 Valuations will be carried out at different points in time.
 Sales of certain types of investment property are relatively infrequent.

For example, very few large shopping malls are bought/sold in any one day!
 The prices agreed between buyers and sellers of properties are normally
treated with a degree of confidentiality.
For this reason, some of the major firms of surveyors produce property price
indices from their own client database. Similarly, different building societies
develop their own indices for residential properties.
Question 14.19
The argument about heterogeneity might also be applied to equity indices. Comment on
this suggestion and describe how the situation is quite different for equity indices.

Using surveyors’ valuations as an alternative to actual sale prices has problems too:
 subjectivity – different surveyors would give different values for the same
property
 cost – it can be time-consuming and expensive
 circularity – the indices would be based too heavily on the surveyors’ views, but
the surveyors would form their views on the trends of the indices!
Clearly, surveyors’ valuations would not give the independent measure of the market’s
behaviour that an index strives to provide.
Hence there typically isn’t a universally accepted index for property prices.
The heterogeneity of property magnifies the problems of obtaining price data. It

is difficult to group properties into usefully homogeneous groups and still obtain
sufficient price data for each group.
6.2 Types of property index
There are two main types of investment property index – portfolio-based indices,
which are the most common, and barometer indices.
Their different characteristics mean that each is useful for different purposes.
Portfolio-based indices
Portfolio-based indices measure rental values, capital values or total returns of

actual rented properties. Different indices of this type will give different results
because the underlying portfolio of properties will vary in size, regional spread
and sector weighting (office, retail etc).
As these actual properties may be sold very infrequently, the valuations upon which the
index is based will largely reflect the prices at which comparable properties are sold.
Even these valuations may be out-of-date if the comparables themselves do not come up
for sale very often.
The rates of return will typically be money-weighted, meaning that the timing and
magnitude of cashflows into the particular property fund will influence the
results.
However, some property indices in the UK have now moved to a time-weighted

calculation basis.

In addition, as the current rental income is fixed until the next rent review, any
response to movements in rental values will be sluggish.
Portfolio-based indices are used mainly for performance measurement.
Barometer indices
As the name suggests, these are designed to act as a barometer of current market
conditions.
The barometer type of index aims to track movements in the property market at
large by estimating the maximum full rental values of a number of hypothetical
rack-rented properties.
As with portfolio-based indices, different barometer indices are produced in practice for
different property sectors and (hypothetical) regional spreads. The values underlying
the index are based on valuers’ estimates of current rack rents, rather than actual rents,
and should therefore give an earlier indicator of changes in market rent levels. In order
to calculate meaningful index values, strict guidelines are required covering both the
constituent hypothetical properties to be valued and the assumed lease terms of those
properties – eg length of lease, who is responsible for repairs etc
The main use of this type of index is in highlighting short-term changes in the
level of the market in terms of rents and yields. But an index of this type is
unsuitable for portfolio performance measurement since an investor could not
closely match its movement with an actual portfolio of property holdings.
Question 14.20
What is the main weakness of a barometer index?
Index providers
There are a number of index providers who produce property indices that are
suitable as benchmarks for property investors. Indices are typically divided into
residential and commercial indices, and where sufficient data exists the
commercial indices are often further subdivided into industrial, office and retail
categories.
Within the European market, IPD is a leading index provider for commercial
property indices and several of these indices are sufficiently robust to have been
used as a basis for pricing property derivative contracts.

A property derivative is a financial derivative whose value is based on the value of an

underlying property. Because properties can be hard to accurately price, property
derivative contracts are typically written based on a real estate property index. Trading
in property derivatives is also known as synthetic real estate.
Alternatives to property indices
Collective investment schemes investing in real property have the same issues
surrounding producing regular valuation as those identified above. However a
large scheme with a wide range of investments may be trading and valuing
sufficiently frequently to smooth out the main difficulties. Thus using the
published prices of a scheme as a proxy for an index may be a practical
alternative to using an index, particularly in property markets where the indices
that exist are unrepresentative of the property assets held by an investor.
It will be necessary to adjust prices for any regular management or other

charges. As with all indices it is necessary to choose the collective investment
scheme with care. Many schemes invest significantly in property company
shares as well as in real property, which will distort the results.


Chapter 14 summary
An investment index represents the relative changes in the share/stock prices of the
constituent companies or stocks that make up the index.
Construction of indices
Indices need detailed and consistent rules for construction regarding method, prices,
constituents and weights. Generally, to be useful for performance measurement, an
index should be based on an arithmetic average, weighted by market value.
The general formula for a weighted arithmetic average index is:
P
Â wi Pi,t
i i,0
I(t) = K
Â wi
i
The weights are updated each time the number of shares issued by a constituent
company changes and continuity is maintained by chain-linking the index. Index
weights are often restricted to reflect the level of free float of shares available for
purchase, thereby eliminating strategic holdings.
After allowing for chain-linking, the formula for a weighted average arithmetic index is:
Â Ni,t Pi,t
i
I(t) =
B(t)
An ex-dividend or XD adjustment represents the amount of income that has been

received since the start of the year by a capital value index.
Di ,t
xdi ,t = Ni ,t
B (t - 1)
The formula to obtain a total return index at time t is:
I (t )
TRI (t ) = TRI (t - 1)
I (t - 1) - [ XD(t ) - XD(t - 1)]

If no XD adjustment figure is available, then the income received over the 12 months
prior to time t (measured in index points) can be estimated as:
I (t ) ¥ yt
An unweighted arithmetic index is unsuitable as a benchmark for dynamic institutional

portfolios.
A geometric index with n constituents is:
1
Ê Pi ,t ˆ n
I (t ) = K Á ’ ˜
Ë i Pi ,0 ¯
Uses of indices
The uses to which indices can be put include:

 providing a history of market movements and levels
 as a tool for estimating future movements in the market, based on past trends
 as a benchmark against which to assess the investment performance of portfolios
 valuing a notional portfolio
 analysing sub-sectors of the market
 as a basis for index funds which track the particular market
 to provide the basis for the creation of derivative instruments relating to the
market or a sub-section of the market.
In particular for government bond indices:

 a standard against which yields on other fixed interest investments can be
assessed
 approximate valuation of a fixed interest portfolio
 providing a picture of general yield structures of fixed interest investments
 a measure of the yield gap between bonds and equities.

UK equity indices
The FTSE UK Index Series are market capitalisation weighted arithmetic indices. In
addition to the capital and total return index numbers they give:
 average net dividend cover
 actual dividend yield
 price earnings ratio
 ex-dividend adjustment.
The FTSE 100 index is based on the 100 largest companies in the UK equity market and
covers about 80% of the market by value. It is calculated every minute, is the most
widely quoted of the FTSE UK Index Series and is used as the basis for derivatives
contracts.
The FTSE All-Share Index covers about 98% of the market by value and is calculated
and updated every minute.
The other FTSE indices include:

 FTSE 250
 FTSE 350
 FTSE SmallCap
 FTSE Fledgling
 FTSE Aim.
US equity indices
The Dow Jones Industrial Average is a price weighted index of 30 leading New York
shares. Although widely quoted, it is not suitable for performance measurement
because of its poor market coverage and its construction method. The Standard &
Poor’s 500 Index is more suitable for this purpose. Another widely used US equity
index is the NASDAQ composite.

Equity indices for Japan
Japanese equity indices include the Topix and the Nikkei Stock Average 225. The
Topix
is more suitable for performance measurement than the more widely quoted Nikkei
Stock Average 225.
Equity indices for Europe
The main index in France is the CAC General, and in Germany the DAX.
New European-wide indices include the FTSE Eurotop 100 and FTSEurofirst 300, their
Eurobloc equivalents and the Dow Jones Eurostoxx 50.
Volatility indices
Volatility equity indices, such as VIX, measure the volatility of equities. Such indices
are typically used as an indication of the market perception of risk.
International equity indices
The FTSE Global Equity Index Series covers over 98% of the world’s equity markets in
terms of investible market capitalisation.
The indices are weighted arithmetic indices based on market capitalisations and reflect
free float weightings. Index numbers are shown for each country in US dollar and the
local currency.
There are indices in respect of market type and region.
The FTSE All-World Index covers over 3,000 (as at May 2015) stocks from the Global
Equity Series.
The Morgan Stanley Capital International Indices are a widely used series of
international equity indices covering both developed and emerging markets. They are
calculated on a market capitalisation weighted arithmetic basis and total returns are
published both gross and net of withholding tax.

UK bond indices
The FTSE Gilts Index Series include price and yield indices. Conventional gilts and
index-linked gilts are treated separately, and indices are produced for a variety of
different terms.
The price indices are weighted average indices based on market capitalisations and dirty
prices. For each category of the price indices, the information given includes the:
 index number
 accrued interest
 XD adjustment for the calendar year to date.
International bond indices
Establishing a suitable benchmark for a bond portfolio can be more complicated than
for a portfolio of equities, as bond portfolios are often constructed subject to specific
constraints such as duration or credit rating. Many different series of international bond
indices are produced, mostly by brokers.
International bond indices include the FTSE global bond index series and the Markit
iBoxx fixed income indices. Investment banks, such as Barclays Capital, Merrill
Lynch, Saloman and J P Morgan, also produce bond indices.
Credit derivative indices allow investors access to standardised credit default contracts
on many different securities. The main families of CDS index are iTraxx and CDX.

Property indices
Property price indices are very difficult to maintain because:

 there is little reliable, up-to-date price data for properties at any one moment
 properties tend to be very heterogeneous.
The problems involved with obtaining market values for property include:
 Each property is unique.
 The market value of a property is only known for certain when the property
changes hands.
 Estimation of value is a subjective and expensive process.
 Valuations will be carried out at different points in time.
 Sales of certain types of investment property are relatively infrequent.
 The prices agreed between buyers and sellers of properties are normally treated
with a degree of confidentiality.
Portfolio-based property indices measure rental values, capital values or total returns of
actual rented properties, split according to size, regional spread and sector weighting
(office, retail etc).
Barometer property indices aim to track movements in the property market at large by
estimating the maximum full rental values of a number of hypothetical rack-rented
properties.
IPD is a leading index provider for commercial property indices.

Solution 14.1
At time 0, the starting date of the index:
N A0 = 100, N B 0 = 100, PA0 = 3, PB 0 = 1
where Nit is the number of Company i shares at time t.
(i) Market capitalisation at time 0
This is equal to: N A0 PA0 + N B 0 PB 0 = 100 ¥ 3 + 100 ¥ 1 = 400
(ii) Weights in the formula
For each share the weight is equal to the opening market capitalisation, thus:
wA = N A0 PA0 = 100 ¥ 3 = 300
wB = N B 0 PB 0 = 100 ¥ 1 = 100
(iii) Value of the constant K
For the opening value of the index I(0) to be 100, we require that:
Ê 3 1ˆ
ÁË 300 ¥ + 100 ¥ ˜¯
3 1
I (0) = 100 = K
(300 + 100)
ie K must be equal to 100.
(iv) Index value at time 1
Ê 3.2 1.1ˆ
ÁË 300 ¥ + 100 ¥ ˜
3 1¯
I (1) = 100 ¥ = 107.5
(300 + 100)

Solution 14.2
Using the second formula, the index value at time 1 is given by:
Â Ni ,1Pi ,1
I (1) =
i = A, B
=
(100 ¥ 3.2 + 100 ¥ 1.1) = 107.5
B(0) 4
Note that the base value or divisor is unchanged at time 1, as there have been no
changes to either of the constituents and hence no chain linking.
Solution 14.3
Circumstances in which chain-linking would be required include:

 a rights issue or a share buy-back by a constituent company
 a new issue of a share in the sector covered by the index – eg newly-formed
company, privatisation, demutualisation
 a merger, takeover or break-up involving a constituent company or companies
 a change in the constituent companies in an index, resulting from a change in
relative market capitalisations due to share price movements. For example, the
share price of Company P increases so that its overall market capitalisation now
exceeds that of Company Q, which was formerly the 100th largest company.
Thus, P replaces Q in the index of the largest 100 companies.
Solution 14.4
The total return yielded by an investment market consists of two elements – the capital
gain and the income received. The change in the capital value index from time t to
time t+1:
I (t + 1) - I (t )
gives us an estimate of the capital gain yielded by the market. Likewise, the increase in
the XD adjustment:
XD(t + 1) - XD(t )
measures the income received by an investment in the market over the same period.

By adding the two together and dividing by the initial value of the capital index, we can
estimate the total return yielded by an investment market from time t to time t+1 as:
I (t + 1) - I (t ) + XD(t + 1) - XD(t )
TR =
I (t )
We use this idea to develop the total return index.
Solution 14.5
An investor who held a single share at yesterday’s close had a shareholding then worth
simply Py .
D
At today’s close, the investor holds 1 + shares, each worth Pt giving a portfolio
Py - D
value of:
Ê D ˆ Py - D + D Py ¥ Pt
Á1 + P - D ˜ ¥ Pt = P - D ¥ Pt = P - D
Ë y ¯ y y
So the total return to the shareholder over the day is:
Py ¥ Pt 1 Pt
¥ =
Py - D Py Py - D
Solution 14.6
The usual assumption is to use the ex-dividend date. However, this may lead to
problems if the index is used by index tracking funds, since the tracking funds will not
be able to reinvest the dividends until actually received.
Solution 14.7
It is unsuitable because the performance of any investment portfolio will reflect the
actual weights – ie market capitalisations – of the constituent investments held within
that portfolio, which are unlikely ever to be equal.

Solution 14.8
The arithmetic index would rise faster. The geometric index will lag the progress that
should be made by a typical portfolio.
If both components rise by, say, 5%, then both types of index will rise by 5%.
However, if one constituent rises by 10% and the other not at all, the results will be:
 arithmetic index: up 5%
 geometric index: up 4.88%
ie given that not all constituents move at the same rate, the geometric index lags behind
the arithmetic index.
Solution 14.9
The ten economic groups used in the FTSE classification system are:
1. oil and gas
2. basic materials
3. industrials
4. consumer goods
5. health care
6. consumer services
7. telecommunications
8. utilities
9. financials
10. technology.
Solution 14.10
The yields on other fixed interest investments are likely to be higher than those on
comparable government bonds to compensate for:
 the higher level of default risk
 the lower level of marketability.

Solution 14.11
There are many factors that will need to be addressed. The following is an illustrative
list;
 purpose of index (this will help define answers to issues below)
 constituents and basis for inclusion/exclusion
 type of index (eg weighted arithmetic)
 frequency of calculation
 price data to use (eg mid-market prices)
 how to deal with capital changes (eg chain-linking)
 what to do about income (eg XD adjustments, total returns indices).
Some issues (eg the final issue relating to income) will need much detail in practice.
For example, how to deal with tax, when to credit income, when to reinvest etc.
Solution 14.12
Based on a growth rate assumption of 5% pa (reflecting real economic growth plus

expected inflation over a ten-year period), a reasonable estimate might be:
6,566 ¥ 1.0510 = 10, 695
However, the truth is that nobody has any real idea and any estimate must necessarily
be pretty much a complete guess.
All we can perhaps say is that it is unlikely that the index value will fall over any ten-
year period. However, it is certainly not impossible!
Solution 14.13
You should use the FTSE All-World (Germany). (This is a better answer than the
DAX, which is based on fewer shares. )

Solution 14.14
The DAX is a total return index, ie it also includes income, where the FTSE All-Share
index that is most often quoted is just a capital value index.
This answer ignores any currency related factors. For example, persistently higher
inflation in the UK might increase the FTSE All-Share in nominal terms more rapidly.
Solution 14.15
1. Use an option pricing formula, typically Black-Scholes, and the actual market
option price to estimate the unknown volatility parameter according to the
formula. In reality, different estimates may be achieved depending on the strike
price of the option. This would need to be taken into consideration along with
any criticisms of the assumptions underlying the option pricing formula being
used.
2. Volatility is the same as annualised standard deviation. You could observe the
sample standard deviation from historical values of the equity and perhaps adjust
it for any expected changes in the future.
Solution 14.16
The two main uses are:

1. for performance measurement for international investments
2. to help research into the relative merits of investing in different countries.
Solution 14.17
When a stock goes ex-dividend . . .

 the price index would fall to reflect the drop in dirty price of one of the
constituents – though this may be swamped by other price movements for all of
the stocks eg if yields fell, and prices rose, generally
 the accrued interest would fall correspondingly
 the ex-dividend adjustment would increase correspondingly.
For example, suppose that a particular bond pays an annual coupon of 6% and goes ex-
dividend 10 days before the coupon is due to be paid (and 355 days since the last
coupon was paid), at which point it has a quoted (ie clean) price of 98%.

The accrued interest immediately before the bond goes ex-dividend is then equal to:
355
¥ 6 = 5.836
365
giving a dirty price of:
98 + 5.836 = 103.586
Immediately after the bond goes ex-dividend:

-10
 the accrued interest will fall to ¥ 6 = - 0.164
365
 the dirty price of the bond will fall by six to 98 - 0.164 = 97.836
 the clean price remains unchanged at 98.
Solution 14.18
The FTSE Gilts Index Series publishes price and yield indices for conventional and
index-linked gilts.
For the price indices the following figures are published:

 index value
 day’s change
 accrued interest
 ex-dividend adjustment for the year to date
 total return index figure
 the weighting that each price index is given in the make-up of the all stocks
index.
 the gross redemption yield
 the duration of the index.
For the yield indices, the figures given are:

 the yield yesterday
 the yield the day before
 the yield one year ago.

For individual index-linked gilts, the real gross redemption yields are given based upon
assumed future inflation rates.
The main uses of the FTSE Gilts Index Series are:

 providing a history of market movements and levels
 a tool for estimating future movements in the market, based on past trends
 a benchmark against which to assess the investment performance of portfolios
 analysing sub-sectors of the yield curve (eg shorts, mediums etc)
 providing a standard against which yields on other fixed interest investments can
be assessed
 approximate valuation of a fixed interest portfolio
 providing a picture of general yield structures of fixed interest investments.
Solution 14.19
It is true that there is heterogeneity within equity indices, but this is not a problem
because:
 the mix of different shares within a given index is kept stable over time
 reliable and up-to-date price data exists for all the different types of constituent
 the shares within individual companies are homogeneous
 indices are also maintained for the more homogeneous sub-groups (ie different
industry sectors, large/medium/small companies).
Solution 14.20
The main weakness of a barometer index is that the rental values on which it is based
are subjective estimates for hypothetical properties – as opposed to actual rents for
actual properties.

ST5-15: Performance measurement (1) Page 1
Chapter 15
Performance measurement (1)
Syllabus objectives
(n) Analyse the performance of an investment portfolio and discuss the limitations
of such portfolio measurement.
(i) Assess the performance of a portfolio relative to a published market

index.
(ii) Assess the performance of a portfolio relative to a predetermined

benchmark portfolio.
(iii) Analyse the performance of a portfolio into components relating to

investment sector selection and individual stock selection.
(iv) Discuss the relative merits of assessing portfolio performance relative to

published indices, other portfolios or a predetermined benchmark
portfolio.
(v) Discuss the uses of risk-adjusted performance measures.
(vi) Discuss the value of portfolio performance measurement and its

limitations.

Page 2 ST5-15: Performance measurement (1)
0 Introduction
Actuaries often need to assess the returns achieved by particular investments,
investment funds or investment portfolios, whether or not they work directly in the
investment field. Indeed, the measurement of investment performance against the
investment objectives is the key element in the monitoring of the asset management
process. It is crucial to both assessing the success or otherwise of the process in
meeting the investment objectives and also to identifying the underlying reasons for any
success or failure – and thereby indicating how the process can be improved in future.
This chapter is divided into eight sections:

 Section 1 is concerned with the methods of calculating a rate of investment
return. It reviews the money-weighted, time-weighted and linked internal rates
of return.
 Sections 2, 3 and 4 are concerned with the methods used for comparing the rate
of return from different portfolios and analysing the factors that have influenced
the returns achieved. Numerical questions on this topic have appeared regularly
on ST5 exam papers.
 Section 5 looks at performance measures that allow for the level of risk
undertaken by the fund.
 Section 6, 7 and 8 discusses the role of performance measurement, its limitations
and the relative merits of the various methods employed.
The basic measures of investment performance measurement were introduced in

Subject CT1 and this is recapped in the first section below.
You may recall that these included the:

 money-weighted rate of return
 time-weighted rate of return
 linked internal rate of return.

1 Comparison between different methods of calculating

return
1.1 The money-weighted rate of return (MWRR)
The money-weighted rate of return (MWRR) is useful as an absolute measure of

the achieved return. It can be compared with the actuarial assumptions
underlying the fund to see whether the achieved return is higher or lower than
that expected.
The standard formula for calculating the MWRR is:
V0 (1 + i )T + Â Ct (1 + i )T -t = VT
t
Question 15.1
What does each of the symbols represent in the above formula?
Cashflow v investment income
Cashflow in the above formula represents the excess of contributions received over
claims and expenses paid. It is the money moving into (or out of) the fund.
Tax and expenses
For rates of return net of tax and expenses, VT and all disinvestments should be net of
tax and expenses.
Basic problem with the MWRR
The money-weighted rate of return is not a good basis for comparing two
different fund managers. The main reason for this is that the rate of return can
be heavily influenced by the timing and size of cashflows. The payments into
and out of a particular fund are not usually within the control of the investment
manager, so rates of return influenced by cashflows are not very useful when
comparing investment managers.

This can be illustrated by a simple example.
Question 15.2
Fund Managers A and B are both given 10 million to invest. Both managers invest the
whole 10 million in equities. Over the next six months the equity market is very
sluggish, and the funds for both managers are still standing at 10 million. (There are no
contributions to and no payments from either fund during the first six months. )
Then Manager A is asked to return 5 million to the trustees of the fund who need to
make a large payment out. Meanwhile Manager B is given another 5 million to invest
because the trustees of Fund B happen to have received a large payment into the fund.
In the next six months, there is a strong bull market in equities and both Managers
achieve a 50% return on their equity investments over the six-month period.
Calculate the annual money-weighted rate of return for each manager over the year
described above. Comment on the results.
Question 15.3
Will money-weighted returns always give figures that are unsuitable for comparing
different fund managers? Under what circumstances is the money-weighted rate of
return least appropriate for comparison purposes?
1.2 Time-weighted rate of return (TWRR)
The time-weighted rate of return overcomes the basic problem associated with
money-weighted rates of return. Theoretically, it is usable as a basis for
comparing different investment managers because the timing and size of
cashflows will not distort the rates calculated.
It is calculated by
1. assessing the fund value at each time there is a cashflow in or out
2. calculating the return achieved for each period between cashflows
3. linking these returns together to give the time-weighted rate of return.
Note that the amount of money invested at each time will not affect the result.

Question 15.4
Give a formula for the TWRR.
Question 15.5
Calculate the time-weighted rate of return for Managers A and B from Question 15.2.
Comment on your results.
1.3 Comparison of time-weighted return and money-weighted

returns
The time-weighted rate of return and the money-weighted rate of return will be very
similar when either the:
 cashflows during the valuation period are small relative to the funds involved or
 the rate of return is stable over the period.
When neither of these conditions hold, the two rates of return can be very different.
Impracticality of time-weighted rate of return
The problem with using the time-weighted rate of return in practice is the amount
of data that is required: fund values are needed for every occasion on which
there is a cashflow. This is often impracticable in practice.
A practical compromise solution is to use the linked internal rate of return as an

approximation for the time-weighted rate of return; this is often done using
quarterly sub-intervals.
1.4 Linked internal rate of return (LIRR)
The LIRR for a fund over a given year is found using the following process:
1. Determine the value of the fund at various dates throughout the year (eg at
monthly or quarterly intervals).
2. For each inter-valuation period, calculate the money-weighted rate of return.
3. Link the inter-valuation MWRRs together to get the linked internal rate of return
for the year.

Question 15.6
Under what conditions will the linked internal rate of return provide a very good
approximation for the time-weighted rate of return?
Question 15.7
For each of the money-weighted rate of return, time-weighted rate of return and linked
internal rate of return give one sentence summarising the main use and one sentence
summarising the main weakness.

2 Comparison of portfolio performance with an index
2.1 Introduction
The performance of a portfolio is often compared with the returns that would have been
available from a published market index. Active fund managers in particular are keen
to show that their portfolios have “beaten” the index. If the fund managers could not
show this, then investors might decide to stop paying fees to the active fund manager
and invest their funds in the same way as the index (ie by investing in index tracker
funds with lower expenses).
The merits of active investment management and index tracking are discussed in detail
in Chapter 20.
How to do the assessment
There are two basic ways in which to compare the performance of a portfolio
with an index:
1. By comparing the actual value of the portfolio at the end of a defined

period with the value that would have been achieved had the initial value
of the portfolio and subsequent net new money been invested in the same
way as the index.
2. By comparing the time-weighted return from each (or the linked internal rate
of return as an approximation to the time-weighted rate of return).
In practice the method chosen and the type of return calculated will depend
partly on the data available.
Question 15.8
An investor has total assets at the start of a year of $47 million. At the end of the year
the fund has assets of $57 million. Over the same year, the index rose from 2,000 to
2,090.
What can you say about the performance of the portfolio? What further information
would you need to assess the performance of the investor’s portfolio over the year
compared with the index?

2.2 Example assessment
To the initial data in the question above, we will add the missing data and compare the
fund against the index.
 There was just one cashflow in the year: an amount of $4 million paid in on
1 July. There was also investment income of $0.6 million (net of tax) at the end
of each quarter. (The $57 million is quoted after all of the cashflows. )
 The investor pays tax at 20% on all income, but no capital gains tax. At the end
of the year, there is no outstanding tax due.
We now know that the increase in value of $10 million was made up of:
 $4 million in new money
 $2.4 million in investment income (net of tax)
 $3.6 million capital gains (as the balance to make the total $10 million).
It is often useful to do this summary very quickly as it gives you a feel for what is going
on. For example, we know from this summary that the net rate of return achieved is
approximately 12% – ie $51 million growing into $57 million in one year. In fact, the
return is better than this because the $4 million new money was invested for 6 months
only. Knowing this will help us understand whether our answer looks right. This is
important because examiners are very unimpressed by candidates who fail to spot silly
answers.
Assessment based on amounts
Let’s now look at the $47 million invested in the same way as the index, together with
the $4 million new money. We need some more information on the level of the index
throughout the year and also on the amount of investment income that it would have
produced. This data is often given in the form of the capital index value and the
dividend yield at the time:
Date Index Gross dividend yield

1 January 2,000 4.0% pa
1 April 2,098 3.9% pa
1 July 1,914 4.2% pa
1 October 1,970 4.0% pa
1 January 2,090 3.8% pa

Our initial assessment will be based on $47 million invested in equities when the index
is at 2000. Three months later the value will be:
2, 098
47 ¥ = $49.303m
2, 000
However, this allows only for the capital value. We need also to include the income.
From the dividend yield, we can estimate the income over the three months as:
0.039
49.303 ¥ = $0.481m
4
You should note that:

 we ignore any investment return that might have been achieved by reinvesting
part way through each quarter
 on the basis that the dividend yield is gross, this is the gross income
 the dividend yield must be applied to the market value of assets at the same date
as the date of the dividend yield. (This should be intuitively obvious if you
consider that if the market value of equities doubled overnight, then the dividend
yield would halve. So to estimate the dividends for the last year, we need to use
the new dividend yield on the new market value. )
 dividend yields are calculated as one year’s dividends divided by market value,
so we need to divide by 4 to get an estimate of the quarterly dividend income.
So, including the notional net investment income, the notional value of the portfolio at
1 April, if it had been invested in the index, would have been (allowing for the 20% tax
on dividends):
49.303  0.80  0.481  $49.688m
We can use a similar calculation to determine the notional fund as at 1 July:
1,914 0.042
49.688 ¥ ¥ (1 + 0.80 ¥ ) = $45.711m
2, 098 4
After the addition of the $4m new money, the notional fund would be $49.711m.

Question 15.9
Calculate the value of the notional portfolio:

 as at 1 October
 as at the start of the next year.
If we had allowed for the likely expenses of tracking the index, the value of the notional
portfolio might have been slightly less than $55m. This compares with the $57m
actually achieved by the portfolio. Therefore the actual portfolio appears to have out-
performed the notional portfolio by about $2m.
Amounts by which a portfolio out-performs (or under-performs) a notional portfolio can

be expressed as a proportion of the mean funds invested. In this case, the out-
performance would be approximately 4%, ie 2  (47+0.54).
Assessment based on internal rate of return
If we wanted to measure the out-performance in relative terms (eg with a % figure),

then we could also use the time-weighted rate of return. However, in this example, we
do not have the market value of the portfolio on 1 July, so we cannot calculate the time-
weighted return.
In this example, we might use the internal rate of return to compare the portfolio against
the index.
This is because the problem of different cashflows is less acute than it is when
comparing different funds because we have already notionally mirrored the actual
cashflows within the calculation of the notional index tracking fund. In other words,
the timing and amounts of the cashflows are the same for both funds.
However, there could still be some distortion. For example, if the relative performance
of the actual fund is greatest when the fund is large, then the internal rate of return will
magnify the extent of the out-performance. (Even here, it may be debatable whether
this “distortion” is really undesirable. If you were responsible for a fund, you might be
very keen for out-performance to occur when the fund was at its largest!)
Question 15.10
Calculate the internal rate of return for the portfolio and the notional index tracking
fund.

Although we have carried out a reasonable assessment of the portfolio against the index
based on an internal rate of return, the calculation is not ideal because the calculations
are not robust enough to be used for other portfolios over the period. This is because
the internal rate of return for the index will vary when we look at portfolios that have
different cashflows. The solution is to use the time-weighted rate of return, or the
linked internal rate of return as an approximation.

3 Comparison of portfolio performance with a benchmark

portfolio
3.1 Introduction
Assessing the performance of a portfolio against a predetermined benchmark

portfolio (often called a “notional fund”) is similar to assessing against a
published index. The only difference is that rather than develop a notional fund
based on a particular market index, the notional fund is defined in some other,
predetermined manner (eg a mix of more than one index, such as 50% in a fixed
interest index and 50% in an equity index).
This is best illustrated with a worked example.
3.2 Worked example
The trustees of a pension scheme decide (after advice from the scheme actuary on the
nature of the liabilities) that the assets should be invested 60% in domestic equities,
15% in overseas equities and 25% in fixed interest securities.
The trustees appoint a fund manager who is given some freedom to move away from the
benchmark within some parameters (eg within a maximum tracking error).
Although the fund manager has some freedom, the regular performance assessments
will be based on the 60/15/25 benchmark portfolio. For each sector, the most
appropriate index will be used.
At the start of the year, the pension scheme’s assets will be notionally invested in the
indices in the 60/15/25 proportions and subsequent net cashflows will be invested in the
same proportions. The final total of the notional fund can then be compared with the
final total of the actual fund.
The fund manager will hope that the actual portfolio exceeds the notional fund.
3.3 Complications
There are, inevitably, various issues which may make the assessment more complex.

Cashflows, investment income, tax and expenses
These are the four standard issues that we have mentioned throughout this chapter.
They are all relevant here.
For the comparison of the actual fund with the notional fund to be valid, we must make
appropriate allowance within the notional fund for:
 contributions in and repayments out, as actually experienced by the portfolio
 investment income and capital gains, as would have been experienced in the
notional fund
 taxes on income and capital gains, as would have been experienced in the
notional fund
 expenses, as would have been experienced in the notional fund.
Maintaining the notional 60/15/25 split
The initial split of the notional fund is simple: just follow the split as defined by the
trustees. However, it is not so straightforward once the market values of the different
sectors start to move in different directions. For example, a fund that starts at 60/15/25
might soon move to 65/13/22 if domestic equities increase rapidly in value. Should the
notional fund be rebalanced or left in the new proportions?
In specifying the benchmark portfolio it is necessary to set out how new money
and investment income are to be invested and how often the benchmark is to be
rebalanced. Care will need to be taken that the calculations allow correctly for
these factors.
A pragmatic basis to follow is as follows:

 the notional fund starts with the 60/15/25 split
 all investment income from a particular sector is reinvested within that sector
 all contributions in and payments out are split in the 60/15/25 split
 no attempt is made to rebalance the notional fund during the period of
assessment (eg one year).
This basis is effectively the same as the trustees saying to the fund manager: “Divide
the fund into three distinct sub-funds. Keep the three funds separate during the year.
Split all cashflows by the original proportions of 60/15/25. ”

4 Performance attribution
4.1 Introduction
Fundamentally, there are two ways that a fund manager can out-perform a benchmark
portfolio:
1. by choosing the right investment sectors (eg equities, property, fixed interest)
2. having chosen the sector, choosing the right stocks (eg IBM, Microsoft).
Some investment managers may be very good at sector selection, while others may be
very good at stock selection. If we analyse the performance of a portfolio into the
components of stock and sector selection, then we will be better placed to understand
the relative strengths and weaknesses of each investment manager. This process of
attributing performance to stock and sector selection is called performance attribution
or attribution analysis.
4.2 How to find the sector and stock components
Suppose that we want to carry out the analysis for a particular portfolio over a given
year. We start by considering the size of the actual fund (in monetary units) at the end
of the year. This is the amount that has been generated from:
 the actual sector split (eg 68/11/21)
 the actual stocks chosen by the fund manager.
Call this amount Fundvalueactual / actual or FAA .
Now consider the end of year amount that would have been generated by the notional
benchmark portfolio that we discussed in Section 3. This is the amount that would have
been generated from:
 the notional sector split (eg 60/15/25)
 the notional stocks (eg the market indices for each sector).
Call this amount Fundvaluenotional / notional or FNN .
Then FAA - FNN is the overall amount of profit (or loss if negative) generated by the
fund manager’s choice of sectors and stocks.

Now consider another notional fund, which we will call Fundvalueactual / notional , or
FAN , calculated from:
 the actual sector split chosen by the fund manager

 the notional stocks (eg the market indices for each sector).
This will give us the fund that would have been achieved if the fund manager had
followed his/her strategic decisions on the allocation of funds between sectors, but had
invested in the overall market rather than the stocks actually chosen.
Having generated this intermediate notional fund we can now calculate the sector
selection profit and the stock selection profit:
 stock selection profit = FAA - FAN
 sector selection profit = FAN - FNN
The stock selection profit is the amount of out-performance achieved by virtue of the
actual stocks selected. It is therefore the difference between the performance of the
actual fund and the performance of a notional fund invested in the same actual sector
split, but with stocks selected as per the underlying sector indices.
Likewise, the sector selection profit is the amount of out-performance achieved by

virtue of the actual sectors selected. It is therefore the difference between the
performance of a notional fund invested in the same actual sector split, but with stocks
selected as per the underlying sector indices, and the benchmark fund with notional
sectors and notional stocks.
Note that by adding together the stock selection profit and the sector selection profit
you get the total amount by which the portfolio out-performed the notional fund, ie the
FAN terms cancel out.
It is normally the case that the simplest notional fund to design will involve an actual
sector split and notional stock selection. This is determined by the information
available.

4.3 Example 1
A pension scheme has a benchmark portfolio that is 50% equities, 30% fixed interest
and 20% property, in each case invested in unitised funds run by the XYZ Insurance
Company. The benchmark portfolio is rebalanced only at each year-end and net
cashflows are invested or disinvested in the benchmark proportions on the dates at
which they are received.
The pension fund portfolio is actually invested on a segregated basis and the fund
manager is given complete freedom to move away from the benchmark proportions and
to invest in whatever securities he chooses.
At the start of the year, the fund manager divides the total assets ($70 million) into three
distinct funds, which are kept separate. The values of the three funds are shown in the
table below.
Sector 1 January 1 May 1 September 31 December

Equity $50.0m $51.1m $61.3m $61.9m
Fixed interest $10.0m $10.8m $11.0m $6.2m
Property $10.0m $10.3m $10.2m $10.0m
The values shown are just prior to the two cashflows during the year. First, $10m was
paid into equities on 1 May. Secondly, $5m was paid out from fixed interest on
1 September.
Amongst other things, this table tells us that the actual fund value at the end of the year
was $78.1m. In terms of the earlier notation, this fund value is FAA .
The XYZ Insurance Company runs unitised managed funds for each of the three
sectors. In each case the units are accumulation units, and so include investment
income. The unit prices throughout the year are (ignoring bid-offer spreads):
Sector 1 January 1 May 1 September 31 December

Equity $0.554 $0.563 $0.570 $0.582
Fixed interest $1.284 $1.306 $1.325 $1.349
Property $0.769 $0.770 $0.762 $0.754

If the fund had been invested in the unitised funds in the benchmark proportions, and
the flows invested/disinvested in the same benchmark proportions, then the values in
each sector would have been:
0.582 0.582 0.582

Equity: 70 ¥ 0.5 ¥ + 10 ¥ 0.5 ¥ - 5 ¥ 0.5 ¥ = 39.385
0.554 0.563 0.570
1.349 1.349 1.349

Fixed interest: 70 ¥ 0.3 ¥ + 10 ¥ 0.3 ¥ - 5 ¥ 0.3 ¥ = 23.635
1.284 1.306 1.325
0.754 0.754 0.754

Property: 70 ¥ 0.2 ¥ + 10 ¥ 0.2 ¥ - 5 ¥ 0.2 ¥ = 14.696
0.769 0.770 0.762
Total: 39.385 + 23.635 + 14.696 = 77.716
In terms of the earlier notation, this fund value is FNN .
At this stage, we can make an initial interpretation of the performance of the fund. The
actual fund at the end of the year was $78.100m. This exceeds the notional fund by
$0.384 million. Expressing this as a proportion of the average funds invested over the
year, the out-performance is about 0.5%.
We next need the value of a fund based on the actual sector split and the performance of
the notional stocks. Here we include the decision as to where to invest new cash during
the year as part of the asset allocation decision.
0.582 0.582
Equity: 50 ¥ + 10 ¥ = 62.865 vs actual value of 61.9
0.554 0.563
1.349 1.349
Fixed interest: 10 ¥ - 5¥ = 5.416 vs actual value of 6.2
1.284 1.325
0.754
Property: 10 ¥ = 9.805 vs actual value of 10.0
0.769
Total = 62.865 +5.416 + 9.805 = 78.086
In terms of the earlier notation, this fund value is FAN .
Comparing this value to the actual fund value tells us that the stock selection profit is
78.100 – 78.086 = +$0.014m.

If we look at the actual fund size for each of the sectors, we can see that the negligible
overall stock selection profit comes from very good stock selection on fixed interest
(+0.784 = 6.2 – 5.416) and good stock selection from properties (+0.195), compensating
for under-performance on equities (–0.965). (Relative to the amount invested in fixed
interest the fixed interest stock selection profit is very large. The stock selection loss on
equities is a bigger absolute amount only because there is so much more invested in
equities. )
The sector selection profit of $0.370m (ie 78.086 – 77.716) arises mainly because the
actual fund was underweight in property, which performed poorly.
Question 15.11
A UK fund manager is assessed against a benchmark portfolio which is invested 50% in

UK equities and 50% in US equities. Over the year being assessed, the total returns
from the UK equity market were 23%, while from the US market the total returns were
15% in sterling terms.
The fund manager invested £2.5m in UK equities and £1.5m in US equities. By the end
of the year, the funds were £3.3m and £1.8m respectively.
Assuming that there were no net cashflows during the year, calculate the overall profit
or loss and the sector and stock selection profits (or losses) for the portfolio. State any
assumptions you make.
An alternative derivation of sector and stock profit
We have assessed the sector and stock profit or loss by devising a hybrid portfolio using
the actual sector split and the notional stocks.
It is also possible to devise a hybrid notional portfolio based on the actual stocks
invested notionally between the sectors in the benchmark proportions. Let’s call this
Fundvaluenotional / actual , or FNA . We can then find values for the sector selection profit
FAA - FNA , and the stock selection profits FNA - FNN .
The conclusions using this approach are slightly different from the conclusions we
arrived at when we first split out the sector and stock components. The reason for this
is that the two methods effectively put different weights on the different elements of
out-performance and under-performance.

We recommend that you stick to the first method, ie derive the sector and stock splits by
producing a notional fund from the notional stocks invested in the actual sector split.
The examiners seem to prefer this approach.
The most important point is that you should look carefully at the figures and think about
the reasons for the differences between the actual fund and the notional fund.
Question 15.12 (optional)
Rework Example 1 using the alternative method of calculating sector and stock
selection profits.
4.4 Core reading for performance attribution
This section gives the Core Reading for attribution analysis. Having worked through
Sections 4.2 and 4.3 you should find it easy to follow.
The overall investment performance of a fund can be divided into:

 sector selection, ie the extent to which the fund’s proportions in the
various sectors will have affected performance. (Sector selection
performance is sometimes known as asset allocation performance. )
 stock selection, ie within any one sector, have the selected stocks
performed better or worse than the sector as a whole?
As an example, consider a pension fund that is only invested in two sectors, UK

equities and gilts. Suppose the trustees’ guidelines to the investment manager
are that the proportions of the fund invested in equities and gilts should be 85%
and 15% respectively. The investment manager is permitted to depart to some
extent from these guidelines and the actual proportions adopted were 90% and
10%.
Let:
 F = the actual fund value at the end of the year
 N1 = the fund produced if 85% of the fund and 15% of the fund
had been invested in the FTSE All-Share Index and the Over
15-Year Gilt Index respectively
 N2 = the fund produced if 90% of the fund and 10% of the fund
had been invested in the FTSE All-Share Index and the Over
15-Year Gilt Index respectively

Then the overall relative performance:
= F - N1
= (F - N2 ) + (N2 - N1)
= stock selection performance

+ sector selection performance
Note that the notation used here differs from that used in Sections 4.2 and 4.3. As there
is no standard notation, the exact notation used when answering an actual exam
question does not matter, provided your answer is set out clearly so that the examiner
can see exactly what you are doing. If the examiner can follow your calculation easily,
then he or she will be able to award you method marks even if your final answers are
not entirely correct.
Question 15.13
Recall that in Example 1 in Section 4.3 we used the notation FNN , FAA and FAN for
the actual and notional fund values at the end of the year. How do these relate to the
F , N1 and N 2 used in the Core Reading?
The stock selection performance can, if required, be subdivided into that from
equities and that from gilts, eg if F is made up of F E equities and F G gilts and
N2 is made up similarly of N2E and N2G then:
F - N2 = (F E
) (
- N2E + F G - N2G )
= equity stock selection performance
+ gilt stock selection performance
So, for Example 1 in Section 4.3 above, recall that on pages 17 and 18 we split out the
stock selection performance as follows:
 Equity stock selection performance = 61.9 – 62.865 = –0.965m
 Fixed interest stock selection performance = 6.2 – 5.416 = +0.784m
 Property stock selection performance = 10 – 9.805 = +0.195m
These three components sum to the total stock selection performance of +0.014m.

An alternative method of splitting the stock and sector selection components of

relative performance is to substitute for N2 the value of the fund that would have
been attained if the actual stocks selected were held but the sector proportions
were the same as the benchmark. The two methods will give slightly different
answers because the two methods are effectively assuming different weights on
the two components that make up the total relative return.
In practice, the method most commonly used by investment performance

analysts involves the following approach:
 the first method outlined above, ie splitting overall performance into stock
and sector performance using an intermediate fund based on actual sectors and
notional stocks
 calculating percentage returns rather than monetary amounts
 attributing the sector and stock selection profits to each of the asset
classes, rather than to aggregate categories – we will consider this in detail
in the next section.
So, this is the approach the examiners are likely to want you to follow!
A good example of what the examiners expect can be found in the Examiners’
Report to the examination paper for ST5 April 2006, Question 5.
Section 4.5 of this chapter includes a simple example to illustrate this approach.
The technique can be adapted to investigate the influence of other factors

thought to have a bearing on overall performance. However, there must be a
benchmark against which the particular element of “style” which is of interest
can be judged.
For example, where a fund includes investment in both domestic and overseas equities,
the attribution analysis could breakdown any under-performance or over-performance
as compared to the appropriate benchmark into three elements:
1. stock selection profit
2. sector selection profit
3. currency selection profit.
Question 15.14
What do you think is meant by each of the above terms in this case?

4.5 Attributing stock selection and sector selection profits
Introduction
We can sometimes go further in our performance attribution than Example 4.1 suggests.
In particular, having split out the overall performance between stock selection and
sector selection performance, we can then split each of these in turn into the
contribution from each of the asset classes involved. We will illustrate this by means of
a simple example involving the returns over a single year on a fund invested only in
equities and bonds. The approach illustrated here extends naturally to a fund invested
in more than two asset classes.
Example 2
The data used is presented in the following table.
Actual fund Benchmark fund

Asset
class Asset Return Asset Return
allocation allocation
Equities 80% 15% 50% 10%
Bonds 20% 4% 50% 5%
Question 15.15
Estimate the overall out-performance of the actual fund and show that this can be split
into stock selection profits and sector selection profits of +3.8% and +1.5%
respectively.
Split of stock selection profit
As suggested above, we can split the total stock selection profit of 3.8% (from the
solution to Question 15.15) between the individual contributions of equities and bonds.
Recall that the figure of 3.8% is derived by considering the difference in performance
between:
 the actual fund (actual sectors and actual stocks), and
 a notional fund based on the actual sectors and notional stocks.

Thus, to determine the contribution of each asset class to the overall stock selection
profit we calculate:
actual sector weight  (actual sector return – notional sector return)
So, in this instance and given that the actual equity weighting was wEA = 80% , the
contribution of equities to this total stock selection profit is given by:
wEA ¥ (rEA - rEN ) = 0.8 ¥ (15.0 - 10.0) = +4%
Likewise, the contribution of bonds is given by:
wBA ¥ (rBA - rBN ) = 0.2 ¥ (4.0 - 5.0) = -0.2%
So, the two individual contributions sum to the total stock selection profit of 3.8%. In
this instance, the actual equities chosen out-performed the equity index by 5%, which
given the actual equity weighting of 80%, produced the equity contribution of 4%.
Similarly, the actual bonds under-performed the bond index, so producing a negative
contribution to the total stock selection profit.
Split of sector selection profit
In addition, recall that the total sector selection profit of 1.5% is derived (in the solution
to Question 15.15) by considering the difference in performance between:
 a notional fund based on the actual sectors and notional stocks, and
 the benchmark fund (based on notional sectors and notional stocks).
Thus, to determine the contribution of each asset class to the overall sector selection
profit we calculate:
(actual sector weight – notional sector weight)

 (notional sector return – overall benchmark return)
So, here the contribution of equities to the total sector selection profit is:
( wEA - wEN ) ¥ (rEN - rNN ) = (0.8 - 0.5) ¥ (10.0 - 7.5) = +0.75%
This figure reflects the fact that the equity index out-performed the overall benchmark
fund by 2.5%. Given that the fund was 30% overweight in equities, this sector choice
contributed +0.75% to performance. Here we have used the notional returns in order to
strip out any effect due to stock selection.

The corresponding calculation for the contribution of bonds to the sector selection profit
gives:
( wBA - wBN ) ¥ (rBN - rNN ) = (0.2 - 0.5) ¥ (5.0 - 7.5) = +0.75%
In this instance, the individual contributions to sector performance are the same because
the benchmark was chosen to be a 50%/50% split. More generally, they are likely to be
different. Additionally, although splitting the sector selection performance may seem
fairly pointless here (because an overweight position in equities implies an underweight
position in bonds), the analysis becomes much more useful when there are three or
more sectors are involved – as may be the case in the exam.
Finally, although this is the approach that has been taken by the examiners in recent
exam papers, these types of calculation can equally be carried out to split out the total
stock and selection profits estimated using the alternative method described on page 21.
The formulae used will then need to be adjusted accordingly and different answers to
those just calculated will be obtained.

5 Risk-adjusted performance measures

The measurement of the investment performance of portfolios usually
concentrates on the return, often relative to some benchmark. However, in order
to get a true picture of performance we also need to pay attention to the risk
dimension.
This is because the investment return achieved will typically depend on the risk
incurred by the investor.
MPT and the CAPM give us a framework for doing this.
The risk-adjusted performance measures are not very commonly used in the UK
but their use is more widespread in the USA. One problem with the measures
described below is that they only allow for risk defined in terms of variance of
return and do not allow for actuarial risk or downside risk.
Question 15.16
What do you think are meant by actuarial risk and downside risk?
The appropriate measure of risk for an investor to use, within the MPT
framework, depends on whether the portfolio being considered represents all his
assets or just a part of them. Where the portfolio represents the whole of the
investor’s wealth the appropriate measure is the standard deviation. If it is a
subset of his assets, the appropriate measure is the portfolio beta.
The reason for this is that the beta of a portfolio is a measure of its risk relative
to a well-diversified portfolio and adjusting the return using beta tells us how
good the manager is at picking out-performing securities, given the level of
systematic risk assumed. Using standard deviation to adjust the return allows
us to measure how well-diversified the whole portfolio is as well as how good
the manager is at individual stocks that produce an excess return relative to their
betas.
The measures that interpret risk in terms of the standard deviation are based on the
capital market line equation, which applies only to efficient portfolios. Recall that the
CAPM suggests that a rational investor should hold a well-diversified portfolio of risky
assets (the market portfolio in fact) that is efficient.
In contrast the measures that interpret risk in terms of beta are based on the security
market line equation, which applies to all portfolios, efficient or otherwise. In
particular, it will apply to subsets of any efficient portfolio, which need not by
themselves be efficient.

Four risk-adjusted return measures can be specified according to whether beta

or standard deviation is the appropriate measure of risk and according to
whether the required level of risk is pre-specified or not.
5.1 The Treynor measure
This is a measure of reward per unit systematic risk defined as:
Rp - r
T =
bp
where:
 Rp is the return on the portfolio
 r is the risk free rate of return over the period
 b p is the systematic risk of the portfolio.
5.2 The Sharpe measure
This is similar to the Treynor measure but uses standard deviation:
Rp - r
S =
sp
where s p is the standard deviation of the portfolio, and the other terms are as
defined above.
The Treynor and Sharpe measures measure out-performance compared to the CAPM
per unit risk, ie as a proportion of the return predicted by the CAPM. They can
therefore be used to compare investment managers who have taken differing levels of
risk.
5.3 The Jensen measure
Where risk is pre-specified the appropriate measure is the return relative to a

benchmark portfolio with the same degree of risk. If beta is the appropriate risk
measure, the expected return Rb on the benchmark is given by the CAPM as:
Rb = r + b p (Rm - r )
where Rm is the return on the market portfolio.

The Jensen measure is:
J  R p  Rb
5.4 Pre-specified standard deviation
If the standard deviation of the portfolio return is pre-specified the return on the
benchmark portfolio is given by:
Rm - r
Rb = r + sp
sm
and the differential return measure is Rp - Rb .
These last two measures therefore measure out-performance compared to the CAPM in
terms of the absolute amount by which the actual return exceeds that predicted by the
CAPM at the pre-specified level of risk.
Question 15.17
What is the beta of a stock?

6 Uses of performance measurement

There are various reasons why the performance of an investment portfolio will
be measured.
To improve future performance
First, data collected during performance monitoring can form the inputs for
planning future strategy, ie by finding out what has been successful in the past,
investors should be better able to determine what might perform best in the future.
Secondly, if fund managers know that their performance is being measured, it

might give them an extra incentive to maximise the returns of the funds they
manage.
Comparison of the rate achieved against a target rate
Many funds will have one or more “target” rates of return. For example, the
trustees of a pension fund will want to know the rate of return achieved on the
investments compared with the rate of return assumed in the actuarial valuation.
Similarly, the actuaries and managers of a life insurance company will need to know
what rate of return has been achieved on the fund compared with the rate assumed in
premium rate, bonus distribution and reserve calculations.
Comparison against the performance of other portfolios, an index

and/or a benchmark portfolio
Those responsible for the funds will want to know how the performance of the
portfolio compares with other portfolios. On the basis of this information, they
are able to make decisions regarding the future investment of the assets,
eg should a new fund manager be hired?
Also, by analysing the performance against a notional portfolio, it may be

possible to identify some relative strengths and/or weaknesses of individual
fund managers (eg in sector or stock selection).
There may also be other factors that depend on the performance of the fund. For
example, the fees paid to the fund manager may be linked to the performance of the
fund.

These reasons have been given as if from the viewpoint of those responsible for the
management of a fund. Similar reasons can be devised from other perspectives. For
example, fund managers (eg unit trust managers) will want to advertise the good rates
of return they have achieved.
Question 15.18
For each of the second and third of the first 3 key reasons for measuring the
performance of a portfolio given above, state the type of calculation you would carry
out.
To appraise and remunerate investment managers
Following from the above, performance measures can be used in the appraisal
and remuneration of managers.

7 Limitations of performance measurement

There are several limitations and disadvantages of portfolio performance
measurement.
Projection of past results
The fact that a particular result was attained in the past does not mean that it will
occur in the future. There is a random element in investment returns and it may
be difficult to determine how much a fund manager’s results are due to method
and how much to luck. Furthermore a technique that proved successful in a
particular set of circumstances may not work so well in changed circumstances
in the future.
So, past performance may be a poor guide to the future and it may not be easy to
distinguish good luck from skill.
Risk
In the long term we would expect a riskier strategy to produce higher average
returns. The measurement of relative performance should therefore take
account of the degree of risk taken on by a fund manager.
When a fund manager invests largely in high-risk investments, there are likely to be
implications for the relative performance of the fund manager in performance
measurement tables:
 In the very long term, the manager should achieve a higher rate of return.
 In short-term periods, the results will probably be more volatile. There may be
some periods of excellent results and other periods of very poor results.
So, a fund manager who takes a high-risk strategy could quite easily appear at the top of
both the short-term and long-term performance tables. But, because high levels of risk
may be undesirable for some funds, users of the performance tables will want to be able
to identify those fund managers who have generally invested in high-risk investments.
Beta values can be used as one indication of the level of risk (in the traditional sense of
variability of return) of a portfolio. They provide a useful insight into how different
portfolios may have performed and may be used to construct risk-adjusted performance
measures, as outlined in Section 5 above.

Timescale
Determining the frequency of performance measurement calculations requires a

delicate balance between assessing performance frequently enough so that
problems can be spotted and corrected and avoiding spurious conclusions
based on too short a measurement period.
It might take five years to obtain data that gives a reliable verdict on a particular fund
manager. However, the trustees of a pension fund should not have to wait for five years
before they realise that the assets are being poorly managed.
In practice, many pension fund investment valuations are carried out each quarter, with
analyses over a variety of periods (eg 3 months, 1 year, 3 years, 5 years, 10 years).
The users of these analyses therefore have:

 the regular data they need to stay informed
 the longer-term data to help make judgements.
They should resist the temptation of making bold conclusions from the very short-term
data.
Differing fund objectives
Different funds may have different objectives and constraints. Comparisons

between such funds may not be valid.
The main difference will often be that the liabilities underlying one fund may differ
from those underlying another. There may also be other reasons why different funds
cannot be directly compared:
 different constraints imposed by the directors or trustees
 different taxation positions (eg this may apply for insurance companies where
the tax positions may vary from one office to another).
Comparisons between different unit-linked funds and collective investment vehicles is

clearly sensible only if they have similar investment objectives.
You may also come across “different cashflow” and “different size of fund” as reasons
why different funds cannot be validly compared. In practice, these two factors should
not really invalidate comparison between the investment returns achieved by different
portfolios.

Impact on fund manager behaviour
Knowledge of how and how often he will be assessed is likely to influence the
investment strategy of a manager. This may not be in the fund’s best interests.
For example, frequent monitoring can encourage a short-term approach to
investment.
Some people will argue that this may mean that the long-term performance of the fund
could be sacrificed. Others would argue that it is not a problem because the long run is
simply a series of short runs.
More generally, the investment management decisions should be driven entirely a desire
to meet the investor’s objectives. It is therefore important to ensure that the mandate
given to the investment manager is consistent with the investor’s objectives (as was
discussed in Chapter 9).
Cost
Users of performance measurement services must balance the value of the

service against the cost. Also, for a number of assets (eg property), valuation is
difficult, time-consuming and very subjective. Detailed, frequent calculations
based on subjective valuations are inappropriate.
Question 15.19
A pension fund hires two different fund managers. Manager A looks after the fixed
interest investments. Manager B looks after the equity investments.
All funds and net cashflows are split in the proportion 1:2 between A and B.
In a given year, A achieves an internal rate of return of 12%, while B achieves 8%.
What conclusions would you draw?

8 Relative merits of different ways of assessing portfolios
8.1 Performance relative to published indices
The main advantage of assessing the performance relative to published indices

is that it is relatively easy to do. By definition, the data for published indices is
readily available - and it should be reliably accurate.
However, this advantage can be easily outweighed by a major potential

disadvantage: the published index might not be appropriate. There may be no
single index which is consistent with the objectives of the investor.
For example, comparing the returns achieved by a life insurance company’s with-profit
fund with the returns achieved from an index holding of domestic equities will not be
appropriate because the objectives and constraints imposed on the insurance company
would probably make a 100% holding in domestic equities inappropriate.
8.2 Performance relative to other portfolios
This type of comparison is appropriate if the funds being compared have the
same objectives and the same factors influencing investment strategy. It also
gives an indication of the cost or benefit of following a particular strategy,
relative to that adopted by other funds.
For example, considering pension funds, it would be quite sensible to compare the
returns achieved by different pension funds where the:
 funds have the same liability profile (by type and term)
 funds have similar levels of solvency
 funds are of similar size
 fund managers have been given similar levels of freedom by the trustees (or at
least, similar instructions)
 fund managers have adopted the same level of risk
 funds have similar levels of cashflow (although use of time-weighted rate of
return should mean that differences will not invalidate comparison).
Taken to these extremes, you may find that, for each pension scheme, there are very few
other pension schemes that can be used for a valid comparison. In practice, the
comparisons tend to be driven more by what data is available.

However, it may be totally inappropriate to compare the performance of funds

that have very different investment objectives, eg insurance company with-profit
funds because:
 there is generally more variation in the type and term of liabilities
 the investors may have quite different tax positions
 the data is generally not widely available.
Overall, performance measurement relative to other portfolios is not ideal.
8.3 Performance relative to a benchmark portfolio
Benchmark portfolios can be constructed to reflect the objectives of the fund.

They should also be constructed in such a way that the data necessary for
comparisons is easily obtained.
They can therefore overcome the problems we identified with the other two forms of
comparison.
By having a benchmark portfolio that reflects the liabilities of the fund, the
danger of giving the fund manager conflicting objectives is also avoided. This
would occur where the basis for assessment encourages the fund manager to
adopt a strategy that is not necessarily consistent with the objectives of the
fund.

Chapter 15 summary
Rates of return
When calculating rates of return, take extra care with:

 the timing and size of all cashflows
 differentiating between investment income and new money
 tax and expenses.
The money-weighted rate of return is found by equating the present value of the money
in with the present value of the money out. It is affected by the timing and size of
cashflows.
The time-weighted rate of return is found by linking the rates of return for each inter-
cashflow period. It is not affected by the size or timing of cashflows.
The linked internal rate of return is a practical approximation for the time-weighted rate
of return. It is found by linking the internal rates of return calculated over short periods.
Assessing portfolio performance
Notional funds, based on an index or on weightings of several indices (ie a benchmark

portfolio), can be used as a yardstick to assess the performance of a particular portfolio.
The benchmark portfolio can be used to determine the sector and stock selection profit
achieved by a portfolio. This is done by producing a hybrid notional fund based on the
actual sectors and the notional stocks.
Sector selection profit arises from differences between the fund’s choice of proportions
in the various sectors and the proportions in the benchmark portfolio.
Stock selection profits arise when the selected stocks within a particular sector perform
better or worse than the sector as a whole.

Risk-adjusted performance
Risk can be allowed for in the assessment of investment performance through measures
based on portfolio beta or through measures based on the standard deviation of return.
Examples of risk-adjusted performance measures include:
Rp - r
 the Treynor measure: T =
bp
Rp - r
 the Sharpe measure: S =
sp
 the Jensen measure: J = R p - ÈÎ r + b p ( Rm - r )˘˚
È R -r ˘
 the pre-specified standard deviation: R p - Í r + m s p˙
Î sm ˚
Uses and abuses of portfolio measurement
The main uses of performance measurement are to:

 help improve performance
 compare actual performance against target rates
 compare actual performance against a benchmark portfolio or other portfolios.
 appraise and remunerate investment managers
The limitations of performance measurement include:

 the past may be a poor guide to the future
 the difficulty of allowing for risk
 the possibility of spurious and/or misleading results if invalid comparisons are
made or time periods that are too short are considered
 different fund may have differing objectives
 measurement may influence the actions of fund managers in ways that are
inconsistent with the fund’s long-term objectives
 it adds to the cost of investment.
Comparisons against benchmark portfolios are generally more appropriate than

comparisons against a single index or against other funds. Benchmark portfolios can be
made to be consistent with the overall objectives of the fund.

Solution 15.1
In this formula:
 V0 is the market value of the fund at the beginning of the period
 VT is the market value of the fund at the end of the period
 Ct is the net cashflow into the fund (excluding investment proceeds) at time t
 i is the money-weighted rate of return.
Solution 15.2
The money-weighted rate of return for Manager A is given by:
10 ¥ (1 + i ) - 5 ¥ (1 + i ) = 7.5
½
ie i = 33%
The money-weighted rate of return for Manager B is given by:
10 ¥ (1 + i ) + 5 ¥ (1 + i ) = 22.5
½
ie i = 61%
Both managers adopted the same, equally successful, strategy. Yet B achieved a far
better money-weighted rate of return. The reason for this was that B was “lucky” in
being given a positive cashflow to invest just before the market took off, whilst A was
“unlucky” in having to disinvest at that time.
Comparing the two managers on the basis of money-weighted returns is not appropriate.

Solution 15.3
No. Money-weighted rates of return will give figures that might be reasonable as a
basis for comparison if either of the following conditions applies:
 there are no large cashflows in the valuation period
 the rates of return during the period remain stable (ie there are no great
fluctuations in market values during the period).
Money-weighted rates of return are not suitable when there are large cashflows (relative
to the overall funds) at times when asset values are unusually high or low.
Solution 15.4
The TWRR can be found from:
Vt1 Vt2 VT
(1 + i )T = ¥ ¥ ... ¥
V0 Vt1 + Ct1 Vtn + Ctn
where:
 V0 is the market value of the fund at the beginning of the period
 VT is the market value of the fund at the end of the period of T
 Ctr is the net cash inflow, excluding investment proceeds, at time t r
 Vtr is the market value of the fund at time tr just before the cashflow
 i is the time-weighted rate of return.

Solution 15.5
Time-weighted rate of return for A is given by:
10 7.5
(1 + r ) = ¥ = 1.50
10 10 - 5
ie the time-weighted rate of return is 50%
Time-weighted rate of return for B is given by:
10 22.5
(1 + r ) = ¥ = 1.50
10 10 + 5
ie the time-weighted rate of return is 50%
Both managers achieved the same rate of return. This is as expected, given that both
managers achieved the same investment performance return for each six-month period.
Solution 15.6
The conditions for linked internal rate of return being a good approximation to the time-
weighted rate of return are:
 cashflows small relative to the size of the fund, or
 rate of return very stable over each inter-valuation period.
Note that the two rates will be identical if the valuations occur on the same date as the
cashflows.
Solution 15.7
MWRR gives the rate of return actually achieved by an investment or portfolio. It is

not good as a basis for comparing portfolios because the rate can be distorted by the
size and timing of cashflows.
TWRR is unaffected by cashflows, so it is good as the basis for comparisons between

funds and over time. It does not give the rate actually achieved, and it is potentially
impractical if cashflows are frequent or if valuation is difficult.
LIRR is a practical approximation for the TWRR. The main downside is that it does
not give the rate of return actually earned on the assets over the period.

Solution 15.8
Comments about the performance of the portfolio
Not much! We do not have enough information to make any form of comment on the
performance of the portfolio.
Further information
 timing and size of cashflows

 the level of the index at the dates the cashflows occur
 the amount of investment income that would have been earned by investing in
the index
 the taxation basis of the investor, and hence the tax that would have been
incurred by investing to track the index including any change in outstanding tax
liability over the year.
 the expenses that the investor would have incurred by investing to track the
index
. . . and further information to enable comment on the figures:
 the “riskiness” of the investments held by the investor

 the appropriateness of the “index” for the investor
 the value of the portfolio at regular intervals over the year.
Solution 15.9
The notional fund at 1 October would be:
1,970 0.040
49.711 ¥ ¥ (1 + 0.80 ¥ ) = $51.574m
1,914 4
And at the start of the next year, the notional fund would have grown to:
2, 090 0.038
51.574 ¥ ¥ (1 + 0.80 ¥ ) = $55.131m
1,970 4

Solution 15.10
Internal rate of return for the actual portfolio is given by the solution to:
47 ¥ (1 + i ) + 4 ¥ (1 + i )0.5 = 57 i = 12.2% pa
Internal rate of return for the notional fund is given by the solution to:
47 ¥ (1 + i ) + 4 ¥ (1 + i )0.5 = 55.131 i = 8.4% pa
Solution 15.11
Assume that:
 We can ignore taxation, eg that the fund is gross and that the market data is also
gross.
 We can ignore expenses, eg the quoted market returns are net of investment
expenses.
 The “market” is an appropriate index.
The fund split 50:50 and invested in the same way as the whole market would have
given:
2 ¥ 1.23 + 2 ¥ 1.15 = 4.76
The fund split 2.5:1.5 and invested in the same way as the whole market would have
given:
2.5  123
.  15
.  115
.  4.80
 The stock selection profit = 5.10 – 4.80 = £0.30 million

 The sector selection profit = 4.80 – 4.76 = £0.04 million
 The total out-performance is £0.34 million
Solution 15.12
We already know that the actual fund has an end value of $78.10m and the notional
fund has an end value of $77.716m. Neither of these figures will alter when we use the
alternative method of calculating the sector and stock components.

We now need to do the other notional fund, which is based on the notional asset split
(50/30/20) and the actual stocks chosen. From the table of the actual portfolio values
during the year, we can assess the actual performance of the individual stocks. These
are used to determine the notional value of the fund based on notional sectors and actual
stocks:
Ê 51.1 61.3 ˆ 61.9

Equity: ÁË (70 ¥ 0.5 ¥ + 10 ¥ 0.5) ¥ - 5 ¥ 0.5˜ ¥
¯ 61.3
= 38.779
50.0 61.1
Ê 10.8 11.0 ˆ 6.2

Fixed interest: Á (70 ¥ 0.3 ¥ + 10 ¥ 0.3) ¥ - 5 ¥ 0.3˜ ¥ = 25.477
Ë 10.0 10.8 ¯ 6.0
Ê 10.3 10.2 ˆ 10.0

Property: ÁË (70 ¥ 0.2 ¥ + 10 ¥ 0.2) ¥ - 5 ¥ 0.2˜ ¥
¯ 10.2
= 14.961
10.0 10.3
Total ( FNA ): 38.779 + 25.477 + 14.961 = 79.217
The actual portfolio value at the end of the year is $78.10m. Therefore:
 the sector selection profit is –$1.117m (ie 78.10 – 79.217)
 the stock selection profit is $1.501m (ie 79.217 – 77.716).
These two total to the overall out-performance of $0.384m.
Our conclusion is that the fund manager did poorly by moving away from the
recommended asset split, but more than compensated for this by good stock selection.
We can further sub-divide the stock selection into the profit or loss from each sector:
 loss from equity stock selection = 38.779 – 39.385 = –$0.606m
 profit from fixed interest stock selection = 25.477 – 23.635 = $1.842m
 profit from property stock selection = 14.962 – 14.696 = $0.265m.
Solution 15.13
The two sets of notation are related as follows:

 FAA = F
 FAN = N 2
 FNN = N1

Solution 15.14
Stock selection refers to under-performance or over-performance resulting from the

selection of individual stocks as opposed to the appropriate indices specified by the
notional portfolio.
Sector selection refers to the choice of sectors, including countries – eg for an

international equity fund, this might refer to UK equities, US equities, Japanese equities
etc.
Currency selection refers to the choice of currencies in which the fund is invested,
ie UK sterling, US dollars, Yen, Euro etc. It should be possible to remove (much of)
the effects of any currency appreciation by hedging using currency futures and
forwards. Thus, a UK fund should be able to invest in US equities whilst avoiding
exposure to changes in the value of the US dollar. As the fund is thus able to
effectively choose the currencies in which it invests, independently of the countries in
which it chooses to invest, we can isolate the element of investment performance due to
currency choices alone.
Solution 15.15
In this simple example, the benchmark fund performance is equal to:
rNN = 0.5 ¥ 1.1 + 0.5 ¥ 1.05 = 1.075, ie 7.5%
In addition, the actual fund performance is equal to:
rAA = 0.8 ¥ 1.15 + 0.2 ¥ 1.04 = 1.128, ie 12.8%
So, the overall out-performance is given by:
rAA - rNN = 12.8 - 7.5 = +5.3%
We can attribute the overall out-performance between stock and sector selection by
calculating the return on a notional fund based on the actual sectors and notional stocks.
The return on such a notional fund is equal to:
rAN = 0.8 ¥ 1.1 + + 0.2 ¥ 1.05 = 1.09, ie 9.0%

So, the stock selection profit is given by:
rAA - rAN = 12.8 - 9.0 = +3.8%
And, the sector selection profit is given by:
rAN - rNN = 9.0 - 7.5 = +1.5%
Solution 15.16
Actuarial risk refers to the risk of failing to meet the investor’s objectives. In practice,
it often refers to a failure to meet liability payments as they fall due.
Downside risk refers to the risk of failing to achieve a specified or target rate of return.
The variance of investment return is an inappropriate measure of investment risk if
investors are more concerned with downside than upside risk, as it gives the same
weighting to both.
You may recall the discussion of downside risk measures in Subject CT8. We discuss
such measures further in Chapter 16 of this course.
Solution 15.17
Beta can be defined as a measure of a stock’s volatility relative to movements in the

whole market. It is usually calculated as the covariance of the return on the stock with
the return on the market, divided by the variance of the market return.
Solution 15.18
To find the actual rate of return achieved (ie for comparison with the assumed rate,
salary increases, or inflation), use the money-weighted rate of return.
To compare against other portfolios, use the time-weighted rate of return, or the linked
internal rate of return as an approximation to it. You could also compare against a
benchmark index or benchmark portfolio.

Solution 15.19
Hopefully you would not draw any conclusions!
To assess the performance of each manager, we would need to compare A with fixed
interest funds and B with equity funds over the year. Even then we would need to be
careful because each manager may have had specific instructions within their own
sectors.





the course.

Chapter 16
Performance measurement (2)
Syllabus objectives
(l) Analyse the performance of an investment and discuss the limitations of such
measurement techniques:
 portfolio risk and return analysis
 equity price
 net present value
 net asset value
 risk-adjusted return on capital.
0 Introduction
This short chapter considers a number of further ways of measuring investment
performance. More specifically, it considers how to assess the performance of:
 a portfolio of assets
 an individual asset
 an individual company.
In doing so, it builds on the discussion of performance measurement in the previous

chapter of this course.

1 Portfolio risk and return analysis
1.1 Assessing fund performance
Portfolio risk and return analysis involves plotting the overall time-weighted
return from a portfolio over a period against the “riskiness” of the portfolio. The
portfolio is then compared to its peer group and to simulated portfolios such as
median trackers.
The diagram below shows the results of plotting average annual investment return
achieved over recent periods against the corresponding risk measured in terms of
standard deviations of returns for a group of 30 portfolios. Ideally we would like to
achieve a higher return and a lower risk than the alternative portfolios. Here Portfolios
A, B and C appear to have produced the best results in terms of high return and low
risk.
average annual
return, % C
+
B
+ + +
A + +
++
+ +
+ + +
+ + +
+ +
+
+ + +
+ +
+ +
+ +
0
+ + standard deviation
of annual return, %
Figure 16.1: Risk v return analysis chart
The riskiness can be measured by the standard deviation of returns over historic
sub-periods. One method is to consider the volatility implied by derivative
contracts on the markets and individual stocks in which the portfolio is invested.

The standard deviation of monthly, quarterly or annual returns is often used in practice.
The use of standard deviations is consistent with the capital asset pricing model, but
other measures or interpretations of risk could equally be used. In practice a
combination of several different measures might be used to assess risk.
Question 16.1
Explain what is meant by the implied volatility of a derivative.
The aim is to help assess the investment manager by ascertaining if superior

performance has been obtained by taking more risk or by superior market and
stock selection/timing, and conversely for inferior performance.
Investment performance is a function of both return and risk, so a true and fair
assessment of investment performance needs to allow for both factors. One way of
doing this is to use risk-adjusted performance measures, examples of which were
described in the previous chapter. These aim to quantify the under- or out-performance
after removing the influence of either total risk as measured by the standard deviation,
or systematic risk as measured by beta.
A further alternative is the information ratio described in Chapter 21 of this course.
Hirers of investment managers would not want excessive risk to be taken.

However this is difficult to enforce in real time. In practice, control over risk may
be achieved by guidelines on the asset allocation and stock weightings, and
perhaps by specifying a maximum under-performance over specified periods.
Thus, the investment managers might be told that the benchmark equity allocation over
the next year is 50% of the total fund, but that they are permitted to deviate from this
benchmark by up to 10% of the total fund size in either direction. Alternatively, the
limits for departures from the benchmark might be expressed as a percentage of the
benchmark allocation to the particular asset class, which has the advantage of
permitting a smaller absolute variation in the lower weighted asset classes.
Limits expressed in this way are sometimes referred to as load differences and load
ratios. We will discuss them further in the next chapter.

Alternatively, the investment manager may be instructed that the investment return over
any particular period cannot:
 be less than a specified absolute figure
 fall below that of the average of the peer group by more than a specified
percentage.
Downside measures of risk such as the downward semi-standard deviation mentioned in

Chapter 21 might be of use here. The expected shortfall and shortfall probability
measures described in Subject CT8 might also be used – the latter indicating the
frequency with which under-performance occurs.
Question 16.2
What is the shortfall probability?
1.2 Implementing risk controls
If the results of a risk and return analysis are discussed with investment
managers at six monthly intervals, then there will be some measure of control,
as it is reasonable to assume that, if only because of dealing costs, the portfolio
will not be radically changed over such a period.
The dealing and other costs associated with a large change in asset allocation are
discussed in detail in Chapter 22 later in this course.
Some problems with relying on this approach are:
 Creeping change in portfolio composition. A portfolio may change every

six months by an amount which is not of concern each time but which is
significant in total. More risky stocks may be included which do not
immediately show up in the standard deviation of returns.
This is because the standard deviation will be calculated as an average over a
period of time longer than the last six months. Hence it will take some time for
any creeping change in the overall volatility of the portfolio to show up in the
data.
 A successful investment manager may be treated unfairly by the

measurement system. For example, the manager may be skilled in
selecting the good stocks amongst those which the market views as risky,
as measured by the implied volatility in the prices of derivative contracts.
Or he may be skilled at selecting stocks and markets that will be volatile
but will grow over the period.

Hence, just because a manager has chosen a high-risk portfolio that has recently
under-performed does not mean that he is performing badly. If the ultimate
return turns out to be better than that required on such a risky portfolio, then he
has done well. A sensible measurement system therefore needs to reflect the
skills of the manager it is being used to assess.
 The manager may disagree with the market view of a stock’s or market’s
prospects and/or the uncertainty attached to those prospects. Market
prices are a result of a pricing process which is likely to result in 50% of
investors viewing a price as too low, and 50% viewing it as too high.
Perhaps only very few professional investors will see a particular market
price as roughly fair.
Likewise, the implied volatility of a share is set by the market, which may not be
100% rational. Thus, even if the manager’s portfolio has a high implied
volatility, it does not necessarily mean that it will actually experience high
volatility in the future.
It is hard to determine which of the above applies to an investment manager.

Ultimately it is important that the manager can demonstrate a realistic and
convincing rationale for investment decisions.
So asking the investment manager what she has done and why is as important as
quantifying exactly what the consequences have been in terms of investment
performance. The investment performance over a short period of time might have been
disappointing even though the manager pursued an entirely sensible investment
approach. Equally, good performance could be due to luck rather than sensible
investment decisions.
It is likewise sensible discuss the investment manager’s ongoing approach at the start of
each investment period.
Question 16.3
Name the four risk-adjusted performance measures discussed in the previous chapter of
this course.

2 Valuation and performance of equity investments
2.1 Using market price
The most obvious way to measure the performance of an individual equity investment is
via changes in its market price.
As the market price is the yardstick by which an equity investment would usually
be regarded as a success or failure, it is hard to argue that it has real limitations.
However, there are some refinements which should be considered:
 It is the total return that is of interest to an investor and so dividend

income must be allowed for.
 It may be that an equity price is influenced by short-term concerns

whereas many investors are more focussed on the long-term. However
on the other hand the long term is clearly uncertain. An equity price
represents the market’s best estimate of the value of future cashflows to
the average investor. If this estimate can move significantly over the
short term, it is because some item of news has changed the market’s
estimate of long-term cashflows or from movements in the market price of
risk.
Best estimates of the value of long-term cash flows do change over the short-
term because of the uncertainty attached to long-term estimates and the flow of
potentially significant news items. The only alternative path for share prices
would be long periods of stability punctuated by discontinuous jumps. Thinly
traded shares tend to behave more like this than shares that are more liquid.
A separate point is whether decreases or increases in share prices should, in

themselves, be part of the control process. This is basically an investment
management call rather than a matter for automatic reaction. Typically markets
go through periods of several years in which underperformers and
outperformers frequently reverse their relative performance, and then go through
other periods when over- or under-performance can be very persistent. The first
sort of market tends to favour “value” investors whereas the second favours
“growth” investors.
Question 16.4
What are value investors and growth investors?

2.2 Using net present value
Absolute net present value
The net present value of an investment depends on many assumptions, which

can result in a wide variety of results. The absolute result from an estimate of
net present value may therefore be of limited use.
Different assumptions regarding future cashflows and the risk discount rate will lead to
different estimates of the net present value at any point in time. In addition the
corresponding changes in net present value estimates through time will be different.
The estimated net present value of an asset will also typically differ from the market
price where there is one. This is because the assumptions underlying the net present
value estimate (eg with regard to future earnings growth) will generally differ from
those implicit within the market price.
It is important to investigate where the assumptions differ from those implied by

the market price, since the market price represents a best estimate of present
value. It is, in a very approximate sense, an “average” of investors’ estimates of the net
present value of the asset, reflecting the average of investors’ views on future
cashflows, investors’ risk tolerances, investors’ tax positions, etc.
However a particular investor may have different risk, or perhaps tax,

considerations to those which drive the market price. Differences between the
market price and an investor’s estimate of net present value can derive from:
1. differences between a particular investor and the average investor, eg with

regard to their attitude to risk or their tax position
or:
2. other differences in assumptions. Different investors will always have

differing expectations with regard to the future cashflows (profits, dividends,
rents, etc) yielded by a particular asset. Thus, two otherwise identical investors
may come up with different estimates of the value of an asset. These are part
of the range of value estimates that give rise to the current market price.
It would be justifiable to allow for 1, if the differences could be identified reliably.

Allowing for 2 involves the investor in active investment management.

Changes in net present value over time
The trend of net present value estimates, and in particular their relationship to
market prices, may be helpful. For example if large differences between net
present value estimates and market prices tended to diminish over time, then the
model used to estimate the net present values would be a helpful way of
assessing cheapness/dearness of stocks or markets.
If the difference diminishes over time, this suggests that the net present value estimate
has been proved to be “correct”. We might therefore assume that any existing
differences will likewise diminish in the future and so buy shares for which the market
value is currently less than the net present value.
2.3 Using net asset value
The net asset value of a company, or the net asset value per share, is only one
component of overall value. Typically, the majority of the value of a company arises
from the future profits that it is expected to generate.
So, if other things are equal, a share with a higher proportion of its share price
represented by net asset value should be cheaper than a share that has less
asset backing.
However, other things are unlikely to be equal as the market will, in both cases,
be attaching a full value to all future cashflow, including that resulting from
holding all existing assets and liabilities.
The net asset value is an accounting number, so it is important to understand

how it has arisen and to make appropriate adjustments.
For example a company that has expanded by acquisition will have acquired
goodwill on its balance sheet, which will form part of its net asset value. A
similar company that has only grown organically will appear to have a lower net
asset value per share. Generally, goodwill will have to be removed in order to
make valid comparisons.
The goodwill, referred to here, represents the excess of the value paid for a subsidiary
company over the value to the acquiring company of the share of the assets purchased.
Some businesses require more assets than do others. For example a

manufacturing business will generally require plant, premises and stock whereas
a service business will typically require less assets. In the latter case, there will
consequently be more “human capital”, which does not appear on the balance sheet. In
addition, some companies will lease assets, whereas others may own them.

Comparisons of net asset value between companies in different sectors may

inform predominantly about the difference between the sectors. Valid
comparisons can therefore generally only be made between companies in the same
sector.
Net assets surplus to those required to run the business may not attract full
value. It is usually regarded as inefficient for a company to hold surplus assets,
and also it is harder to maintain management discipline when there is a
substantial asset cushion.
The role of management is to maximise the earnings from the available assets (on
behalf of the shareholders), ie to “work the assets hard”. If the company has surplus
plant, machinery and stocks then it is easy to cope with variations in turnover and order
levels. Thus, they avoid one of the important management tasks of efficiently
scheduling the use of available assets.
In this context, you may recall the discussion of stock/inventory policy within the short-
term financial planning section of Chapter 6.
Question 16.5
Define net asset value per share.

3 Risk-adjusted return on capital
3.1 Introduction
Here we have in mind the assessment of the performance of a company, rather than an
individual equity or an equity portfolio.
There are many different ways of assessing the performance of a company and in
practice a combination of approaches is used, reflecting the motivation for assessing the
performance. The obvious way to assess performance is perhaps via the profits reported
in the income statement (profit and loss account). However, this doesn’t allow
explicitly for the capital invested in the business to generate those profits. We might
therefore look at measures such as economic value added (net operating profit after tax
less cost of capital). However, this doesn’t allow for the degree of risk involved in the
generation of added value. Consequently, we might therefore decide to estimate some
interpretation of risk-adjusted return on capital.
3.2 CAPM
The CAPM would suggest that the risk-adjusted return on capital should be
equal to the risk-free rate. If capital assets are priced correctly then returns in
excess of the risk-free rate will only be generated from taking risk. The risk-
adjusted return is the actual return, reduced by b (rmarket - rrisk - free ) .
This idea is based on the CAPM security market line, which predicts the returns on
different assets when asset markets are in equilibrium. Here rmarket is the actual return
on the market portfolio, which is often proxied by a market index. Thus, if we are able
to identify both the capital invested in a company and the return generated using that
capital, we can in principle calculate the company’s return on capital. This could then
be adjusted as described above to obtain an estimate of the company’s risk-adjusted
return on capital, which can then be compared with the risk-free rate.
Question 16.6
What is likely to be the main difficulty with using the risk-adjusted return on capital
approach to assess company performance?

Generally a high actual projected return on capital using normal accounting

measures and a starting measure of the market capitalisation, would imply, in
the framework of the CAPM, the successful creation of intangible assets and
shareholder value. The company would therefore be an attractive investment
proposition. Similarly, high historic figures imply historic creation of goodwill
and shareholder value.
Here intangible assets and goodwill both refer to any non-monetary and non-physical
resources that are controlled by the company and from which future economic benefits
(ie cashflows and asset growth) are expected. For example, successfully marketing a
new brand and obtaining new customers both create value, but neither may appear
explicitly on the balance sheet.
Clearly the appropriate b is an area where there can be different views.
Although historical values of beta can always be estimated from past price data, these
estimates will be subject to the usual problems of statistical inference – eg choice of
time period, random variation, etc. When assessing projected returns, however, we
need forward-looking estimates of beta, which must always be subjective.
3.3 Calculation of capital and return
However it is difficult in practice to identify the appropriate return and capital

figures for a rigorous CAPM-type return on capital calculation.
Capital
For example rather than excluding goodwill from all companies and transactions,
as we suggested in Section 2.3 above, we have to include it in the capital for all
companies, including in circumstances where normal accounting would not
recognise a goodwill item.
This is usually the case with internally generated goodwill, which consists of intangible
assets that are “self-created” – ie they are not purchased, for example via a merger or
takeover. Possible examples of internally generated goodwill include customer
relationships and brand names.
Question 16.7
For what type of company are intangible assets likely to be the major component of
CAPM capital?

Consider the successful acquisition of a new customer or client, in a

manufacturing or service business. This would be a balance sheet event for a
CAPM calculation as an internally generated goodwill asset would have been
created. However, the increment to value arising on this event would not be part
of the return element of the CAPM calculation. The value attributed to such
assets is just the number which, given the future incremental cashflow from the
new customer, makes the risk-adjusted return on capital going forward equal to
the risk-free rate.
It can therefore be very difficult to estimate the value of “capital” when attempting to
calculate the risk-adjusted return on capital.
Ultimately, the best measure of the capital in a company, including all intangibles
as required by the CAPM, probably is the market capitalisation itself. Building
this up from historical transactions, including all intangibles is, though, a
complex, and perhaps unnecessary, process.
Return
profits
Return can be calculated as .
capital
The return part of the calculation also has to be adjusted from the starting point
of accounting profits.
For example items such as advertising expenditure, which may all be expensed
in accounts, will in part have to be treated as investment expenditure. The part
aimed at expansion, will have to be added back to profits to calculate the return,
or numerator, in the return on capital calculation. Only the expenditure
necessary to defend existing goodwill should be charged to profits. Similar
comments apply to investment in tangible assets.
Thus there is also much scope for judgement in deciding exactly what constitutes
“return” when attempting to calculate the risk-adjusted return on capital.
According to the CAPM, return in excess of the risk free rate will only ,arise
through taking risk. This does not mean that management cannot add value.
Management’s job may be seen as the creation of internally generated goodwill
in excess of the investment on intangible assets.
Management also needs to defend existing goodwill. An important part of all

these efforts is well-directed investment, on both tangible and intangible assets.

Sometimes internally generated goodwill will automatically be recognised in

accounts. For example if a property company lets an hitherto vacant building
then the increment to value will be recognised next time the building is revalued.
For a listed property company this may, depending on the listing authority, be
every year.
Summary
Thus, to summarise the main points from the above:
 when calculating capital include and value:

– goodwill from mergers/takeovers
– internally generated goodwill
– any other intangible assets
– all tangible assets
 when calculating return:

– add back to profits any investment in the creation of new intangible
assets and in the expansion and purchase of tangible assets
– continue to deduct any expenses incurred defending and servicing
existing tangible and intangible assets.
Question 16.8
State the security market line relationship.

4 End of Part 4
What next?
of your revision.
Time to consider – “revision and rehearsal” products
Revision Notes – Each booklet covers one main theme of the course and includes
integrated questions testing Core Reading, relevant past exam questions and other
useful revision aids. Students have said:
“Revision books are the most useful ActEd resource.”

Chapter 16 summary
Portfolio risk and return analysis
Portfolio risk and return analysis typically involves plotting the overall time-weighted
return from a portfolio over a period against the “riskiness” of the portfolio. It is used
to assess whether superior investment performance has been obtained by taking more
risk or by superior market and stock selection/timing.
Problems with regular risk and return analysis include:

 creeping change in portfolio composition
 a successful investment manager may be treated unfairly by the measurement
system
 the manager may simply disagree with the market view of a stock’s or market’s
prospects and/or the uncertainty attached to those prospects.
It is important that the manager can demonstrate a realistic and convincing rationale for
investment decisions.
Equity market price
Changes in the market price of an equity that is held as an investment would usually be
regarded as a measure of the success or failure of that investment decision. However:
 dividend income must be allowed for
 an equity price may be influenced by short-term concerns whereas many
investors are more focussed on the long term.
Net present value
The NPV of an investment may be of limited use for performance measurement as it

depends on many assumptions which can produce a wide variety of results.
In particular, an investor’s estimate of net present value may differ from the market
price due to:
 differences between the particular investor and the average investor
 other differences in underlying assumptions between the investor and the
market.
However, the trend of net present value estimates and their relationship to market prices
may be helpful.

Net asset value
The net asset value of a company, or the net asset value per share, is clearly only one
component of overall value.
The net asset value is an accounting number, so it is important to understand how it has
arisen and to make appropriate adjustments.
Sensible comparisons of net asset value between companies in different sectors are
difficult to make.
Risk-adjusted return on capital
The CAPM suggests that if capital assets are priced correctly then:
 returns in excess of the risk-free rate will only be generated from taking risk
 the risk-adjusted return on capital should be equal to the risk-free rate.
Generally, a high risk-adjusted return on capital implies the successful creation of

intangible assets and shareholder value. However, it is difficult in practice to identify
the appropriate return and capital figures for a rigorous CAPM-type required return on
capital calculation. Broadly:
 when calculating capital include and value:
– goodwill from mergers/takeovers
– internally generated goodwill
– any other intangible assets
– all tangible assets
 when calculating return:

– add back to profits any investment in the creation of new intangible
assets and in the expansion and purchase of tangible assets
– continue to deduct any expenses incurred defending and servicing
existing tangible and intangible assets.
The best measure of the capital in a company, including all intangibles as required by
the CAPM, is probably the market capitalisation.

Solution 16.1
The Black-Scholes approach to option pricing prices a European option as a function of:
 the current share price
 the strike price of the option
 the risk-free rate of return
 the volatility of the underlying share price
 the outstanding term to expiry
 the dividend payout rate.
All of the above are observable in the marketplace except for the volatility. However,
given the actual derivative price and reliable values for each of the other parameters in
the formula, we can use the Black-Scholes formulae to work backwards and derive an
estimate for  . It is this estimate that is known as the implied volatility.
Solution 16.2
The shortfall probability is the probability that the actual investment return falls below
a benchmark level chosen by the user. The benchmark might be expressed in absolute
terms, or relative to an index, competitors or liabilities.
Solution 16.3
The four risk-adjusted performance measures discussed in Chapter 15 were:

1. Treynor
2. Sharpe
3. Jensen
4. pre-specified standard deviation.

Solution 16.4
Value investment and growth investment are two distinct investment styles – “value”
investors and “growth” investors are those who look to invest predominantly in value
and growth shares respectively.
Value shares are shares that appear cheap compared to other shares in terms of ratios
such as price-to-book value and price earnings ratio – ie they have low values for these
ratios. Conversely, growth shares are those that have high values for these ratios,
reflecting the market’s view that they have good growth prospects.
The various investment styles are discussed in detail in Chapter 20.
Solution 16.5
Net asset value per share is often defined as the book value of the shareholders’ interests
in a company (ie shareholders’ capital and reserves), usually excluding intangibles such
as goodwill, divided by the number of shares in issue.
For investment trusts, it is usually defined as:
market value of underlying assets

number of shares
Solution 16.6
The main difficulty with using the risk-adjusted return on capital approach to assess
company performance is to correctly and accurately identify both the company’s
“capital” and the “return” on that capital.
Solution 16.7
Intangible assets are likely to be the major component of CAPM capital for service-
based companies, which may have little in the way of tangible assets.

Solution 16.8
The security market line relationship is:
(
Ei = rrisk - free + b i Em - rrisk - free )
where:
 Ei and Em are the expected returns on security i and the market respectively
Cov( Ri , Rm )
 bi = .
Var ( Rm )
It suggests that the expected return on a security is a linear function of its systematic risk
as indicated by its beta.





the course.

ST5-17: Risk control Page 1
Chapter 17
Risk control
Syllabus objectives
(a) State what is meant by a risk-free return, and describe assets that may be
assumed to be risk-free in practical work.
(f) Describe methods by which an institution can monitor and control its exposure
to the following types of risk:
 asset / liability mismatching risk
 market risk
 credit risk (including counterparty risk)
 operational risk
 liquidity risk
 relative performance risk
and explain in the context of mean-variance portfolio theory what is meant by:
 opportunity set
 efficient frontier
 indifference curves
 the optimum portfolio.

Page 2 ST5-17: Risk control
0 Introduction
This chapter discusses:
1. the concept of the risk-free return
2. how asset liability modelling (ALM) may be used by the investor to develop an
investment strategy that best meets its investment objectives Asset liability
modelling can be described as actuarial in the sense that it takes explicit account
of the liabilities of the investor.
3. the five major financial risks faced by an institutional investor and what can be
done to control their incidence.
In the last section we will summarise some important prerequisite material from
Subject CT1 and Subject CT8. The ST5 syllabus objectives explicitly refer to this
material so we recommend that you make yourself very familiar with it.

1 Risk-free return
The risk-free rate of return can be defined as the rate at which money is
borrowed or lent when there is no credit risk, so that the money is certain to be
repaid.
Assets issued by national governments in their own currency were traditionally

assumed to be “risk free”, and so the risk-free rate was often referred to as the
“Treasury rate”.
In practice, and depending on the particular context, the risk-free return might therefore
be interpreted as the rate of return offered by:
 Treasury bills
 short-term conventional government bonds
 long-term conventional government bonds
 index-linked government bonds.
This assessment was based on the thinking that national governments can
always print money to ensure that their debts will be paid. Thus the concept of
national debt being risk-free was only valid in a closed economy, where all
financial transactions are in the currency of that economy. This feature was
seen in much of the early part of the twentieth century, where large economies of
China and the Soviet Union were effectively closed to outside influence.
However, as recent events have demonstrated, the ability of governments to

print money is a route not available to governments that use a shared currency
(such as the euro), or those who wish to tie their exchange rate closely to
something else (like the dollar).
However in practice at the current time, all economies interact with each other,
and therefore currency risk needs to be taken into account. Printing money
deflates its value against other currencies, and thus the holder of overseas
government debt may not receive a return that is free of currency risk, or is risk
free in real terms if the inflation rates in the overseas territory and in the
domestic economy of the holder differ.
For this reason the main rating agencies assign a credit rating to the government
debt of most countries, generally assessed against the US Dollar. One key
measure to be considered is the ratio of outstanding debt to GDP, as well as the
maturity of the existing debt, since this will determine the cost of servicing the
debt and the need to raise refinancing capital as existing debt matures.

2 Asset liability modelling

Perhaps the most important practical actuarial technique for use in determining an
investment strategy nowadays is asset liability modelling.
Asset models and the fundamentals of Asset Liability Modelling were discussed
in the Core Reading for Subject CA1.
2.1 Introduction
An investor’s objectives will normally be stated with reference to both assets

and liabilities. In setting an investment strategy to control the risk of failing to
meet the objectives a method of taking into account the variation in the assets
simultaneously with the variation in the liabilities is required. This can be done
by constructing a model to project the asset proceeds and liability outgo into the
future.
In other words, by constructing and using an asset liability model.
The outcome of a particular investment strategy is examined with the model and
compared with the investment objectives. The investment strategy is adjusted in
the light of the results obtained and the process repeated until the optimal
strategy is reached.
The optimal strategy being that which best meets the objectives of the investor.
Models can either be deterministic or stochastic. In both deterministic and

stochastic models it is important that the assumptions made in constructing the
model are consistent with each other.
It is essential to ensure that the assumptions and parameter values underlying both the
assets and the liabilities are consistent if sensible results are to be obtained. In practice,
this may be achieved by modelling of the appropriate dynamic links between assets and
liabilities. For example, in many models inflation is assumed to influence both the asset
returns and the liabilities.
Advantages of asset liability modelling
An advantage of modelling is that it encourages investors to formulate explicit

objectives. The objectives should include a quantifiable and measurable
performance target, defined performance horizons and quantified confidence
levels for achieving the target.

For example, a typical objective might be to:

 maximise the expected solvency level
 at the end of a 3-year period
 subject to the probability of insolvency at any time over that period being no
more than 0.1%
For an institution such as a pension fund or insurance company the objectives

might be specified in terms of the results of a valuation carried out at a specified
time in the future. In practice there is likely to be feedback between the model
output and the setting of the objectives. This may be because the additional insight
provided by the model projections may help the investor to refine its investment
objectives.
The success of the strategy is monitored by means of regular valuations. The

valuation results will be compared with the projections from the modelling
process and adjustments made to the strategy to control the level of risk if
necessary. The model itself may also be refined in the light of how the actual
experience compares to that which it predicted.
2.2 Deterministic asset liability modelling
A deterministic model is based on a single set of assumptions about future experience.

Using the assumptions we project the asset proceeds and liability outgo for each future
time period. We can then compare the incidence of income and outgo to check that the
outgo can always be met. We will also want to know the value of assets and the value
of liabilities at each future time period according to one or more valuation bases.
Question 17.1
What assumptions would be required in an asset model used to estimate the future
income stream and asset values of an investment portfolio?
2.3 Stochastic asset liability modelling
In contrast to a deterministic model, a stochastic model treats the key parameters as

random variables with a given mean and a defined probability distribution. For
example, future inflation might be defined by a normal distribution with mean of 5%
and standard deviation of 2%, and real interest rates (ie the excess of nominal short-
term interest rates over inflation) might be distributed between –2% and +8%, say.

In practice, we might develop a stochastic asset model in which each of the key
variables is modelled as a random variable, typically depending upon
 past values of itself
 present and past values of other economic and/or investment variables.
Question 17.2
What is the main problem with relying solely on past data to develop a stochastic asset
model?
Having run the model a large number of times, we would scan the results from each
simulation to gauge how likely it is for an unsatisfactory result to emerge. For example,
we might define an unsatisfactory result as the company becoming insolvent.
If say seven out of 1,000 simulations resulted in insolvency at some point over the
projection period, then we might conclude that the probability of insolvency or ruin
over that period is about 0.7%. A further set of simulations could then be performed
based on a different investment strategy to see how the probability of ruin compared.
By repeating the projections for a suitable number of different investment strategies, we
can ultimately determine which is optimal in terms of best meeting our investment
objectives.
It is important that the particular structure of the model and value of the
parameters depend on the purpose of the model. Although there are powerful
statistical techniques to aid in the construction of the model, it will be necessary
to apply judgement in establishing the most appropriate form and appropriate
value of the parameters. If the results are to be used in an intelligent and critical
manner, the actuary should be aware of the strengths and weaknesses of a
particular model before interpreting the output.
Using a stochastic model is, arguably, the most appropriate way of allowing for the
volatility and uncertainty underlying the assets and liabilities. However, this is highly
dependent on whether we can specify probability distribution functions that reflect the
true level of uncertainty.
Asset liability modelling is discussed further in Chapter 18.
Question 17.3
What are the two main risks involved in the development of an asset liability model?

Question 17.4
List five “actuarial” techniques that may be used to develop an appropriate investment
strategy and that take into account the liabilities.

3 Financial risks
The financial risks faced by an institutional investor can be considered under
five headings, according to the source of the risk:
1. Market risk is the risk relating to changes in the value of the portfolio due
to movements in the market value of the assets held.
2. Credit risk is the risk that a counterparty to an agreement will be unable or

unwilling to fulfil their obligations.
3. Operational risk is the risk of loss due to fraud or mismanagement within

the fund management organisation itself.
4. Liquidity risk is the risk of not having sufficient cash to meet operational
needs at all times. It is related to market risk in as much as the liquidity of
the overall portfolio is need to be taken into account in portfolio selection.
5. Relative performance risk is the risk of under-performing comparable

institutional investors.
Question 17.5
List 12 sources of operational risk for a small domestic company.
3.1 Monitoring and controlling market risk
Introduction
For many institutional investors, variations in the market values of its assets represent
the main risk of failing to meet its investment objectives. For example, a fall in asset
values to levels far below those anticipated may threaten the financial integrity of the
institution. It is therefore crucial to try and control market risk. The first steps in the
control process will be to:
 identify and define the risks
 develop techniques and/or models by which to quantify such risks.

Defining market risk
The first stage in monitoring and controlling market risk is to define what is
meant by risk. A suitable measure might be the variance of the return on the
portfolio over a specified period of time or the maximum loss that could be
suffered with say 95 or 99% probability within the timescale. The latter measure
is commonly known as Value at Risk (VaR).
The concepts of VaR and tail VaR were introduced in earlier subjects (CT8 and
CA1). We discuss the use of Value at Risk further in Chapter 21, when we consider
measures of downside risk.
The returns and losses may be measured in absolute terms or relative to some
suitable performance benchmark such as an index, an industry median fund or
the value of the liabilities.
The timescale chosen will depend on the institution. For a long-term investor
such as a pension fund the period may be measured in months or years,
whereas for a bank it is likely to be measured in hours.
Question 17.6
Define Value at Risk, specifying the two parameters that need to be set in order to
calculate it.
For example, the estimation of market risk for the purposes of the Basel regulations that
are intended to ensure the solvency of banks is based on a 2-week timescale and a 99%
probability level. However, banks are likely to use different time periods and
probability levels for their own internal risk assessment calculations. In contrast,
insurance companies and pension funds typically use time periods of several years.
Modelling risk
Having defined risk it will be necessary to establish a mathematical model which

will allow the risk at any point to be calculated. For example, in the mean
variance framework, given the expected returns on all the assets in a portfolio
and the variance/covariance matrix, the mean and variance of the return on the
portfolio can be calculated. These can be used to calculate the desired risk
measure.

In practice, banks often perform market risk calculations based on the assumption that
the individual investment returns are normally distributed. Using estimates of means,
variances and covariances of the returns for individual securities, it is then a simple
matter to calculate the distribution of portfolio returns, which will likewise be normally
distributed, and hence calculate the Value at Risk.
However, normality of returns may not be an appropriate assumption in practice, as

investment returns may demonstrate fat tails or negative skew.
Question 17.7
State two ways in which allowance might be made for non-normal investment returns.
An alternative approach is to carry out use simulations based on time series modelling.
Thus an insurance company or a pension fund is more likely to use a suitable asset
liability model to estimate the variance of expected surplus or the Value at Risk based
on the surplus of assets over liabilities.
One desirable feature of any model used is that the factors that determine risk
level are understandable.
Systems, reporting and benchmarks
The next stage is to ensure that the computer systems and data inputs are in
place to calculate the risk exposure as often as is required.
The model can be used to assess the market risk associated with different asset
allocation strategies and thereby determine which strategy is optimal given the
objectives of the investor. The levels of market risk should be monitored at regular
intervals, and the results of the analysis disseminated to all parties involved in the
investment decision process, so as to enable them to make properly informed decisions.
Individual fund managers will need to be continuously aware of their risk

exposures and the reports should also be made regularly to senior management.
In practice, fund managers will not only need to know their risk levels but will
also need the tools to understand the effect of their actions on the risk of the
portfolio. Guidelines will need to be established which can be translated into
practical benchmarks and limits for departure from the benchmarks. A typical
risk control system might therefore give the fund manager a benchmark asset
distribution, expressed as a percentage of the portfolio in specified asset
categories.

For a risk control system to be effective it is also desirable that it is clearly

documented and that the personnel responsible for monitoring risk are
independent of the fund managers.
Load differences and load ratios
Limits for departure from the benchmark would also be set. Limits can be
expressed in two ways.
A load difference specifies the range over which the percentage allocation to a
specific class can vary, for example limiting overseas equities to between 5 and
15% of the total portfolio.
A load ratio specifies the maximum variation of the allocation to a specific asset
class expressed as a percentage of the benchmark allocation to that class. This
has the advantage that a constant load ratio permits a smaller absolute variation
in the lower weighted asset classes.
Question 17.8
A fund manager is set a benchmark for overseas investment of 20%, with a permissible
range of 15% to 25%. Express this benchmark as a load ratio.
Question 17.9
What type of base output would you expect from a simple risk control system for an
institutional investor?
Question 17.10
You have been asked to develop a risk monitoring system. List the desirable features and
requirements of such a system.
Question 17.11
How might risk be defined or measured for a manager responsible for a unitised fund,
eg the pension managed fund run by a life insurance company?

3.2 Monitoring and controlling credit risk
The key factors in managing credit risk are:

 the creditworthiness of the counterparties with which an institution deals;
 the total exposure to each counterparty.
Creditworthiness
Creditworthiness can be controlled by placing limits on the credit ratings (as

published by the major rating agencies) of counterparties with which an
institution may deal. Different limits might be imposed depending of the
potential length of exposure. For example investing in a company’s corporate
debt is a different risk to a settlement period risk with a broker or market maker.
Credit risk can be also controlled in derivatives transactions by dealing on a

recognised exchange with a central clearing house that stands as counterparty
to all deals, rather than over-the-counter. The clearing house will seek to protect
itself by requiring the counterparties to deposit “margin” with it. These margin
payments are a particular example of the use of collateral provided by a
counterparty as a tool against credit risk.
More generally, any institution may demand collateral or margin payments as a way of
protecting itself against the credit risk it faces under a particular transaction. The
operation of a clearing house was described in more detail in Chapter 1.
Credit exposure
It is important to monitor and place limits on the credit exposure to any single
counterparty.
An example of such a limit might be that the investor is limited to a total investment in
a bond with a credit rating of BBB of no more than the maximum of 5% of the total
fund size or $250m. Of course the upper limit could be zero for bonds with a low credit
rating.
This will involve aggregating exposures in different areas. For example a

pension fund may hold both equity and debt issued by a bank as well as having
cash on deposit with the same bank and having them as a counterparty to a
derivatives deal. It will also be necessary to be aware of the particular
relationships between different companies within the same group.
In addition, credit risk can be hedged using the credit derivatives discussed in
Chapter 3.

Allowance for credit risk is often made in the model used to analyse Value at Risk. In
practice, many quantitative investment models allow for both elements of risk
simultaneously.
3.3 Monitoring and controlling operational risk
Operational risk may not be as easy to quantify and measure as credit and
market risk but it has arguably been responsible for more spectacular corporate
losses. For example, the collapse of Barings Bank in the 1990s.
Given that operational risk refers to losses due to internal fraud or mismanagement,
control of operational risk essentially depends on good management practices
including having established and documented chains of reporting and
responsibility.
In addition, those with responsibility should have suitable qualifications and experience.
Two areas that have been highlighted in recent years are:

1. the need for management to understand the nature of the complex deals
undertaken by traders
2. the need for the separation of “front office” and “back office” functions.
Front office functions are making and recording deals, back office functions are
settlement and accounting.
Question 17.12
Which types of security give rise to potentially large credit risk as well as increased
probability of operational risk?
3.4 Monitoring and controlling liquidity risk
For all companies liquidity risk is the risk that cashflows from assets are
insufficient to meet liabilities in all future periods. The focus is on cash, which is
a different test from the company having assets in excess of its liabilities.
For financial services institutions liquidity risk is the risk of not being able to
raise funds (by borrowing or sale of assets) at a reasonable cost at all times and,
therefore, the risk that a market does not have the capacity to handle the volume
of desired transactions when needed.

Techniques that can be used for identifying and measuring liquidity risk include
the cash budgeting / short-term financial planning techniques considered in
Chapter 6 of this course.
Gap analysis
A simple “balance sheet” model of liquidity is useful for establishing liquidity

policies and operating limits. All assets are allocated to one of two categories -
liquid or illiquid. All liabilities are classified as either stable or volatile. The focal
point of the analysis is the concept of “net liquid assets” or the “liquidity gap”.
Liquidity gap or net liquid assets are defined as:

the difference between the level of liquid assets and volatile liabilities.
A six-month remaining maturity criterion is usually adopted in classifying assets

and liabilities. So, assets maturing in six months or less would be classified as liquid,
and liabilities that are due in six months or less would be classified as volatile.
Assets Liabilities
Illiquid assets
Stable liabilities
Liquidity gap
Liquid assets
Volatile liabilities
In analysing the net liquid assets position, allowance should be made for the
liquidation costs associated with converting items to cash. These costs will be a
function of brokerage and investment banking fees and the basic bid-offer
spread in the market for the assets involved, as well as the time available for
conversion.
So, the "liquidity gap" (or "net liquid assets") method considers the difference between
liquid assets and volatile liabilities. This gap represents a liquidity risk.
Question 17.13
What is the main problem with this approach?

Duration analysis
A more rigorous approach involves the concept of liquidity duration or liquidity

risk elasticity (LRE), where the impact of changes in market conditions is
considered.
Extending the liquidity gap approach, it looks to quantify the potential cost of such a
gap by considering the impact of a change in interest rates (specifically, an increase in
the cost of raising funds).
The process consists of two steps:
1. Calculate the present value of assets and liabilities using the “cost of
funds” rate as the discount rate
The basic gap (or institution's equity) is calculated as the present value of assets
minus the present value of liabilities. The effect of an increase in interest rates
at all durations is then measured. This rate of change is called the LRE.
2. Measure the change in the market value of the institution’s equity (LRE)
from a change in the cost of funds (due to an increase in the risk premium
paid to raise money).
If the LRE is zero, the institution has zero liquidity risk (by this measure).
If the duration of the assets is longer than that of the liabilities, the LRE will be
negative. This is because the value of assets will decrease more than the value of the
liabilities following such a increase in interest rate.
So, if the LRE is negative then increases in interest rates will pose liquidity problems
under stress situations where the cost of finance is high.
If the LRE is sharply negative, it will pay the institution to shorten the maturity of
its assets and lengthen the maturity of its liabilities, thereby increasing liquidity.
Question 17.14
(i) What would be the cost to a bank of not maintaining sufficient liquidity?
(ii) How might a bank reduce its exposure to liquidity risk?

3.5 Monitoring and controlling relative performance risk
The techniques for monitoring and controlling relative performance risk are
essentially the same as those for controlling market risk except that performance
is measured relative to the performance of the institution’s competitors rather
than in absolute terms or relative to the whole market.
Typical objectives here might be to aim to minimise the risks of achieving:

 below median investment returns over one or more specified terms, eg 1 year,
3 year, 5 year and/or 10 year terms
 median or above investment returns less than 90% of the time (for any particular
term)
 returns below those yielded by a particular investment index.
Ways to minimise relative performance risk might therefore include:

 commercial matching¸ ie holding similar investment portfolios to your
competitors
 index tracking.
Question 17.15
What will be the major difficulties when attempting to assess relative performance risk?

4 Important prerequisite material

In this section we will summarise some important prerequisite material from
Subject CT1 and Subject CT8. The ST5 syllabus objectives explicitly refer to:
 asset/liability mismatching risk (immunisation) and
 portfolio theory.
In theory, any topic from earlier subjects can be examined in later subjects but perhaps
these are more likely to be examined because they are in the syllabus objectives. You
may find it useful to revisit the material in the earlier courses but we recommend that
you at least re-familiarise yourself with this summary information.
Immunisation
Immunisation is the investment of the assets in such a way that the present value of the
assets minus the present value of the liabilities is immune to a general change in the rate
of interest. Immunisation requires that:
1. The present values of the liability outgo and asset proceeds are equal.
2. The discounted mean term of the value of the asset proceeds must equal the
mean term of the value of the liability outgo.
3. The spread about the mean term of the value of the asset proceeds should be
greater than the spread of the value of the liability outgo.
Problems with immunisation
Problems with immunisation:

1. the amounts of the liabilities may not be known with certainty
2. it removes the possibility of mismatching profits, apart from a very small,
second-order effect
3. it works only for small changes in interest rates
4. it assumes a flat yield curve at all times
5. it requires constant rebalancing
6. assets of a suitably long discounted mean term may not exist
7. the timing of asset proceeds and liability outgo may not be known.

Portfolio theory
Portfolio theory enables the investor to identify its optimal portfolio – the one that
maximises expected utility as a function of the mean and variance of investment returns.
The assumptions underlying portfolio theory are as follows:

● All expected returns, variances and covariances of pairs of assets are known.
● Investors make their decisions purely on the basis of expected return and
variance.
● Investors are non-satiated.
● Investors are risk-averse.
● There is a fixed single-step time period.
● There are no taxes or transaction costs.
● Assets may be held in any amounts, ie short-selling, infinitely divisible holdings,
no maximum investment limits.
The opportunity set is the set of combinations of means and variances that the investor
is able to obtain by constructing portfolios containing the available securities.
A portfolio is efficient if there is no other portfolio with either a higher mean and the
same or lower variance, or a lower variance and the same or higher mean. The efficient
frontier is the set of efficient portfolios in E - V space.
Indifference curves join points of equal expected utility in E - V space.
The optimal portfolio is the portfolio that maximises the investor’s expected utility as a
function of the mean and variance of investment returns.
Portfolio theory can be used to explain how risk can be diversified away.

Chapter 17 Summary
Risk-free return
The risk-free rate of return can be defined as the rate at which money is borrowed or
lent when there is no credit risk, so that the money is certain to be repaid.
Asset liability modelling
The appropriateness of an investment strategy can be assessed using deterministic and

stochastic models of asset proceeds and liability outgo.
A deterministic model is based on a set of specific assumptions about the future. It is

simpler, and can be used to check the term of the assets compared with the term of the
liabilities. Scenario modelling is then required to test whether the assets are of the right
type.
A stochastic model allows for the random nature of some of the model parameters. If
the assumptions underlying the model are realistic, then a clearer picture of the
appropriateness of the assets is possible.
Monitoring and controlling risk
Investors need systems to monitor and control the different forms of financial risk:
 Market risk is the risk relating to changes in the value of the portfolio due to
movements in the market value of the assets held. It can be measured using
Value at Risk (the possible loss in the value of the fund, with a probability of p%
over a time period of t) and controlled by regular modelling and reporting.
 Credit risk is the risk that a counterparty to an agreement will be unable or

unwilling to fulfil their obligations. It can be controlled:
– by limiting the creditworthiness of the counterparties
– by limiting the total exposure to each counterparty.
– using credit derivatives.
 Operational risk is the risk of loss due to fraud or mismanagement within the
fund management organisation itself. It can be controlled by appropriate
internal reporting and by separation of front office and back office functions.

 Liquidity risk is the risk of not having sufficient cash to meet operational needs
at all times.
Liquidity risk elasticity (LRE) considers the impact of changes in market

conditions. The process consists of two steps:
1. Calculate the present value of assets and liabilities using the “cost of
funds” rate as the discount rate
2. Measure the change in the market value of the institution’s equity (LRE)
from a change in the cost of funds (due to an increase in the risk
premium paid to raise money).
If the LRE is zero, the institution has zero liquidity risk (by this measure). If the
LRE is sharply negative, it will pay the institution to shorten the maturity of its
assets and lengthen the maturity of its liabilities, thereby increasing liquidity.
 Relative performance risk is the risk of under-performing comparable

institutional investors. It can be measured and controlled in the same way as
market risk.

Solution 17.1
An asset model would require assumptions concerning the following variables in order
to estimate the income stream from each asset category:
 inflation (for index-linked bonds)
 interest rates (for money market investments)
 dividend growth rates (for equities)
 rental growth rates (for property).
Assumptions required to estimate the asset values in the future might include:
 gross redemption yields (to value fixed interest bonds)
 real yields (to value index-linked bonds)
 dividend yields (to value equities)
 property yields (to value properties).
Overseas investments may require further assumptions for growth rates and yields in
each country as well as exchange rates. In practice, you may decide that a more
pragmatic approach is suitable, eg treating overseas equities like domestic equities.
However, if overseas holdings are large, it may be necessary to develop a more explicit
allowance for the extra volatility created by currency fluctuation.
Solution 17.2
The main problem with relying solely on past data to develop a stochastic asset model is
that the past may not necessarily be a reliable guide to the future, as economic and
investment market conditions change through time.
Additionally, all parameter estimates based on past data will be subject to random
variation.

Solution 17.3
The two main risks involved in the development of an asset liability model are:
1. model risk – the risk that the model structure is wrong
2. parameter risk, the risk that the model parameters, such as expected future
return, are incorrectly specified.
Solution 17.4
1. matching
2. immunisation
3. deterministic asset liability modelling (possibly with scenario modelling)
4. stochastic asset liability modelling
5. mean-variance portfolio theory applied to the surplus
Solution 17.5
 manufacturing failures
 IT problems
 fraud and theft
 human error
 staff resource problems
 internal control problems
 confidentiality and security breaches
 delivery failures
 product liability
 health and safety issues
 disasters
 third-party dependency

Solution 17.6
Value at Risk is the maximum loss in the value of the fund, with a probability of p%
that may be suffered by an institution as a result of market risk over a time period of t.
Solution 17.7
Allowance might be made for non-normal investment returns by:

 using a non-normal distribution for investment returns – ie one incorporating fat
tails and/or negative skewness
 retaining the normal distribution, but adjusting upwards the standard deviation
of returns to indirectly allow for fat tails and/or negative skewness.
Solution 17.8
The benchmark is 20% of assets, with an allowable load ratio of 25% above or below.
Solution 17.9
Base output: benchmark asset distribution between the main asset sectors, with limits
for deviations from the benchmark. (You may also have mentioned Value at Risk. )
Solution 17.10
Desirable features and requirements of a market risk control system:

1. it should give up-to-date reporting of risk exposure ...
2. ... on a regular basis
3. there should be a standard (automated?) data input procedure so that changes (eg
in asset values, the portfolio mix) are captured quickly
4. managers should be able to see the effects of their proposed actions (ie prior to
taking the actions)
5. there should be regular reporting to senior management
6. the factors that determine risk should be understandable to the fund managers and
other personnel using the system
7. the monitoring personnel should be independent of the fund managers
8. the output should be quantifiable.

Solution 17.11
A fund manager for a unitised fund would probably assess risk against the returns
achieved by similar funds, eg the manager may be required to achieve “top quartile
performance” or “above median returns”. This is relative performance risk.
Solution 17.12
Over-the-counter (OTC) derivatives give rise to potential for both credit risk and
operational risk:
 OTC arrangements don’t have the benefit of the clearing house reducing
counterparty risk
 the arrangements can be complex, increasing the chance that senior management
fail to spot the weak links in the reporting and monitoring processes.
Solution 17.13
The liquidity gap approach does not quantify the potential cost or impact of such a gap
under stressing situations such as an increase in the cost of finance.
Solution 17.14
(i) The bank may be forced to borrow emergency funds at excessive cost. (Many
banks have Repo desks ready to meet this risk as they can sell bonds in large
quantities, with a contract to repurchase, without affecting the market price
significantly, thus raising emergency cash.)
(ii) The bank could increase the funds held in cash and readily marketable assets
such as government securities, FTSE 100 stocks etc and/or increase the term of
the bank’s liabilities.

Solution 17.15
The major difficulties are likely to include:
1. Identifying an appropriate peer group against which to compare investment

performance. Whilst this may be relatively straightforward for a unitised fund
with a clearly stated objective (eg invest solely in US equities), it might be
extremely difficult for, say, an insurance company with-profit fund, which may
have a very different liability profile and hence investment objectives from that
of other insurance companies.
2. Obtaining reliable and accurate data on the performance of competitors. This

may present problems for certain financial institutions, eg insurance companies
3. Making appropriate allowance for the risk of the positions taken. In other
words, if the portfolio has been continuously accepting higher risks than the
benchmark, the relative out-performance or under-performance would have to
be adjusted to compensate for this.





the course.

ST5-18: Actuarial techniques (1) Page 1
Chapter 18
Actuarial techniques (1)
Syllabus objectives

investment strategy.
 asset pricing models
 asset liability modelling
 asset liability mismatch reserving.
0 Introduction
This chapter considers a number of approaches that may be used to develop an
appropriate investment strategy.
Section 1 introduces asset pricing models, which can be used to determine the value of
risky assets such as equities, bonds and derivatives. These models are all based on the
notion that the value of an asset is equal to the expected discounted payoff(s) that it
provides.
Section 2. continues our discussion of the asset liability modelling process. Section 3
briefly describes the related topic of asset liability mismatch reserving.
So far, the material in this and the following chapter have not featured greatly on ST5
exam papers.

Page 2 ST5-18: Actuarial techniques (1)
1 Asset pricing models
1.1 Asset pricing
Asset pricing relates to the systematic determination of the value of risky

securities such as equities, bonds and derivatives. Modern asset pricing models
all derive from the notion that price equals the expected discounted payoffs from
an asset. This is also the basis of the discounted cashflow approach that actuaries have
traditionally used to value sets of cashflows.
Approaches used include consumption-based models, which are derived from

the fact that an asset’s price should equal the expected discounted value of the
asset’s payoff, using the investor’s marginal utility to discount the payoff.
Other approaches used include:

 the capital asset pricing model (CAPM)
 arbitrage pricing theory
 multifactor models
 option pricing models and
 term structure models
all of which were considered in Subject CT8. All these models are attempts to
handle the effects of delay and risk in evaluating a sequence of anticipated
payments. The models therefore attempt to allow for the fact that payments:
 occur in the future

 cannot usually be predicted with certainty.
Asset pricing models help us to perform two functions:
1. To determine whether an observed asset price is “wrong” – whether an

asset is mispriced (and represents a trading opportunity for the shrewd
investor).
Thus we could use CAPM, for example, to price an asset. Then if the price
predicted by CAPM is greater than the actual market price of the asset, CAPM
suggests that the asset is cheap. We might therefore decide to buy the asset in
the expectation that its price will rise once other investors also realise that is
cheap and start buying it too.
This is an example of quantitative analysis, to which we will refer again in
Chapter 20.

2. To determine what the price of an asset should be (where it cannot be

observed). Examples here might be capital projects or unquoted investments.
Absolute pricing
Absolute pricing prices assets by reference to exposure to fundamental sources

of macroeconomic risk – ie unpredictable macroeconomic variables such as inflation,
economic growth and interest rates. It is the unpredictability of these variables that
leads to the unpredictability of returns on risky assets
The consumption-based and general equilibrium models (such as CAPM) are

examples of this approach, which can be used to predict how prices might
change if policy or economic structures change. The prices so obtained are
therefore capable of an economic interpretation.
Relative pricing
Relative pricing, as exemplified by Black-Scholes option pricing and Arbitrage

Pricing Theory, considers the value of an asset given the price of some other
assets. Here we use as little information about fundamental risk factors as
possible, and we do not ask where the prices of the other assets came from.
Thus, the Black-Scholes option pricing formula tells us what the price of a call option
on a share should be given the current share price and a particular set of assumptions –
most importantly that markets are arbitrage-free. This makes sense as the option price
must be closely related to the share price, but it does not tell us where the share price
itself comes from. More generally the predictions obtained by relative pricing may be
more accurate than those obtained by absolute pricing.
1.2 The general asset pricing formula
Asset pricing can be summarised in two equations:

(1) pt = E (mt +1xt +1 )
(2) mt +1 = f (data, parameters )
where:
 pt = asset price
 xt +1 = asset payoff
 mt +1 = stochastic discount factor (or state price deflator).

Question 18.1
Briefly interpret the above two equations.
In this way, we can separate the specification of the economic assumptions of

the model (2) from the step of deciding which kind of empirical representation to
pursue (1). Thus the first equation can lead to predictions stated in terms of
returns, price-dividend ratios, expected return (beta) representations, moment
conditions and so on.
Equation (1) is therefore consistent with the discounted cashflow approach that
actuaries have traditionally used to value sets of cashflows. It is a general equation that
holds for many different asset pricing models, including the risk-neutral approach used
to price share options in Subject CT8. It is Equation (2) that both differs between, and
distinguishes between, different asset pricing models.

2 Asset liability modelling
2.1 Background
The process of asset liability modelling (ALM) was introduced in Subject CT8 and
considered further in Subject CA1.
We also discussed it again in the previous chapter of this course.
Recall that an investor’s objectives will often be stated with reference to both assets and
liabilities. In setting an investment strategy to control the risk of failing to meet the
objectives it is therefore necessary to take account of the simultaneous variation in both
the assets and the liabilities. This can be done by constructing an appropriate model to
project the asset proceeds and liability outgo into the future.
Banking
In banking, ALM is used to describe a process that actuaries would regard as

closer to matching – ensuring that any mismatches between assets and
liabilities are not so large as to expose them to serious risk if there is a sudden
sharp market movement in the near future. Bankers have developed techniques
such as Value at Risk (VaR) to help assess such risks – see Chapters 17 and 21.
Question 18.2
Define Value at Risk (VaR).
So the aim here is to assess the market risk that the bank faces on its trading in bonds,
equities, derivatives and commodities. For example, the Basel Regulations concerning
the financial soundness of international banks encourage banks to develop market risk
measurement systems based on Value at Risk, calculated using a 99% confidence
interval over a 10-day holding period. The 10-day period is designed to reflect the
length of time over which a bank could realise the assets in order to limit any further
losses. We will discuss Value at Risk in more detail in Chapter 21.

Actuarial work
Actuaries, on the other hand, see ALM as being an investigation of longer-term

issues – the carrying-out of projections of assets and liabilities (and of related
characteristics such as solvency levels) over periods of several years. This is
because actuaries have traditionally been involved in the financial management of
institutions with longer time horizons, such as life insurance companies and pension
funds.
Institutional investors
ALM is commonly used by institutional investors when setting their investment

strategy. Historically an ALM study has resulted in an investment strategy
following one of the two techniques:
 a benchmark consisting of specific (fixed) percentages allocated to each
asset class which the investment manager is expected to follow (within
suitable ranges), or
 extraction of a “core” portfolio, typically of bonds, with the remaining
assets invested in a “balanced” fashion.
The use of ranges provides the investment manager with the freedom to undertake
short-term tactical deviations away from the benchmark asset allocation in an attempt to
boost investment returns based on current market conditions.
Question 18.3
What were the “suitable ranges” referred to in the first bullet above called in
Chapter 17?
The percentage of the total market value of the portfolio invested in each asset
category (or in the core / non-core split) is typically rebalanced back to the
benchmark weighting from time to time. The benchmark used for investing the
assets is typically static and not directly linked to the performance of the
underlying liabilities.
A more recent development within ALM is the use of stochastic modelling to

evaluate the performance of investment strategies under different scenarios.
Investors, and pension funds in particular, are becoming increasingly focussed

on hedging liabilities which has resulted in approaches such as Liability Driven
Investing (LDI) gaining popularity. Under a LDI approach the underlying
benchmark is more directly linked to the actual liabilities.

LDI is discussed in Section 2 of Chapter 19.
The benchmark for investing the assets changes as the underlying liabilities
change. This type of benchmark is often referred to as a ‘dynamic liability’
benchmark and is a better reflection of the underlying liabilities than the static
benchmark which have been prevalent during the 1990s and early 2000s.
2.2 Stages in an ALM exercise
The main stages in an ALM exercise are usually as follows. They are described
in the context of a pension benefit scheme, but can readily be adapted to many
other situations:
1. The key objectives that investment and funding policy should aim to
achieve need to be clarified. These involve objectives such as:
 future ongoing funding levels
 future solvency levels
 future company contribution rates
 the level of risk (performance mismatch between assets and
liabilities) that is prepared to be taken.
Here we have in mind a pension fund, although the ideas apply equally to other
investors. The objectives might also specify:
 appropriate time horizons and probability levels
 how both assets and liabilities are to be valued.
Example
A typical objective might be to:

(i) maximise the expected surplus of assets over liabilities at the end of a five-year
period, with both asset and liability values calculated on a consistent discounted
cashflow basis, subject to:
(ii) ensuring that the value of the assets exceeds 110% of the value of the liabilities
at all points during that five-year period with a probability of 99%.
2. Suitable assumptions to use in the study need to be agreed.
3. Data on the liabilities needs to be collected to carry out the projections.

For detailed liability analysis data on individual members is required to
build up an accurate assessment of the future cashflow projections.

4. The overall nature of the liabilities is considered — an analysis of current

funding level, maturity and cash flow projections under different
scenarios is considered
5. An analysis would be carried out to identify how the pension fund might
progress in the future if different investment strategies were adopted.
In other words, the projected possible future values of the important outputs of
the model – ie values of assets and liabilities, surplus/funding levels,
contribution rates etc – would be analysed according to the assumed mix of
bonds and equities.
6. Different asset mixes would then be analysed in more detail to assess the
risks (relative to the liabilities) and the rewards of each alternative under
consideration – in order to assess which look most likely to meet the investor’s
investment objectives.
For example, at this stage we might consider the split of equities between
domestic and overseas and the split of bonds between different durations. Of
course, Stages 5 and 6 might be combined into a single stage in practice.
7. The results would be summarised and presented – often in graphic format,

so as to make them easier to understand for those such as directors or trustees
with ultimate responsibility for the investment decision.
Compared to a traditional actuarial valuation, ALM provides much more

information in three (or more) extra dimensions:
1. providing projections into the future (time dimension)
2. providing some estimate of the range of likely outcomes (probabilistic
dimension)
3. indicating the effect of changing investment strategy (asset mix
dimension).
In steps 5 and 6, ALM uses an asset model to produce stochastic simulations of

returns on asset classes and other relevant economic data (such as inflation).
For pension funds looking to hedge their liabilities or adopt an LDI approach to
investment strategy an in-depth analysis on the impact of changes to the liability
profile is undertaken. The output from the ALM model is used to calculate
(approximate) liability values at different time horizons.
The models in common use are all designed to be used in Monte Carlo
simulation exercises.

Question 18.4
Why is Monte Carlo simulation usually used in practice?
2.3 Presentation of ALM results
The presentation of ALM results is usually in graphic format, and looks at the
distribution of a target objective (such as level of solvency or funding) resulting
from an investment strategy over the projection period.
Figure 18.1 is an example of this graphic format. This graph shows how the Favourable
(90th percentile), Median and Unfavourable (10th percentile) outcomes might develop
through time for a single potential investment strategy. All three outcomes start from
the same current solvency level.
solvency level
favourable
current median
solvency
level
unfavourable
0 future year
Figure 18.1: Favourable, Median and Unfavourable outcomes for a particular

investment strategy
Where an investor has decided to not fully hedge the assets and liabilities the
results often show a range of results (funding levels) based on projected asset
and liability performance based on different economic scenarios.

We could, instead plot just the median outcome under various different investment
strategies. Figure 18.2 provides an example of this type of graph, which shows how the
median outcome varies through time for different potential investment strategies.
solvency level
75% equities/25% bonds
current 50% equities/50% bonds

solvency
level
25% equities/75% bonds
0 future year
Figure 18.2: Median outcomes for three different investment strategies
An alternative way of presenting the analysis would be to select a single

projection date (say three, five or ten years ahead) and plot the Favourable,
Median and Unfavourable results using the asset mix as the variable on the
horizontal axis.
An example of this type of graph is shown on Figure 18.3 below.
solvency level at future time t
favourable
current
median
solvency
level
unfavourable
0 % equities
Figure 18.3: Favourable, median and unfavourable outcomes at a particular projection

date as a function of the percentage of equity investment

Thus, for any given output variable and any given time horizon, the results
resemble an expanding “funnel of doubt” where the uncertainty associated with
the output increases the further into the future projections are made. As a result,
asset liability models are essentially a qualitative method for explaining risks.
For strategies that are designed to hedge the liabilities, either partially or fully,
the funnel of doubt is narrower than an investment strategy that has significant
mismatch between the assets and liabilities.
2.4 Choosing between different investment strategies
The final stage in any ALM exercise is to use the results obtained to choose the
appropriate investment strategy to pursue. Some form of objective criterion is therefore
needed to decide between the alternative possible strategies. For example, if the
investor has clearly stated investment objectives specified in terms of the mean and
variance of end-of-period surplus, then ALM could be used to estimate the values of the
mean and variance and a choice of investment strategy subsequently made.
Using shortfall or ruin probabilities
ALM can also provide an assessment of the likelihood of a shortfall. For

example, a common use of ALM is to assess “ruin probabilities” of insolvency
for a fund.
Question 18.5
Explain briefly how this could be done.
However, these probabilities cannot be translated directly into assessments of

the value of different strategies except by using the concept of “risk-neutral
probabilities” or by adopting deflator (stochastic discounting) methodologies.
Just because the ALM results suggest that Investment Strategy A (high equity
proportion) yields a higher ruin probability than Investment Strategy B (low equity
proportion), it does not necessarily follow that A should be rejected in favour of B.
This is because, in making a sensible choice, we need to take account of the full range
of possible financial outcomes associated with each strategy. For example, Investment
Strategy A might also lead to a higher average surplus than B.

We may also need to take account of other factors, such as the general economic
circumstances corresponding to any particular outcome. For example, unfavourable
solvency outcomes are likely to be associated with unfavourable economic conditions,
which may affect the investor in other ways than just directly via the solvency level of
the fund. The value the investor places on a particular solvency outcome may therefore
vary according to the prevailing economic conditions. So, we may require a different
approach to simply estimating ruin or shortfall probabilities.

3 Asset liability mismatch reserving
3.1 Definition
Asset liability mismatch reserving is an example of the use of modelling in

actuarial work. The emerging asset and liability position is projected under a
range of possible conditions (economic, environmental, etc) in order to establish
the extent to which assets and liabilities are mismatched. Appropriate
supplementary reserves can then be set up to cover the possible levels of
shortfall identified.
Here we are assessing the extent to which we are mismatched relative to a perfectly or
absolutely matched position.
Question 18.6
Explain precisely what is meant by absolute matching.
The modelling can, as usual, be carried out using either deterministic or

stochastic methodologies.
3.2 Deterministic modelling
In a deterministic framework, it is up to the modeller to decide the nature and

extent of the scenarios to be tested for the purpose of setting the reserves. At
its simplest, the investigation may be restricted to the current portfolio of assets
and liabilities only, and consider the impact of an immediate change in
conditions, rather than involve projections of the emerging state of the fund.
For example, we might consider the impact of factors such as:

 an immediate fall of 25% in equity prices
 an immediate increase of 1% in bond yields.
Such an approach is often referred to as resilience testing – as it assesses the

resilience of the investor to sudden changes in market conditions.
However, with modern computer modelling power readily available, more

dynamic approaches are typically adopted. These assess the resilience of the fund
to changes in market conditions through time.

3.3 Stochastic modelling
These would include the use of stochastic techniques, where multiple

projections would be made in order to generate many possible future scenarios.
Certainly, stochastic modelling allows the assessment of many more scenarios and a
wider range of scenarios than could be quickly and easily tested using a deterministic
approach.
Most often, the stochastic element of the projections would apply to the asset
portfolio and investment returns, in order to assess exposure to systematic risk.
Given that a finite number of projections must be performed, assessment of the
results is often carried out in the form of ruin probability, that is, the outcomes
are ranked in terms of a target measure (such as the shortfall of assets relative
to liabilities at a specified future date). Additional reserves are then set up at a
level sufficient to cover all but a specified proportion of such shortfalls.
For example, suppose that the 10th worst outcome out of 1,000 simulations produced a
shortfall of $10 million. This suggests that an extra $10 million of reserves would be
required if the aim of the investor is to ensure that the probability of ruin is no greater
than 1%.
Question 18.7
In practice why might the investor actually increase the reserves by more than
$10 million?

Chapter 18 Summary
Asset pricing models
Modern asset pricing models all derive from the notion that price equals the expected
discounted payoffs from an asset. They are used:
 to determine whether an observed asset price is “wrong” – whether an asset is
mispriced (and represents a trading opportunity for the shrewd investor)
 to determine what the price of an asset should be (where it cannot be observed).
Absolute pricing prices assets by reference to exposure to fundamental sources of

macroeconomic risk, eg consumption-based and general equilibrium models (such as
CAPM).
Relative pricing considers the value of an asset given the price of some other assets,
eg Black-Scholes option pricing and arbitrage pricing theory.

(1) pt = E (mt +1 xt +1 )
(2) mt +1 = f ( data, parameters )
where:
 mt +1 = stochastic discount factor (or state price deflator).

Asset liability modelling (ALM)
In banking, ALM is used to ensure that any mismatches between assets and liabilities are
not so large as to expose the bank to serious risk if there is a sudden sharp market
movement in the near future.
Actuaries use ALM to project the assets and liabilities (and related characteristics such as
solvency levels) over periods of several years and thereby to review investment policy.
The main stages in an ALM exercise include the following:

1. clarify the key objectives of the investment and funding policy
2. agree suitable assumptions to use in the study
3. collect the data to be used to carry out the projections
4. consider the overall nature of the liabilities
5. analyse how the scheme might progress in the future if different investment
strategies were adopted.
6. analyse different asset mixes in more detail
7. summarise and present the results.
The presentation of ALM results is usually in graphic format.
Asset liability mismatch reserving
Asset liability mismatch reserving involves projecting the emerging asset and liability
position under a range of possible conditions in order to establish the extent to which
assets and liabilities are mismatched. Appropriate supplementary reserves can then be set
up to cover the possible levels of shortfall identified.
Resilience testing considers the impact of an immediate change in market conditions.

Solution 18.1
The first equation tells us that the price of an asset is simply equal to the expected value
of the discounted future payoffs. This is the fundamental idea behind asset pricing.
The second equation tells us where the stochastic discount factor comes from. It is
derived either from an economic model (and so reflects the parameters within the
model) or empirical data.
Solution 18.2
The Value at Risk (VaR) is an estimate of the maximum loss that could be suffered by
an investor with a specified probability level over a specified period of time. Thus, a
bank might try to estimate the maximum loss that it might sustain with a 1% chance
over the next week. The returns and losses may be measured in absolute terms or
relative to some suitable performance benchmark such as an index, an industry median
fund or the value of the liabilities.
Solution 18.3
The “suitable ranges” were called load differences and load ratios in Chapter 17.
A load difference specifies the range over which the percentage allocation to a specific
class can vary as a percentage of the total portfolio.
A load ratio specifies the maximum variation of the allocation to a specific asset class
expressed as a percentage of the benchmark allocation to that class.

Solution 18.4
Monte Carlo simulation is usually used in practice because:

 the vast majority of important practical problems are not amenable to analytical
solution
 it is relatively easy to master the basic steps of “Monte Carlo” simulation
techniques, certainly by comparison with setting up and solving analytical
models.
Solution 18.5
ALM could be used to estimate ruin probabilities in the following way. Suppose that
1,000 simulations of the future solvency level over the next five years have been
produced and that in seven of the simulations the fund is insolvent at sometime over the
next five years. Then the probability of ruin over the next five years could be estimated
as:
7
= 0.007
1000
ie 0.7%.
Solution 18.6
Absolute matching of assets and liabilities involves structuring the flow of income and
maturity proceeds from the assets so that they will coincide precisely with the outgo in
respect of the liabilities (claims and expenses less premiums and/or contributions) under
all circumstances. This requires the sensitivity of the timing and amount of both the
asset proceeds and the liability outgo to be known with certainty and to be identical
with respect to all factors.
Solution 18.7
In practice the investor might actually increase the reserves by more than $10 million in
order to be prudent. This is because the results produced by the model are only
(extremely subjective) estimates of the actual ruin probability.

Chapter 19
Actuarial techniques (2)
Syllabus objectives

investment strategy:
 liability hedging
 dynamic liability benchmarks.
0 Introduction
This chapter continues the discussion of some techniques that may be used to develop
an appropriate investment strategy.
Section 1 introduces liability hedging, which aims to select assets that perform exactly
like the liabilities in all states.
Section 2 discusses liability driven investment, ie an approach to investing where the

liabilities are a primary consideration in asset allocation.
Section 3 briefly describes dynamic liability benchmarks, which represent an

intermediate position between conventional static liability benchmarks and liability
hedging.

1 Liability hedging
1.1 Definition
Liability hedging is where the assets are chosen in such a way as to perform in
the same way as the liabilities. In other words, hedging against unpredictable
changes in the liabilities that arise from unpredictable changes in the factors that
influence liability values.
A specific example of this is the familiar concept of immunisation, where assets

are matched to liabilities by term in order to reduce interest rate sensitivity (to
parallel movements in the yield curve). Other familiar forms of hedging would
include matching by currency and the consideration of the real or nominal nature
of liabilities when determining the choice of assets.
However, these examples relate only to specific characteristics of the liabilities,

whereas liability hedging aims to select assets which perform exactly like the
liabilities in all states.
As such, liability hedging is a halfway house between absolute matching (of the timing
and amounts of all the individual cashflows) and immunisation (of the present value of
assets less liabilities against changes in interest rates only).
1.2 Cashflow matching using bonds
A common method of liability hedging would be for an investor to hold a

portfolio of government bonds (in the appropriate currency) until maturity to
meet a pre-specified stream of future fixed payments.
For example, an investor with five rental payments to make over the next five years
might hold five different zero-coupon bonds with terms 1, 2, 3, 4 and 5 years, with
maturity payments equal to the annual rental payments.
Provided the future payments do not change in amount or timing, the coupon
and principal proceeds from the bond portfolio can be used to meet the
obligation to make the payments.
In the example above, the rental payments may well change, eg increase with inflation.
This depends on the initial contract and how diligent the landlord is.

Question 19.1
What suitable investment could the investor choose if the rental payments were pre-
specified to increase with inflation?
Difficulties
Difficulties with this approach arise for the following reasons:
 Such an approach requires a bond asset to be held that is equal in

present value to the future payments discounted at bond yields (using the
full yield curve). Therefore, only a partial hedge is possible if asset cover
is less than 100%.
So, it may be that the investor does not yet have the funds to invest because he is
intending to earn them in the future.
 If the latter payments are payable after the principal payment of the
longest available government bond then it will not be possible to hedge
these payments at present (until longer maturity bonds become available,
ie creating reinvestment risk).
In the UK, this is unlikely to cause too much trouble because government bonds
are available for terms of up to 50 years.
 Due to “gaps” between bond maturities (particularly at longer durations),

there may be a need to reinvest or disinvest bonds prior to maturity, and
the hedge may therefore be imperfect.
It may be possible to buy 40-year bonds and 50-year bonds but not 45-year
bonds. A 45-year liability could be hedged using a 30-year bond and then using
the proceeds at maturity to purchase a 15-year bond. However, if interest rates
are unfavourable at the 30-year mark, the proceeds might not be sufficient.
 The use of government bonds gives risk to a (small) degree of credit risk
that may not necessarily be reflected in the liability.
As mentioned in Chapter 17, Western European government bonds are generally

considered to be risk-free assets. However, in recent years, Greece, Ireland and
Portugal, among others, have seen their government bonds’ credit ratings
downgraded. There is always the possibility that UK government bonds could
also be downgraded.
 If the tax status of the government bonds worsens, this will mean the
assets are likely to be insufficient to meet the liability payments.

 Due to the above factors, there may be some mark to market risks
between the asset value of the bond portfolio and the present value of the
liability payments discounted using the bond yield curve. In some cases
this may be a material risk factor, but in other cases this will be much
smaller than uncertainties in the liability payments themselves or other
portfolio risks.
This approach can be extended to payments that are subject to indexation,

provided there are bonds of the appropriate maturity available with the
appropriate indexation built into their payment.
Examples
 UK index-linked Gilts can be used to meet Sterling RPI-linked payments
 US Treasury Inflation Protected Securities can be used to meet US Dollar

CPI-linked payments.
Question 19.2
What is the main problem for a UK company investing in index-linked gilts to meet the
payments on an annuity?
Where there are liquid repo markets on the bonds being used to construct the
liability cashflow hedge, repo contracts can be used to release funds. In this
way a leveraged exposure to bonds can be created without investing the full
market value.
1.3 Cashflow matching using bonds and swaps
In markets where liquid and deep interest rate derivative markets have
developed, additional flexibility in hedging fixed payments is available through
the use of interest rate swaps.
Inflation-linked payments can similarly be hedged using inflation swaps in

combination with an interest rate swap. This approach is commonly termed
“Liability Driven Investment” (LDI) see Section 2 below.
Using derivatives to as opposed to direct investment is often termed synthetic portfolio

management. This idea is also discussed in Chapter 20 in the context of tracking an
index.

Question 19.3
Before moving to the next page, suggest some advantages and disadvantages of using
swaps to achieve a liability hedge as opposed to direct investment in bonds.
Advantages of synthetic portfolio management
The use of swaps rather than bonds has the following advantages:
 Interest rate and inflation swap markets may have longer maturities
available than bond markets.
 Swap markets may have greater liquidity and lower transaction costs than
bond markets.
 Swaps permit hedging to be achieved without full asset cover being

required, as they are a contract for difference rather than a funded asset.
 Swaps are in most cases bespoke contracts that are agreed with a single
counterparty, rather than a standardised listed security (like a bond).
Therefore greater flexibility is possible within the schedule of payments.
Disadvantages of synthetic portfolio management
The use of swaps does create the following complications and disadvantages:
 If the investor wishes to enter into a swap contract directly then they will
need to have ISDA documentation in place with one or more market
counterparties (typically investment banks), which is a legal document
that is negotiated and can be expensive and time consuming to set up.
 If the swaps are subject to collateralisation (to mitigate credit risk), then
this will require the movement and investment of collateral on a daily or
weekly basis.
 The bespoke nature of a swap means that closing out a swap position is
more complex than selling a bond. However, in a liquid market closing
out a swap may in fact have lower transaction costs than selling a
government bond.
 Swaps are subject to counterparty risk, if the counterparty bank defaults.

Whilst collateralisation will limit losses, if this happens a new swap will
need to be put in place at potentially higher cost (replacement risk) or the
hedge lost.

 Under an interest rate swap, the receiver of the fixed interest rate will need
to pay a floating interest rate to the counterparty. To the extent that there
is investment risk in the assets that are used to generate the floating rate
(eg cash or other assets), the swap will not mitigate these risks, whereas
a government bond portfolio is intrinsically low risk from a credit
standpoint.
 If the swap interest rate curve moves differently to the government bond
interest rate curve, this can create a basis risk, which could lead to a mark
to market loss.
1.4 Other approaches
Other approaches to meeting liability payments are possible, such as holding

shorter-maturity assets and “rolling-over” contracts. This may result in a higher
yield on assets than investing in long-dated assets or entering into long-dated
swaps, however this higher yield will not necessarily lead to a gain as
reinvestment terms are uncertain and the “roll over” process may lead to higher
transaction costs in the long term.
We described an example of rolling-over above with the idea of using the proceeds of a
30-year zero-coupon bond to purchase a 15-year zero-coupon bond. This process gives
rise to reinvestment risk and increased cost.
In principle these approaches can be extended to meeting liability payments that

are linked to other indices such as asset indices. Either an over-the-counter
derivative can be purchased, or exchange traded derivatives or other assets can
be used to dynamically hedge the liability over time by continually rebalancing
the portfolio and monitoring “Greeks” (ie sensitivities to various parameters).
Question 19.4
Define the Greeks in the context of portfolio management.
This type of process is seen in insurance companies that manage a large

number of variable annuity policies or with-profits policies that contain
guaranteed annuity rates.
PV01 is used as a measure of the sensitivity of the value of liabilities to changes

in interest rates.
PV01 is the change in present value of the liabilities due to a 1 basis point move
in interest rate.

Other terms such as DV01 measure the same change. DV01 (Dollar Value) is
used when the liabilities are US Dollar based.
Question 19.5
Outline how it might be possible to hedge the liability of a fund that promises to pay a
return equal to the increase in the capital value of an equity index over a five-year
period subject to a minimum of zero.

2 Liability driven investment
2.1 Approach
Liability Driven Investment (LDI) is the terminology used to describe an

investment decision where the asset allocation is determined in whole or in part
relative to a specific set of liabilities. LDI is not a strategy or a type of product
available in the market but an approach to setting investment strategy.
Question 19.6
What one word best describes investment that is not LDI?
LDI has gained in popularity since the 1990s and the approach is commonly
used by insurance companies and defined benefit pension funds to manage the
mismatch between their assets and liabilities (which comprise an income stream
to annuitants).
LDI investment strategies have mainly come to prominence in the UK and the US as a
result of changes in the regulatory and accounting framework for pension liabilities
Under an LDI approach it is possible to closely match:

 the interest rate sensitivity (duration) of the liabilities
 the inflation-linkage of the liabilities
 the shape of the liabilities
Some investors will focus on matching cashflows, whereas other will focus more
on balance sheet hedging ie aligning asset and liability sensitivities under
changes in interest rates and inflation expectations. The latter approach is likely
to result in an investor accepting a degree of cashflow mismatch in return for
lower basis risks.
Implementing an LDI strategy an investor would expect changes in the value of

their assets to closely match changes in the value placed on the liabilities.
The liabilities of a pension fund are to employees (future pensioners) and pensioners.
Increasingly, pension schemes are becoming defined contribution (DC) as opposed to
defined benefit (DB).

With a DC scheme, the liabilities are largely determined by the final asset value so there
is more investment freedom. Whereas, with a DB scheme, the liabilities are pre-
determined, so there needs to be much more focus on the liabilities and an LDI
approach is suitable. The extent to which a scheme focuses on LDI will depend upon
the maturity of the fund.
Question 19.7
Explain what this last sentence means.
A combination of interest rate and inflation bearing assets can provide a close
match of projected benefit cashflows, effectively immunising an investor against
future changes in interest rates and inflation expectations.
However, non-investment risks such as longevity tend to remain, although

products are being developed to manage non-investment risks and are gaining
in popularity.
One such product is a longevity bond, which pays coupons in proportion to the number
of survivors in a selected birth cohort, for example individuals turning sixty-five in the
year that the bond is issued. Since this payoff approximately matches the liability of
annuity providers, these bonds can be used to create an effective hedge against
longevity risk.
There are many different approaches to managing LDI, although most investors
tend to focus on:
 swap portfolios or
 long duration bond management.
Historically, bonds were used as a partial hedge for these interest rate risks but the
recent growth in LDI has focused on using swaps and other derivatives. These offer
significant additional flexibility and capital efficiency compared to bonds.

2.2 Liability considerations
Two key risks for most funds, especially pension funds, are:
 interest rate risk and
 inflation risk.
Typical LDI strategies involve hedging, in whole or in part, the fund’s exposure to
changes in interest rates and inflation.
Interest rate risk
The present value of fixed-rate cashflows payable in the future is linked to the
interest rate used to value them. As interest rates rise, the value of fixed rate
liabilities fall and vice versa. The greater the length of time (or duration) until the
future cashflows are due to be paid the more sensitive the value is to a change in
interest rates.
Liabilities that are due further away into the future have a greater interest rate risk than
liabilities that are due sooner.
Interest rate risk can be reduced by investing in instruments which match the
duration and value of the fixed rate cashflows payable. Investments that are
used to match duration include:
 fixed rate bonds
 interest rate swaps
Inflation linked risk
If an investor has liabilities linked to inflation, their present value will be

sensitive to changes in inflation expectations. An investor would need to invest
in assets with the same sensitivity to inflation expectations as the liabilities to
reduce any mismatch in performance. Investments used to match inflation
liabilities include:
 inflation linked bonds and

 inflation swaps (RPI and LPI swaps)

The shape of the liabilities
The shape of the liabilities will depend on when the cashflows are expected to be
paid. For a typical pension fund liabilities follow a similar shape to the diagram
below.
300
275
250
225
Projected cashflows (£m)
200
175
150
125
100
75
50
25
0
2010
2015
2020
2025
2030
2035
2040
2045
2050
2055
2060
2065
2070
2075
2080
2085
2090
2095
2100
2105
For many investors the most straightforward way to match the liabilities would
be through holding a portfolio of bonds. Although it is possible to construct a
bond portfolio where bond payments match the projected liability payments for a
pension fund it is often more difficult to match longer duration payments
(40 to 50 years) due to the limited issuance or non-availability of bonds in some
countries.
Question 19.8
What technique could be used to match these longer duration payments? What
additional risk is introduced by this approach?
This presents particular challenges for long-dated liabilities, especially

inflation-linked liabilities. In order to purchase assets that match the shape of
cashflows at longer durations, investors rely on using swaps to hedge both
interest rate and inflation risks.

More complex hedging portfolios may also make use of repo transactions to
hold some of the bonds on an unfunded basis.
In addition to interest rate or inflation hedging, a number of pension funds and

insurance companies have also entered into longevity swaps or longevity
insurance policies that exchange fixed payments (“premiums” or expected
payments to annuitants) in return for floating payments (“claims” or actual
payments to annuitants).

3 Dynamic liability benchmarks

Dynamic liability benchmarks relate to circumstances where the typical
benchmarks given to an investment manager need to vary according to the
changing nature of the liabilities. Benchmarks will always need to be reviewed
periodically to ensure that they remain appropriate, but where the nature of the
liabilities (and market conditions) is changing rapidly and are unpredictable, then
it may be necessary to link the benchmarks more closely to the liability portfolio
at all times.
In other words, if the aim is to hedge the liabilities with a given level of accuracy, then
the more volatile the liabilities, the more frequently the benchmark asset allocation
should be reviewed to ensure that this is achieved.
In effect, this is an intermediate position between conventional “static”

benchmarks and full liability hedging.
Question 19.9
Explain briefly what this is an intermediate position between conventional “static”

benchmarks and full liability hedging means.
The clearest example of dynamic liability benchmarks is probably in respect of

currencies where the nature of the liability portfolio can change very rapidly as
market conditions change. This is because currencies are typically much more
volatile than are the other possible influences on the liabilities, such as interest rates,
prices and salaries.
Historical benchmarks would therefore rapidly become inappropriate, and it is

necessary to modify these continually as the nature of the liabilities alters.
Where dynamic liability benchmarks are seen to be necessary, this will influence
the choice of assets – in particular, the liquidity of the chosen assets.
Question 19.10
Why will the need for dynamic liability benchmarks be linked to the liquidity of the
chosen assets?


Chapter 19 Summary
Liability hedging
Liability hedging involves selecting assets that perform exactly like the liabilities in all
states. The most familiar example is the choice of assets to hold in order to hedge unit-
linked liabilities.
Potential problems may arise when:

 the underlying assets are valued only on a daily basis, but traded throughout the
day
 the assets held are not the same as those underlying the value of the liabilities,
eg when the liabilities are linked to an external fund or to an external index.
Liability hedging example
The most familiar example would be for an investor to hold a portfolio of government
bonds until maturity to meet a pre-specified stream of future fixed payments.
This can be difficult because:
 bonds may not be available

 funds may be insufficient to purchase all the required bonds
 the timings of the liabilities might not be known
An alternative is to hedge the liabilities synthetically using derivatives. Using swaps

can solve some of the problems above but this approach does open up a counterparty
risk. Swaps may also be more complex and require margin deposits.

Liability Driven Investment (LDI)
Liability Driven Investment (LDI) is the terminology used to describe an investment

decision where the asset allocation is determined in whole or in part to a specific set of
liabilities.
LDI is not a strategy or a type of product available in the market but an approach to
setting investment strategy.
LDI strategies are typically aimed at hedging the main two risks faced by funds:
 interest rate risk and
 inflation risk.
Dynamic liability benchmarks
Dynamic liability benchmarks are benchmarks given to an investment manager that

vary according to the changing nature of the liabilities. Their use reflects an
intermediate position between conventional “static” benchmarks and full liability
hedging.
They are often used in respect of currencies.

Solution 19.1
If the rental payments increase with inflation, this could be hedged better with index-
linked bonds.
Solution 19.2
Knowing the right pattern of maturity dates of the index-linked gilts required to match
the liabilities. Actuaries have a good understanding of expected future lifetimes for
annuitants but this doesn’t guarantee an exact match. In the UK in the late 1990s,
companies paying annuities experienced a period of increasing reserves due to
improvements in longevity rates.
Solution 19.3
Advantages
• Swaps may have more and longer maturity dates available.
• Swaps may be more liquid
• Swaps may have lower transaction costs
• Swaps are geared, which means a full match can be achieved even if funds are
limited.
• Swaps are flexible OTC instruments, which could make it easier to match many
liabilities in one swap.
Disadvantages
• Swaps can require costly legal documentation to be in place with an investment
bank.
• Swaps may require margin payments or other collateral, which could reduce
overall liquidity
• Swaps are OTC instruments, which could make it harder to close out
• Swaps have more counterparty risk – the investment bank may default on
payment.
• Swap interest rate curves can move differently to government bond interest rate
curves - resulting in basis risk.

Solution 19.4
∂f
Delta = D = , the change of the portfolio with the underlying asset.
∂St
∂2 f
Gamma = G = , the change of delta with the underlying asset.
∂St2
(Gamma is a good measure of rebalancing costs.)
∂f
Theta = Q = , the change of the portfolio with time.
∂t
∂f
Vega = n = , the change of the portfolio with volatility.
∂s
(Vega provides a good measure of mispricing risk, especially on unquoted assets.)
∂f
Rho = r = , the change of the portfolio with the risk-free rate
∂r
∂f
Lambda = l = , the change of the portfolio with the dividend rate
∂q
Solution 19.5
It might be possible to hedge this liability by investing in a suitable combination of:

 a portfolio of equities that tracks the performance of the index (or a suitable
forward contract)
 an OTC put option based on the index value and with a five-year term.
An alternative approach might involve:

 a five-year zero-coupon bond to guarantee the capital value
 an OTC call option based on the index and with a five-year term.
Solution 19.6
“Speculative”.
Any investment decision that is determined without any reference to a set of liabilities
is aiming to generate a profit.

Solution 19.7
The maturity of the fund refers to the proportion who are either already receiving their
pension or approaching retirement. A more mature fund would need to be much more
focused on its liabilities and hence LDI.
Solution 19.8
“Rolling over” – buy bonds with shorter terms and use the maturity proceeds to
purchase new shorter term bonds.
This introduces reinvestment risk.
Solution 19.9
Dynamic liability benchmarks represent an intermediate position between conventional

“static” benchmarks and full liability hedging because:
 conventional “static” benchmarks are reviewed regularly but relatively
infrequently, perhaps once a year
 dynamic liability benchmarks are reviewed much more frequently, perhaps
weekly or monthly
 full liability hedging aims to select assets that always respond in exactly the
same way to changes in market conditions as do the liabilities to be hedged – in
effect the liabilities, and hence the benchmark, change continuously.
The consequence of this is that the use of dynamic liability benchmarks is likely to
enable a degree of liability hedging that is less exact than can be achieved via full
liability hedging but more exact than can be achieved using static benchmarks.
Solution 19.10
The need for dynamic liability benchmarks arises when the liabilities are very sensitive
to changes in market conditions and hence when they are very unpredictable. If the
currency mix of the liabilities changes rapidly, then it will be necessary to switch the
currencies of the assets rapidly in response. This may be a key motivation for holding
liquid assets, which can be easily and cheaply switched as and when necessary.





the course.

ST5-20: Portfolio management (1) Page 1
Chapter 20
Portfolio management (1)
Syllabus objectives

(i) Describe and discuss the principal active management “styles” (value,
growth, momentum, rotational).
(ii) Discuss the principal equity portfolio management techniques.
(iii) Discuss the principal bond portfolio management techniques.
0 Introduction
This chapter is the first of three chapters that consider a number of important aspects of
the management of an investment portfolio. In doing so, Chapters 20, 21 and 22 touch
upon many of the key ideas underlying investment and asset management. They
assume that we have already determined the long-term investment strategy using some
of the techniques described in Chapters 17 to 19, including asset-liability modelling.
The first section begins by discussing several different styles of investment

management. In practice, once we have determined the investments that we wish to
hold, we then need to decide first how to manage them and secondly which particular
investment manager to employ to manage them in that way. Many investment
managers specialise in a particular style of investment management, several of which
are described in Section 1.

Page 2 ST5-20: Portfolio management (1)
In Section 2 we consider:
 whether to use a top-down or bottom-up approach to select the investments
 whether to manage the investments actively or passively – although in practice a
mixture of active and passive approaches might be appropriate. Key factors to
consider here are the efficiency or otherwise of the available investment markets
and the skills of the available investment managers.
The most important example of a passive approach is index tracking – ie attempting to

replicate the performance of a particular index or group of indices. Even here though,
there is more than one feasible approach that could be used.
Section 3 discusses bond portfolio management. Often bonds are held to match fixed
liabilities. Even here though, the investor may actively manage the bonds in an attempt
to enhance investment returns by switching between bonds. In this respect, an anomaly
switch is one between two similar bonds that are mispriced relative to each other,
whereas a policy switch is between two different bonds, based on anticipated changes in
the yield curve.
The discussion of bonds concludes by considering the alternatives to government bonds

available in the market.

1 Active management styles
1.1 Introduction
In this section we look at the most common investment management styles and stock
selection approaches, including:
 growth  top-down
 value  bottom-up
 momentum  passive
 contrarian  active
 rotational
Some investment managers are also referred to as “large cap” managers or “small cap”
managers, indicating that they focus on building funds with shares with large or small
market capitalisations. These are not dealt with in this chapter.
1.2 Growth and value styles
Investment styles are a common way to distinguish between asset managers.

Managers describe themselves as either Growth or Value managers – ie managers
who specialise in managing portfolios of growth stocks or value stocks respectively.
Broadly speaking, growth stocks are stocks that are expected to experience rapid growth
of earnings, dividends and hence price. In contrast, value stocks are those that appear
good value in terms of certain accounting ratios, such as the price earnings ratio or book
value per share. In addition, growth stocks tend to be more volatile than value stocks.
There are, however, no hard and fast rules as to exactly what constitutes a growth stock
or a value stock.
Typically, there are long periods during which growth stocks will out-perform value
stocks, and vice versa. Generally speaking, when the market is confident and rising,
growth stocks will tend to out-perform and when investors are nervous and the market
is falling, investors prefer value stocks. Value stocks are seen to have more asset
backing and higher cashflow and therefore will be a safer bet. In the event of
unfavourable economic conditions, the theory is that value stocks will at least be worth
the accounting value of their assets.

Question 20.1
Why might we want to analyse the styles of investment managers?
Question 20.2
Why might a company have a high price-to-book value?
Benchmark providers have developed growth and value variants of standard

indices.
Growth managers and value managers typically aim to actively manage their portfolios.
Such indices are therefore used as a benchmark against which to assess the performance
of an active growth manager or an active value manager. Equally, these indices could
be used as a benchmark for index-tracking purposes.
The most commonly used of these are the MSCI-style indices, which take the
universe of a standard index and rank the securities according to price-to-book
values. The top half – stocks with low price-to-book values – is associated with
the value style and the bottom half – stocks with high price-to-book values – is
associated with the growth style.
An alternative approach identifies five growth factors:

1. sales growth
2. earnings growth
3. forecast earnings growth
4. return on equity
5. earnings revisions
and five value factors:

1. book to price
2. dividend yield
3. earnings yield
4. cashflow yield
5. sales to price
and uses these factors to distinguish between growth and value securities.

Question 20.3
Define each of the above factors, and describe how you might use them to identify
growth and value stocks.
1.3 Other equity investment management styles
These include:
 Momentum – purchasing (selling) those stocks which have recently risen

(fallen) significantly in price on the belief that they will continue to rise
(fall) owing to an upward (downward) shift in their demand curves.
This approach therefore aims to take advantage of momentum effects in
investment markets. Investors that used this method during the early years of
the late 1990s internet boom would have performed startlingly well!
 Contrarian – doing just the opposite to what most other investors are
doing in the market in the belief that investors tend to overreact to news.
The rationale for this approach is that whilst over the long term most shares will
give an average performance, in the short term markets tend to over-react to
good and bad news. So if a share has performed well recently, the chances are
increased that it is over-priced and will perform poorly in the coming months.
This approach therefore aims to take advantage of excessive volatility in
investment markets. Investors that used this approach during the early years of
the internet boom would have performed very poorly.
 Rotational – moving between value and growth depending on which style

is believed to be attractive at any particular point in time.
This approach requires considerable skill (or fortune) in reading the market. In
general such investors will wish to be in growth stocks when the market is rising
and value stocks when it is falling.
 Top-down and bottom-up approaches – considered below. Strictly

speaking, these are ways of constructing a portfolio rather than styles employed
by individual investment managers.

2 Equity portfolio management techniques
2.1 Top-down and bottom-up approaches
Top-down approach
The top-down approach to constructing and managing a portfolio involves a

structured decision-making process which starts by considering the asset
allocation at the highest level ie between different asset classes. Within each
asset class an analysis is then made of how to distribute the available fund
between different sectors (eg different industries for equities) and finally the
selection of the individual assets to purchase is made.
A top-down investment strategy is therefore based upon deciding what the big picture is
likely to be, before looking at the detail. The top-down approach would usually follow
the steps set out below.
1. Decide upon the long-term benchmark or strategic allocation of assets between

countries and between the main asset categories. This might be determined
using asset-liability modelling and the risk budgeting approach described in the
next chapter.
Question 20.4
What types of data will be especially important to consider within the strategic asset
allocation?
2. Decide on the short-term tactical split of investments, again between countries

and between the main asset categories based on a shorter-term view of global
economic and investment issues. The tactical decision may be based on
fundamental, quantitative and technical analyses. (Quantitative analysis is
described later in this chapter and technical analysis in the next chapter. )
Question 20.5
Differentiate between strategic and tactical investment decisions.
3. Given the chosen tactical asset allocation, decide upon the sector split within
each asset category, eg whether banks will perform better than food retailers
over the relevant time period within the domestic equity sector.

4. Finally, within each sector decide which particular stocks are “best value”
(eg whether Bank X will outperform Bank Y within the banking sector). This
will depend upon the results of an analysis of each individual company.
The actual buy and sell decisions with regard to individual investments are made on a
day-to-day basis by the investment analysts working within each of the bond, equities
and derivatives teams.
Bottom-up approach
In contrast, a bottom-up approach seeks to identify the best value individual

investments, irrespective of their geographic or sectoral spread.
These are then combined to form the investment portfolio.
Relative merits of the two approaches
The top-down approach lends itself better to controlling the risk of a portfolio by
virtue of the fact that a balanced, diversified portfolio is held.
The main risk facing the investor is that of failing to meet its objectives, which in
practice will often mean meeting its liabilities as they fall due. Continual reference to
the investor’s liabilities as part of a structured investment decision process ensures that
the process focuses on the matching requirements of the fund, thereby reducing this
risk.
Top-down adherents would also argue that the biggest differences in portfolio
performance come from differences in asset allocation rather than in individual
stock selection.
Question 20.6
Why is this likely to be the case?
This may well depend on the markets considered. For example, currency
movements will often be the biggest influence upon the domestic currency returns
achieved from overseas investment, with stock selection less important. In contrast,
stock selection within unquoted equities may be very important.

Concentration upon the big picture is a major advantage of the top-down approach,
which means that it is most often used in practice. Note that although any specific
institution will normally adopt one approach or the other, usually the top-down
approach, there may still be scope for fund managers to achieve out-performance
through “bottom-up”, or individual stock selection.
Defenders of the bottom-up approach, also known as stock pickers, would argue
that starting with allocation between sectors ignores the fact that all investment
performance starts with the performance of the individual assets held and that is
where the analysis should be concentrated.
In other words, the whole is always simply the sum of the parts. However, the counter-
argument is that too much concentration on individual stocks will mean that less time is
devoted to analysis of the bigger strategic issues, that will ultimately have a greater
impact upon overall investment performance and the satisfactory achievement of
investment objectives. For example, it may prove more difficult to attain the
appropriate level of diversification via the bottom-up approach.
In practice it is often possible to develop a methodology which combines the two

approaches.
For example, prior to each “top-down” meeting, each investment manager might be
required to submit “buy” and “sell” recommendations within her own sector. A
predominance of well-founded buy recommendations within a particular sector might
then indicate that an increased allocation should be given to that sector.
Question 20.7
A growth stock will typically have a high price earnings ratio – true or false?
2.2 Analyses used to aid stock and sector selection
A number of methods can be used for asset allocation and individual stock
selection. These include:
 fundamental analysis
 quantitative techniques
 technical analysis.
Methods for estimating relative value of sectors and individual shares have been
discussed in previous chapters.
This refers to the discussion of fundamental analysis in Chapter 10.

Question 20.8
Define fundamental analysis in the context of shares.
The term quantitative analysis refers to modern mathematical techniques that can be
used to aid stock and sector selection. Essentially these are the asset pricing models
described in Chapter 18 of this course, eg CAPM, which can be used to identify
mispriced assets and hence trading opportunities.
The use of technical analysis and a particular example of quantitative analysis

(multifactor models) are discussed in detail in the next chapter.
A further key decision that must be made by any investor is whether to manage the
investment portfolio actively or passively.
2.3 Passive equity management
Having identified the strategic asset allocation that best meets the investor’s objectives,
a passive approach to investment management involves simply maintaining that asset
allocation until there is a change in the required strategy – eg in response to a change in
the investor’s objectives. Thus, the investor might determine its long-term strategic
asset allocation, reflecting its objectives, liabilities, tax status etc, and then simply
maintain that same allocation, without variation, until the next high level review of its
investment objectives.
Alternative approaches to passive management
Alternative approaches to passive management include:

 index tracking, whereby the investor selects investments to replicate the
movements of a chosen index.
 tracking competitors, which is sometimes referred to as commercial matching
 immunisation, as a method of passively managing a bond fund.
2.4 Index tracking
Index tracking is the most important form of passive investment management in

practice. The aim of index tracking is to replicate the investment performance of a
particular index (or set of indices).

Passive investment managers are, typically, index-trackers. They manage assets

without taking active investment decisions. Instead, their objective is to track
closely the performance of a specified index. This offers the advantages of
lower cost and volatility, but with the loss of upside potential and the implicit
restriction to markets and asset classes where a suitable benchmark exists.
Question 20.9
What is meant by “active investment decisions”?
The assumption behind the index tracking approach is that markets are relatively
efficient and that any out-performance generated by active management does
not justify the increased costs. An index-tracking fund therefore attempts to
replicate the performance of a market index, either by holding all the shares in
the index in the appropriate proportions, by one of a number of sampling
techniques, or by synthesizing the index using derivatives.
Question 20.10
What is an efficient market?
Why index track?
Question 20.11
What are the main potential advantages and disadvantages of index tracking as
compared to active portfolio management?
The mechanics of index tracking
Full replication
Some investment funds may be sufficiently large to justify holding all of the shares in
the index, in proportion to their index weightings – typically their market
capitalisations. This strategy is known as full replication of the index. The advantage
of this approach is that the investment performance of the tracker fund should very
closely mirror or “track” that of the index.
Consequently, the divergence between the performance of the index and that of the
tracker fund (tracking error) should be minimised – at least before allowance is made
for the tax and expenses that will be incurred by the fund but will not be reflected in the
index performance.

Note that:
 normally, active managers are given a maximum tracking error, whereas passive
managers are simply judged on how close to zero they can achieve
 we give a more formal definition of how tracking error is typically measured in
practice in Chapter 21.
Other approaches to index tracking
However, many tracker funds take a different approach. Thus, if the aim is to replicate
the returns achieved by say the FTSE 100 index, rather than holding all 100 shares in
proportions that correspond exactly to the index weightings, the tracking fund might
instead hold:
 a representative selection or stratified sample of FTSE 100 shares. In practice,

this might involve, say, 30 shares carefully chosen so as to broadly reflect the
various characteristics of the shares in the index, eg with regard to factors such
as:
– the market weightings in each of the main sectors,
– the sizes of the companies
– their exposures to overseas earnings etc.
This approach is sometimes also referred to as partial replication.
 an appropriate combination of cash and derivatives, again to broadly replicate

the performance of the index itself, by the creation of a synthetic fund.
In either case, a multifactor model might be used to help construct a suitable portfolio
so as to replicate as closely as possible the characteristics of the index in question.
Question 20.12
What are the main advantages and disadvantages of sampling and synthetic replication
compared to simply holding the full range of FTSE 100 shares in exact proportion to
their index weightings?

Index tracking in practice
Index tracking can be applied in different ways and at different levels – ie at the level of
the entire portfolio, within individual asset classes or just within particular sectors
within each asset class. It is also possible to adapt different variations upon the general
theme of index tracking to different subsets of the entire portfolio.
An investor might actively decide upon the strategic allocation between asset classes
and then index track within each asset class.
An alternative approach might be to index track within some classes/sectors and not
others. For example, index tracking might be more sensible in particularly:
 efficient sectors, such as large blue chip companies, where price anomalies are
likely to prove few and far between
 inefficient sectors, such as emerging markets, where the potential for
underperformance is likely to be greater and/or the level of investment expertise
is lower.
A further variant upon the basic theme of index tracking is the core/satellite approach.
This involves index tracking a “core” proportion of the portfolio whilst allowing the
fund manager(s) to actively manage the remaining “satellite” funds.
There is nothing to prevent a particular investor from using a combination of different

approaches for different asset classes, sectors and/or funds.
2.5 Active equity management
Having identified the strategic asset allocation, an active approach involves actively
seeking out under-priced or over-priced assets, which can then be traded in an attempt
to enhance investment returns via short-term tactical deviations away from the
benchmark strategic position.
By seeking out under-priced or over-priced sectors, the investor may be able to make
sector selection profits, whilst by identifying individual stocks that are under-priced or
over-priced the investor may be able to make stock selection profits. In addition,
additional profits (or losses!) may be generated by switching between sectors and/or
stocks that appear mispriced relative to each other.

This will not be possible if the investment market in question is efficient. Thus, active
investment management is appropriate only if the investor believes that the investment
market is in fact inefficient. In contrast, if the market is believed to be efficient, then a
passive manager might be employed to track a particular benchmark.
Active investment managers, on the other hand, apply various types of

judgement to the selection of portfolios with the objective of out-performing a
benchmark. Active investment managers can be divided into two groups:
1. Multi-asset (balanced) mandates

Such managers manage funds that are invested across a variety of different asset
categories such as equities, bonds, property and overseas. The balanced
mandate manager will take decisions on the weighting in each asset category
and decisions on the type of stocks purchased in each category (value/growth
etc). They will try to out-perform managers that operate funds with similar
mandates, constraints and tax treatments.
2. Specialist mandates
Here each investment manager specialises in a particular asset category and is
employed to manage the funds invested in that asset category only. Each
specialist manager will attempt to outperform the relevant benchmark, eg the
FTSE 100 index.
This approach might be sensible if pension fund trustees wish to make their own
decisions on the amount to be invested in the various asset categories and
possibly the type of investment to make in each category. Specialist investment
management groups therefore offer a range of specialist funds, for example,
specialist “growth-style” equity funds, or specialist UK property funds. Trustees
can then invest the pension fund directly in the chosen asset categories via such
specialist funds.
Why actively manage?
Active management offers the prospect of large returns (in excess of fees paid)
and the limitation of “peer group” risk.
Of course, consistent out-performance is possible only if the investment manager has

the skills to exploit any market inefficiencies.
Question 20.13
Explain what is meant the term “peer group” risk in the above sentence.

However, successful selection of active investment managers is hard to achieve

and timing the changes to the line-up of active managers is also very difficult.
For example, a good past record of successful out-performance will not guarantee future
out-performance. This is because an approach that worked during one period might not
prove successful over a different future period, especially given that investment market
conditions continually change.
The value, growth, momentum, contrarian and rotational styles described above are all
examples of active investment management styles.
2.6 “Active over passive” management
An increasingly popular fund management structure is to manage the majority of

the fund (the “core” portfolio) on a passive, low-cost basis. Specialist satellite
managers are then employed to, hopefully, provide increased performance (in
excess of fees paid) in respect of the balance of the fund. This may extend to
employing a number of competing managers in respect of the specialist asset
classes, if the size of the overall fund warrants this. Increasingly, the satellite
managers will include hedge fund and private equity specialists.
Recall:
 the discussion of private equity and hedge funds in Chapter 4 of this course
 that the investor might choose to combine the active and passive approaches,
managing assets actively within some sectors and passively within others.
Question 20.14
What are the main potential advantages of employing private equity and hedge fund
specialists as satellite managers?

3 Bond portfolio management techniques
3.1 Introduction
Matching
One technique for an institutional investor is to identify the bonds that would best
match its liabilities and select those which give the best yield. Matching by itself is
unlikely, however, to maximise the expected return on the bond portfolio.
Consequently, bond portfolio managers will often adopt a more active approach to bond
management, occasionally involving a divergence (perhaps only short-term) from the
matched position, in order to achieve a higher return. This approach will be based
around switching.
Switching
Active management of a bond portfolio involves selling one stock and buying
another, in the hope of achieving a higher return. Returns can only be enhanced
in this way in markets where there is a variety of highly marketable bonds
available. The process is known as switching and can be classified in one of two
ways. These are known as anomaly switching and policy switching.
3.2 Anomaly switching
Anomaly switching involves moving between stocks with similar volatility,

thereby taking advantage of temporary anomalies in price. It is a relatively low
risk strategy, but widespread use of computer-based analysis limits
opportunities for significant anomalies between similar bonds.
So, this is where an investor spots that similar individual stocks appear to be
temporarily cheap or dear. The investor can profit by selling dear stocks and replacing
them with cheap stocks. It is a relatively low-risk strategy because the move is from the
core portfolio into broadly similar stocks (in terms of coupon and term to maturity, and
hence volatility). The chosen stocks will seem relatively more attractive according to
one of the analytical criteria discussed below.
The idea is that the anomaly will prove temporary and that the switch can be reversed
for a profit, when the situation returns to what is regarded as “normal”. Not
surprisingly, increased sophistication of computer-based analysis has greatly reduced
opportunities for significant anomalies between similar bonds.

Question 20.15
What is the volatility of a fixed interest bond?
The first step with an anomaly switch is clearly to spot an anomaly.
3.3 Techniques for identifying anomaly switches
Yield differences and position relative to a yield curve
In considering possible anomaly switches, yield differences are widely used to

identify individual bonds which seem cheap or dear in relation to other bonds.
However, because high-coupon bonds are likely to have higher gross yields than
low coupons, a high gross yield does not in itself indicate that a bond is cheap.
The investor must examine whether the yield difference is greater or less than it
has been in the past.
Question 20.16
Why might high-coupon bonds have higher gross yields than low-coupon bonds?
The assessment could be carried out against the yield curve or against the most similar
term and coupon stocks. Various systems have been set up to compare yields on
individual bonds with those on a fitted yield curve and to compare current differences
with past averages and with past ranges.
For example, if a bond currently yields 40 basis points more than the yield on the fitted
curve at the same maturity, but has recently traded at an average of 50 basis points
above the yield curve, it might be considered somewhat expensive, on this measure.
A problem with the evaluation of individual bonds in relation to a fitted yield

curve has been the stability of the method used to fit the curve.
In other words, small changes in yields on a few stocks can sometimes cause large
changes in the fitted curve. An unstable fitted curve is a poor benchmark to compare
individual stocks against.
It is now more usual to review a computer-generated history of yield spreads

between actual pairs of bonds.

Question 20.17
Unusually, a particular government bond stands above the yield curve. Give a five-step
guide to what you would do about it if you were a bond fund manager for a portfolio
that did not currently hold the bond.
Question 20.18
Explain why a fund manager having performed an anomaly switch would switch back
to the original stock.
Price ratios
These can be monitored as well as yield differences. Ideally, a switch under

consideration will look attractive, in relation to both yield and price histories. A
practical problem in using price ratios is that they do not allow for the fact that
the two bonds may have different coupons; they will have different prices but
will both be redeemed at 100. So the ratio of the two prices will display a trend.
This history of price ratios may be adjusted by this trend to produce what are
often known as “stabilised” price ratios.
Price models
Some bond analysts have devised price models which try to assess the
“correct” price for a stock, given the key variables. A stock’s price is considered
anomalous if the actual price differs from the price derived from the model.
You are already familiar with a simple price model that incorporates the term and
coupon of a stock:
P = gan| + 100v n
This model is too crude for spotting anomalies because we don’t really know what
valuation rate of interest to use. The valuation rate should vary between stocks to
reflect their differences (eg marketability, coupon, double-dated). More sophisticated
price models will therefore try to allow for these further factors.

Yield models
Rather than compare a bond’s yield with a redemption yield curve it can be
compared with one of the alternatives such as a yield surface or par yield curve.
Question 20.19
Your portfolio holds one bond that has a volatility of 10 and which matches your
liabilities.
One of your colleagues notices a stock priced at $102½, with a volatility of 5, which
appears to be priced below the level your price model suggests. He proposes a quick
anomaly switch whereby switching $5 million should make a profit of about $5,000.
What would worry you most about this proposed switch?
Question 20.20
Why does the investor not need to consider issues such as matching when undertaking
an anomaly switch?
Question 20.21
Summarise Section 2.3 in fewer than 70 words.
3.4 Policy switching
Policy switching is a more risky approach that involves taking a view on future
changes in shape or level of the yield curve and moving into bonds with quite
different terms to maturity and/or coupon. For example if yields generally were
expected to fall, the portfolio might be switched into longer-dated, more volatile
stocks.

So, a policy switch is where an investor takes advantage of a movement in the level of
the yield curve or a change in the shape of the yield curve. It is a more aggressive
approach in which the investor takes a view on future changes in the yield curve. The
investor moves into bonds with quite different terms to maturity and/or coupon, and
hence volatilities, or even between different types of bond, eg fixed interest to index-
linked.
A policy switch offers the prospect of greater profit if expectations are fulfilled, but can
be much riskier than an anomaly switch. A less risky form of policy switch might
involve a less dramatic move along the yield curve. In making policy switches
investors consider the percentage change in value arising from a change in yield, ie the
volatility.
3.5 Techniques for identifying policy switches
We look at three techniques that can help when making policy switches:
1. volatility and duration
2. reinvestment rates
3. spot rates and forward rates.
Volatility and duration
Volatility gives a measure of “risk” in terms of price movement for a given change in
yield. While this is not an appropriate measure of risk for a fund manager whose
investment objectives are determined with reference to long-term liabilities, it is a
useful measure, within a bond portfolio, for policy switching.
In practice, the yield curve does not move by a uniform amount over the whole term.
We need to consider changes in the shape of the yield curve as well as changes in the
level of the yield curve.
Switches based on changes in the level of the yield curve
Calculations of volatility or duration together with forecasts for changes in yield

at different points along the yield curve can be used to estimate percentage
changes in value and so to determine the area of the market which will give the
best returns, if the forecasts prove accurate. This might then lead the fund manager
to make a policy switch between bonds of different duration.

For example, following careful research of government spending, inflation forecasts,

overseas bond yields and exchange rates, we decide that the yield curve is too high and
will shortly fall uniformly (ie once the rest of the market has woken up to the fact that
yields are too high).
To profit most from our prediction we should switch from a short-term stock (A) to a
longer-term stock (B). Because Stock B is more volatile, its price will rise more when
yields fall. Once the yield curve has fallen, we switch back to Stock A.
An important point here is that we make our move before the rest of the market. If we
wait until everyone else thinks the same way as us, then the buying and selling activity
will shift the yield curve before we make our switch. We want to be holding Stock B
when the yields fall.
On the assumption that our holding of Stock A was part of a matched portfolio, we need
to return to Stock A to return to the matched portfolio.
Switches based on pure changes in the shape of the yield curve
It is also possible to profit from changes in the shape of the yield curve regardless of
what happens to the average level of the curve.
Suppose that a fund manager is considering a policy switch from Bond A to Bond B
because he anticipates a change in the shape of the yield curve. Suppose he is selling
$1m nominal of Bond A, he may wish to buy the appropriate amount of Bond B so that
his exposure to changes in the level of yields is not altered. If Bond B has a longer term
to maturity and/or a lower coupon, it is likely to be more volatile and so the fund
manager may wish to buy a smaller amount of nominal, to maintain his original
exposure to changes in the level of yields.
Reinvestment rates
Another technique used in connection with policy switches is based on reinvestment

rates.
Consider two Bonds A and B, the latter having a longer term to maturity.
Knowing their yields to maturity, it is possible to compute a rate at which the
proceeds of the first bond would have to be reinvested, up to maturity of the
second bond, to match its total return. If this reinvestment rate is particularly
high, it may be considered unattainable, leading to the conclusion that Bond B
offers better value.

It is useful to select representative bonds at various points along the maturity

range and to work out the reinvestment rates between each bond and the next.
Examination of the series of reinvestment rates can help to identify areas which
seem cheap or dear in relation to neighbouring areas.
Spot rates and forward rates
A similar technique to using reinvestment rates is to derive forward and/or spot

rates from the yield curve. This may reveal oddities in the term structure of
interest rates which give rise to a policy switch opportunity.
Question 20.22
Suppose that Stock A has a volatility of 5, and Stock B has a volatility of 10. Suppose
that we switch $10 million from Stock A to Stock B and that yields then fall by a
uniform 1% pa. How much money has this switch made us?
This example is rather extreme. However, it does illustrate the concept of policy
switches: making use of the different volatilities of different stocks to profit from
changes in the yield curve.
Question 20.23
What should we have done in the previous example if we thought that the yield curve
would rise by a uniform 1% pa?
Question 20.24
What is the difference between an anomaly and a policy switch?
Question 20.25
What checks might a fund manager carry out before making either an anomaly switch
or a policy switch?

3.6 Alternatives to Government bonds
Bond markets have evolved rapidly over the last few years, increasingly the
investible universe for investors. In addition to Government bonds the types of
bond or bond-like investments include (not exhaustive):
 Agency bonds – bonds issued by US government-sponsored agencies.
 Investment grade corporate bonds
 High yield bonds
 Convertible bonds – bonds that may be converted into equity at a later date.
 Distressed debt - securities of companies or government entities that are either

already in default, under bankruptcy protection, or in distress and heading
towards bankruptcy. While is no precise definition, any debt instrument with a
yield of 10% over the risk-free rate can be thought of as being distressed
 Event-linked bonds – bonds with coupons and redemption payments
conditional on the non-occurrence of a defined event, such as an earthquake.
 Interest rate and inflation swaps
 Credit default swaps – these were discussed in Chapter 3.
 Mortgage Backed Securities (MBS)
 Asset Backed Securities (ABS) - MBS and ABS were discussed in Chapter 4.
Apart from policy and anomaly switching (see Section 3.4 above), a portfolio
manager will use some or all of the above bond like investments to try and derive
additional return from a portfolio relative to a Government bond portfolio.
Question 20.26
Summarise how an investor uses policy switching to generate higher returns.
The additional return or yield premium that a non-government bond offers over a
government bond is generally regarded as being made up of two elements:
 an additional yield to compensate for the risk that the bond issuer will
default (and therefore fail to meet its obligations)
 an illiquidity premium to reflect the typically weaker marketability of
non-government bonds to Government bonds.
There are some additional structural factors, especially with swaps which are
also factored into the price.

Portfolio managers will take a view as to whether the additional yield for default
and liquidity are correctly priced into a bond. Portfolio managers will purchase
bonds where they believe the yield pick-up is greater than the additional risk of
holding the bond.
Yield pick-up refers to the gain in yield when an investor sells one bond and buys
another. They will do this if they believe the gain in yield is more than required for the
increase in risk.
In recent times bond managers investing in non-government bonds have

suffered from poor returns due to the ‘credit crunch’. In particular MBS and ABS
were particularly affected, with liquidity ceasing to exist for large periods of time.
The credit crunch
The phrase "credit crunch" was so widely used between 2008 and 2010 that it was
added to the Oxford English Dictionary.
The credit crunch was a lending crisis caused when banks became nervous about
lending funds to each other because of concerns about the value of collateral used to
secure the loans. For example, Northern Rock found itself unable to refinance a
significant loan and was forced to approach the Bank of England for a loan facility.
Question 20.27
How does credit crunch differ from a recession?
Why did banks become nervous? Over the previous years, easy and cheap credit was
readily available. Individual investors borrowed heavily to invest in property. The
main problem was in the US. Mortgages were sold to individuals with weak credit
ratings – often referred to as sub-prime lending. In the UK self-certified mortgages and
high loan-to-value mortgages meant borrowers were often financially overstretched.
Question 20.28
What is a self-certified mortgage?
Many of these mortgages were repackaged into securitisations. The securitised

mortgages were sold on to investment banks who had seen them as a relatively safe way
to generate high returns.

Unfortunately borrowers started to default on their loans in large numbers. The value of
the securitised investments plummeted resulting in huge losses for banks globally.
Many UK banks had exposure to large sums of these “toxic assets” and had write off
billions of pounds of assets, requiring bail-outs from the government.
3.7 Risk management
Bond portfolios are often held to match specific liabilities. If this is the case
various techniques such as immunisation, stochastic asset liability modelling,
Value at Risk and multifactor modelling may be used to control the portfolio risk.
As such, these models and techniques are used primarily to develop the benchmark
investment strategy. In contrast, switching is based around short-term tactical
deviations from the long-term strategy.
Recall that immunisation and stochastic asset liability modelling were discussed in
Chapter 17 of this course. Value at Risk and multifactor modelling are considered in
detail in the next chapter.
3.8 Use of bond repos
With the move towards central clearing for OTC derivatives in a number of
markets, there is an increased demand for cash from investors to fund initial and
variation margin payments. For some investors, who typically do not have a
large allocation to cash (eg pension funds), the use of bond repos and securities
lending are being used as strategies to generate the cash collateral required.
Repos were discussed in Chapter 3.
Question 20.29
What is a repo?
Question 20.30
What is a reverse repo?

4 End of Part 5
What next?
of your revision.
Time to consider – “revision and rehearsal” products
ASET – This contains past exam papers with detailed solutions and explanations, plus
lots of comments about exam technique. Students have said:
“ASET is the single most useful tool ActEd produces. The answers do go
into far more detail than necessary for the exams, but this is a good
source of learning and I am sure it has helped me gain extra marks in the
exam.”


Chapter 20 summary
Management structures and styles
Investment styles are an increasingly common way to distinguish between asset

managers.
Growth managers specialise in managing portfolios of growth stocks – broadly stocks

that are expected to experience rapid growth of earnings and hence share price.
Value managers specialise in the managing portfolios of value stocks – stocks that
appear good value in terms of certain accounting ratios, such as the price earnings ratio
or book value per share.
Other equity investment styles include:

 Momentum – purchasing (selling) those stocks which have recently risen
(fallen) significantly in price on the belief that they will continue to rise (fall)
owing to an upward (downward) shift in their demand curves.
 Contrarian – doing just the opposite to what most other investors are doing in
the market in the belief that investors tend to overreact to news.
 Rotational – moving between value and growth depending on which style is
believed to be attractive at any particular point in time.
The top-down approach to constructing and managing a portfolio involves a structured

decision-making process that starts by considering the asset allocation at the highest
level, ie between different asset classes. Within each asset class an analysis is then
made of how to distribute the available fund between different sectors and finally the
selection of the individual assets to purchase is made.
In contrast, a bottom-up approach seeks to identify the best value individual

investments, irrespective of their geographic or sectoral spread.
The choice of asset allocation and individual stock selection may be based on:
 fundamental analysis
 quantitative techniques – one example of which is the use of multifactor models
 technical analysis – which aims to predict future market movements by
analysing past market data. The methods used include Chartism, mechanical
trading rules and relative strength analysis.

Passive and active investment management
Passive investment managers are, typically, index-trackers. They manage assets

without taking active investment decisions. Instead, their objective is to track closely
the performance of a specified index. This may be appropriate if the particular market
is efficient.
The available approaches to index tracking include:

 full replication
 sampling
 synthesizing the index using derivatives.
Active investment managers, on the other hand, apply various types of judgement to the
selection of portfolios with the objective of out-performing a benchmark. Active
investment managers can be divided into two groups:
1. multi-asset (balanced) mandates
2. specialist mandates.
An increasingly popular fund management structure is the core-satellite approach,

whereby the majority of the fund consists of a passively managed “core”. In addition,
specialist satellite managers are then employed to provide increased performance via
active management.

Bond portfolio management
Although bonds are often held to match liabilities, investors in bonds often try to
increase their returns through active trading, using anomaly switches and policy
switches.
Anomaly switching involves moving between stocks with similar volatilities, thereby
taking advantage of temporary price anomalies. It is a low-risk strategy. Techniques
used to identify possible anomalies include:
 yield differences
 price ratios
 yield models
 price models.
Policy switching is a riskier approach that involves moving between stocks with
different volatilities, to take advantage of predicted changes in the level and/or the
shape of the yield curve. Policy switching may be aided by the analysis of:
 bond volatilities
 reinvestment rates
 spot/forward rates.
Where a bond portfolio is used to match specific liabilities, techniques that may be used
to control bond portfolio risk include:
 immunisation
 stochastic asset-liability modelling
 Value at Risk calculations
 multifactor modelling.
The ideas of policy switching and anomaly switching apply more generally to switches
between other types of assets.


Solution 20.1
There are various reasons for wanting to analyse manager styles.
One reason is that it is misleading to compare the historical performance of two equity
fund managers if one has been following a growth strategy and the other a value
strategy. The difference in performance between the two managers will be dominated
by whether the growth/value part of the decision has been correct, and the (arguably
more important) information about how each of the managers has succeeded in picking
stocks will be unidentifiable. It would be more useful to compare growth managers
against other growth managers to determine how successful each manager is at picking
stocks.
Another reason for making the analysis is so that investors can select an appropriate
manager for their fund. If a trustee wishes to invest the assets of a pension fund in
growth stocks (because he or she presumably believes that over the long term such
stock will provide a higher return) then appropriate managers can be recommended. If
the trustee wishes to diversify and invest in a mixture of growth and value stocks, then
the assets can be divided between two managers who have proven track records in
growth fund management and in value fund management respectively.
Solution 20.2
A high price-to-book value indicates that a company either has an inflated price or a
low accounting value of assets. The first may be as a result of the market valuing the
company highly, most probably because the company’s earnings are anticipated to grow
strongly or because it is a potential takeover candidate. The second (ie a low
accounting value) is traditionally associated with modern industries such as
management consultancy or IT that have very little in the way of fixed, tangible assets.
Most of the assets are in the form of human capital (which of course does not make it on
to the balance sheet). “Growth” stocks typically have a high price-to-book value.

Solution 20.3
Sales growth
Defined as the average annual percentage growth rate in turnover over a chosen period.
Stocks that claim to be in growth markets should be able to demonstrate high historical
growth in turnover and earnings.
Earnings growth
EPS  previous year ' s EPS
Defined as
previous year ' s EPS
where EPS refers to the company’s earnings per share shown in its accounts. See
comments for sales growth.
Forecast earnings growth

High forecast levels of growth in earnings would be associated with a growth stock.
Return on equity
profit for shareholders
Defined as
equity capital  reserves
This ratio is usually calculated using accounting values for equity capital,
ie shareholders’ capital & reserves from the balance sheet. Accounting value may not,
however, be considered suitable if the company’s assets are not in the form of fixed
assets. In general, a high return on equity would be expected from a growth stock,
based on both accounting capital and market capitalisation.
Earnings revisions
From time to time the management of a company will estimate prospective earnings,
usually to help the stockbroker analysts determine whether their own estimates are
reasonable. These management estimates will be revised upwards or downwards as the
year progresses and events unfold. A stock that is successfully growing would be
expected to err on the low side with its estimates and so have to revise them upwards.

Book to price
net asset value per share
Defined as
market price per share
Value stocks would be expected to have high book to price ratios – indeed some stocks
actually have market capitalisations below their accounting values and hence have
ratios of more than 1.
Dividend yield
dividend per share
Defined as 100%
A value stock would not be expected to have a high price relative to its current earnings
or dividends. Therefore we would expect the dividend yield of such stocks to be high.
Earnings yield
earnings per share
Defined as 100%
We would expect value stocks to have high earnings yields for the same reason as
mentioned above for the dividend yield.
Cashflow yield
net cashflow per share
Defined as 100%
Companies with low prices (as a result of low growth prospects) tend to have high
cashflow yields.
Sales to price
turnover
Defined as
market capitalisation
This ratio has to be used carefully, because companies that have debt capital as well as
equity can clearly generate higher sales volumes for the same equity capitalisation. In
such cases the bottom line should reflect the total value of the company’s equity and
debt capital – its total enterprise value. However, that apart, we would expect value
stocks to generate high amounts of turnover per unit of market capitalisation.

Solution 20.4
The types of data that are important relate to:

 economic growth
 short-term and long-term inflation
 short-term and long-term interest rates
 structural shifts within the economy
 currency movements
 bond and equity market yields
 the investment objectives, attitude to risk and/or liabilities of the investor
 the investment strategies pursued by the investor’s peer group.
Solution 20.5
A strategic investment decision determines the long-term investment strategy of the

investment fund, which should be structured in order to best meet the investment
objectives of the fund.
In contrast, a tactical investment decision involves a short-term divergence from the

long-term strategic asset allocation in order to make additional investment returns. It is
based upon a belief that current investment market values are misaligned and an
expectation that they will consequently correct themselves shortly, at which point the
asset allocation will revert back to the strategic norm.
Solution 20.6
This is likely to be the case because the returns provided by the individual securities
within any particular asset class will generally be a lot more closely (positively)
correlated (as they are affected by similar factors) than will the returns provided by
individual securities in different asset classes.

Solution 20.7
This is true – ie a growth stock will typically have a high price earnings ratio. This is
because investors will be willing to pay a high multiple of current earnings to buy into
an earnings stream that they expect to grow rapidly in the future.
Solution 20.8
Fundamental share analysis is the analysis of a company’s share value and potential for
future profit and dividends, based on accounting and economic information.
Solution 20.9
An active investment decision is a decision to trade a stock that is believed to be

mispriced in order to generate a profit when it price returns to its “correct” level.
Solution 20.10
An efficient market is one in which asset prices accurately reflect all available and
relevant information at all times. This means that it is impossible to generate excess
risk-adjusted returns by pursuing an active investment approach. So, a passive
approach might be more suitable, particularly if it is less expensive to adopt than an
active strategy, which is likely to incur much greater dealing and research costs.

Solution 20.11
Advantages
 The risk of (substantially) under-performing the index in question – and

indirectly also your competitors – is greatly reduced.
 The less active approach to investing should result in lower portfolio
management costs – ie lower dealing and research costs.
 According to the efficient markets hypothesis, it is in any case impossible to
systematically outperform the index – except by investing in securities that
involve a higher degree of risk. Hence a passive investment strategy is
appropriate if the particular market is believed to be efficient.
 Tracking a well-diversified index will ensure that the fund itself is well-
diversified, so reducing specific risk and hence the volatility of portfolio returns.
Disadvantages
 The risk of (substantially) over-performing the index in question – and perhaps

your competitors – is greatly reduced. It may be possible for a skilful
investment manager to out-perform both the index and the competition in an
inefficient market.
 In particular, a fully replicating index tracker is forced to buy new constituents
of an index at inappropriate times, eg when all the other index-tracking investors
are attempting to buy that security and so the price is forced artificially high.
Similarly, it will be a forced seller of shares that drop out of an index.
 The resulting investment strategy may pay insufficient regard to the investor’s
objectives and hence result in unacceptable levels of actuarial risk.
 It may prove difficult either to find an appropriate index to track, eg the indices
available in an emerging market include shares that cannot be purchased non-
residents, or to track the chosen index, eg in the property sector.

Solution 20.12
The main advantages are that:

 by avoiding a more fragmented portfolio, management costs ought to be lower
 dealing costs are likely to be lower, as the fund is not committed to trading
whenever an index constituent changes.
The main disadvantages are:

 that the tracking error is likely to be greater – though expenses mean that exact
replication of index performance will in any case never be possible
 that the research costs of deciding exactly which shares or derivatives to hold
may be higher.
Solution 20.13
Peer group risk is the risk that a fund will under-perform compared with its peer group
over the long term, which situation could arise if the fund’s peers are able to
successfully out-perform a particular index by active management.
Solution 20.14
The employment of specialist private equity and hedge fund managers may offer the
possibility of:
 higher investment returns
 increased diversification, with a consequent reduction in market risk.
Solution 20.15
The volatility of a fixed interest bond measures the sensitivity of the bond price to a
change in its gross redemption yield. Loosely, a volatility of 5 means that a 1% change
in the yield will lead to a 5% change in the bond price. More formally, it is defined as:
-1 dP
V=
P di
where P is the dirty bond price and i is the gross redemption yield.

Solution 20.16
High-coupon bonds will tend to offer higher gross yields if most investors prefer capital
gains to income, in which case they will bid up the prices of low-coupon bonds. This
will be the case if, for example, the income from bonds is taxed more heavily than the
capital gains.
Solution 20.17
1. Check that the yield is genuinely an anomaly, ie is this yield above the stock’s
usual position? If so, the price of the stock has fallen (perhaps because several
major investors happened to start selling the stock in large quantities) and so the
gross redemption yield has moved above the yield curve. This stock is a perfect
target for an anomaly switch. We should buy the stock because we think that it
is temporarily cheap and that its price will at some time (soon) rise back to its
usual position.
2. Find the stock in our portfolio that has the closest volatility to the target stock.
We will sell this stock to ensure we do not end up with an unbalanced or
mismatched portfolio.
3. Simultaneously sell our similar stock and buy the anomaly stock.
4. Wait for the anomaly to disappear. We hope that the stock reverts to its normal
position (ie on the yield curve in this example).
5. Switch back. Once the price of the anomaly stock has risen, we can then switch
back to our usual holding. We end up with more of our original holding than we
started with.
Note that this switch is based on buying a stock that is temporarily cheap. Anomaly
switching can also be carried out if a stock that you hold is temporarily dear, ie sell the
stock and buy it back when it has returned to its usual price level.

Solution 20.18
Why switch back in an anomaly switch?
The reasons for switching back to the original stock are pragmatic rather than
theoretical.
 Fund managers like to “crystallise” their profits from switching activities, as it is

much easier to show a client that some profit has been generated.
 If the fund manager did not switch back, then the portfolio could end up being
very fragmented. Switching back to a few core holdings is better.
Solution 20.19
The really big concern is the different volatilities of the two stocks. For example, if
yields fell by 0.1% for both stocks while we were in mid-switch, then we would lose
around $20,000 by the time we switched back, even if the anomaly gave the predicted
profit.
The $20,000 estimate is based on our matched stock increasing in price by 1% and the
target stock increasing by just ½%. This leads to a loss of about ½% of $5m,
ie $25,000. Allow about $5,000 profit from the anomaly and we are $20,000 down on
the switch.
Solution 20.20
The investor does not need to consider issues such as matching when undertaking an
anomaly switch because the two assets have similar investment and risk characteristics.
So undertaking the switch will not change the characteristics of the assets and hence the
degree to which the portfolio matches the liabilities.
Solution 20.21
There are several techniques for spotting price anomalies between bonds. They are
based on comparing the current difference with past differences in prices or yields on
one bond as compared with another bond, or a model of bond prices/yields. Computers
are used to make the process manageable. The profit is likely to be small, but it should
be almost risk-free if switches are between bonds of similar volatility.

Solution 20.22
Ignoring dealing costs, the value of our holding in Stock B increases by 10% when
yields fall so we now have $11m. Stock A is 5% more expensive when we switch back,
so it costs us $10.5m to purchase the stock we had sold. We now have the same stock
as we started with plus $½m extra.
Solution 20.23
If we had thought that the yield curve would rise by a uniform 1% pa, we would try to
reduce volatility, ie by switching into short-dated stocks or into cash. We would then
switch back into Stock A once yields had risen.
Solution 20.24
For anomaly switches, the volatility of the two stocks needs to be similar. In contrast,
policy switches exploit differences in volatilities.
An anomaly switch leaves the main characteristics the same but makes a change in the
individual stocks making up the portfolio. For example, selling a five-year 9¾%
coupon government bond and buying a six-year 10% coupon government bond, would
be an anomaly switch.
A policy switch is one that involves changing the overall characteristics of the portfolio
– a switch from a five-year bond to a fifteen-year bond, for example.

Solution 20.25
A fund manager may carry out the following basic checks before carrying out an
anomaly switch:
 Is the target stock really above its usual position relative to the yield curve?
 How much profit could be made from the switch?
 Is the profit sufficient to cover the dealing expenses?
 When is the anomaly likely to be corrected?
Policy switches are potentially far more profitable than anomaly switches. However,
they are also far more risky. If the predictions go wrong, then they could result in big
losses. So, some careful checks are needed before embarking on a policy switch:
 Are we sure that the yield curve will move as we predict? Is it possible that
some more significant factor will emerge that will undermine our reasoning?
 How long will it take for the predicted change in the yield curve to take place?
This will happen when the rest of the market comes round to our way of
thinking. If this will take a long time, then it increases the chance of something
going wrong (because other factors might emerge over the period).
 Can we afford to take the risk? If we have to maintain a closely matched
position (eg our free reserves are low), then perhaps we should not risk it. How
much can we afford to switch?
 How exactly will the yield curve change? Do we want more volatile or less
volatile stocks to maximise our profit?
 How much change in yields do we expect and consequentially how much profit
do we expect to make? Is this sufficient to cover the dealing expenses and the
risk?
Solution 20.26
Policy switching involves taking a view on future changes in shape or level of the yield
curve and moving into bonds with quite different terms to maturity. For example if
yields generally were expected to fall, the portfolio might be switched into longer-
dated, more volatile stocks. The strategy is usually reversed once profits have been
achieved.
Solution 20.27
A recession is usually taken to mean two successive quarters of negative economic

growth. A credit crunch can be separate to or part of a recession.

Solution 20.28
It is common for the terms of a mortgage to specify a maximum mortgage/salary ratio,

typically this is 4 or 5. A self-certified mortgage offers the chance for an individual to
claim to be earning a particular salary without providing any proof of earnings. This is
a often necessary for the self-employed, who might find it very difficult to prove their
income.
However, it is open to abuse and some individuals claimed salaries way above what
they actually earned in order to borrow large amounts of mortgage funds.
In July 2010, the FSA announced plans to ban most self-certified mortgages.
Solution 20.29
A repo is an agreement whereby one party sells an asset (often a government bond or a
Treasury Bill) to another with a simultaneous agreement to repurchase it at a later date
at an agreed price. Holders of government bonds and other high quality assets can use
repos as a short-term financing tool, whilst maintaining their underlying economic
exposure to these assets.
Solution 20.30
A reverse repo is the opposite side of the agreement. This is a form of secured lending
as cash is being lent for the duration of the repo by the party buying the stock, with the
security as collateral.

Chapter 21
Syllabus objectives

(vii) Discuss the usefulness of multifactor models in practical investment

management and risk control
(x) Role of the custodian
(xi) Portfolio construction with attention to Value at Risk, tracking error, risk
budgets
(xii) Measurement, comparison and attribution of risk
0 Introduction
This chapter continues our discussion of portfolio management.
Section 1 discusses the factors influencing the construction of a portfolio. In general,

when managing an investment fund to cover liabilities, managers will often face a
conflict between reducing risk (by matching) and enhancing investment return (by
mismatching). The investment policy taken therefore needs to reflect this trade off.
This typically leads to a two-stage process in the construction of a portfolio:
1. establishing the investment strategy
2. the tactical implementation of this policy by selecting appropriate investment
managers and deciding how much risk they are to be allowed to take.
When constructing the portfolio, it will therefore be necessary to identify and quantify
the main risks involved, namely strategic risk, active risk and possibly also structural
risk.

Sections 2 and 3 next consider the use of multifactor models and technical analysis in
portfolio management. Both of these techniques can be used to identify mispriced
assets as a part of an active approach to portfolio management. In addition, multifactor
models may also be used as part of a passive approach to identify assets that match
liabilities and/or track an index.
Risk budgeting is the focus of Section 4. It is a process that can be used to determine
how much risk an investor is able to take and then how to “spend” that risk most
efficiently, ie so as to maximise the expected investment returns. This presupposes that
we are able to quantify risk and so Section 5 discusses various measures that are used in
practice. In particular, and depending on the particular circumstance being considered,
we might wish to use either:
 measures of risk relative to a benchmark index, such as tracking error, or
 measures of downside risk, such as Value at Risk (VaR) and tail VaR.
The concepts of VaR and tail VaR were introduced in earlier subjects (CT8 and
CA1).
The information ratio may also prove a useful indicator of how efficiently additional
risk can be converted into additional return.
Finally, Section 6 gives some information on the role of the custodian. Custodians
provide an important function for fund managers, storing and transferring the documents
to and fro to allow global fund management firms to settle their deals.

1 Portfolio construction
1.1 Strategic benchmarks and tactical asset allocation
Two conflicting objectives
In managing an investment fund established to cover liabilities, managers will

typically face two conflicting objectives:
1. to ensure security (solvency) and stability of costs
2. to achieve high long-term investment returns (in order to reduce cost).
The first of these typically involves reducing risk and the second increasing returns.
The first objective encourages the matching of liabilities to assets, while the
second encourages a move away from a matched position into assets which are
expected to generate higher returns.
Two-stage process
The investment policy therefore needs to reflect the extent to which the risks of
lower stability and security are to be taken on in order to aim for higher returns.
This will typically involve a two-stage process:
1. Establishing an appropriate asset mix for the fund – the strategic

benchmark. The strategic (or policy) risk of the fund is the risk of poor
performance of the strategic benchmark relative to the value of the
liabilities.
For example, suppose that a fund’s liabilities are thought to be best matched
with an asset mix of 50% equities and 50% bonds. The fund’s directors or
trustees might then set the strategic benchmark equal to 60% equities and 40%
bonds if equities were thought to offer higher long-term returns. In other words,
the fund hopes to increase the expected return on the portfolio by deliberately
taking on board strategic risk.
The extent to which risk can be taken in this way will be determined by the risk
appetite of the fund. For an insurance company this will be influenced by the
level of free reserves, and for a pension fund this might be determined by the
risk appetite of the trustees and the level of the surplus.
In practice, strategic risk may reflect both the risk of the matched benchmark
relative to the liabilities and the risk taken by the strategic benchmark relative to
the matched benchmark.

2. The tactical implementation of this strategy by the selection of one or

more managers and a decision on the appropriate level of risk that these
managers should take relative to the strategic benchmark. This is known
as the active (or manager or implementation) risk.
Each individual fund manager will be given a strategic benchmark by the fund
directors or trustees, which for domestic equities might be an appropriate equity
index. The zero-active risk approach would be simply to track the index.
However, the fund could allow an amount of active risk to be taken by the fund
manager in an attempt to out-perform the index.
Active return and active risk
The return that an active manager achieves relative to his particular strategic benchmark
can be defined as active return or relative return. Thus, if the active manager achieves
a total return of 4% compared to a benchmark total return of 3%, then he has achieved
an active return of +1%.
In general, the active returns achieved are uncertain and will vary between time periods.
It is this uncertainty that represents the active risk, which is often measured in terms of
the standard deviation of the active return (though other measures of risk could also be
used). Generally, the more active the manager’s approach – ie the greater the deviation
from the benchmark – then the greater the active risk, and hopefully also the active
return.
Active risk is often measured in terms of the tracking error, which we discuss further in
Section 5.
Structural risk
There may also be some structural risk associated with any mismatch between
the aggregate of the portfolio benchmarks and the total fund benchmark.
This could be the case for a fund that is distributed between various specialist active
managers, each of whom has been given a particular benchmark to beat. The aggregate
of all of the benchmarks given to the specialist managers may not be exactly the same
as the overall benchmark for the fund.
The overall risk is the “sum” of the active, strategic and structural risks. For
schemes that are not very small, structural risks can be made very small,
particularly if “peer group” benchmarking is avoided.

A large fund will have sufficient funds in each asset category to employ a specialist
manager for each portion of the fund. The aggregate of all the specialist managers can
therefore be made to almost exactly reflect the strategic benchmark for the fund. On the
other hand a small fund may not have sufficient funds to employ a UK property
manager (for example) and hence may have a difference between its structural
benchmark and the aggregate of all the individual portfolio benchmarks.
We discuss these risks further in the context of the risk budgeting process in Section 4.
Style identification can be used to ensure that the best managers (within each
style) are picked while keeping the fund as a whole “style neutral” (unless an
exposure to style risk is particularly wanted).
Question 21.1
In practice, the equity manager of a pension fund has traditionally been given a
benchmark expressed in terms of out-performing the average or median of the other
equity pension fund managers. What is the potential problem with such an investment
objective?

2 The use of multifactor models
2.1 Introduction
Quantitative analysis can be defined as the use of modern mathematical techniques to

aid stock and sector selection. These include the asset-pricing models discussed in
Chapter 18 of this course and also in Subject CT8, such as CAPM, which tell us
something about the returns on assets and/or their prices.
One quantitative technique that is fairly widely used is the application of one of a
number of types of multifactor models to portfolio management. The concept of
multifactor modelling was introduced in Subject CT8.
They were also touched on briefly in Chapter 18 of this course.
Question 21.2
What is a multifactor model?
2.2 Use in active management
Multifactor models can be used to estimate the appropriate expected return on a

share given a set of risk factors and its estimated factor returns (the coefficients
of the risk factors used in the model).
This is done by estimating the expected values of each of the factors in the model and
substituting those estimates into the model to predict the expected return on the share.
The resulting estimate represents the return that we ought to receive from holding the
share given its exposure to the various (unpredictable and therefore risky) factors that
are deemed to influence its investment return.
If the risk factors can be predicted with greater accuracy than the market, then
outperforming shares or sectors can be identified. When the model is used to
calculate expected return, this can then be compared with the expected return
based on a discounted dividend or PER model. If the expected return indicated
by the multifactor model is lower than that indicated by the current share price
the share appears cheap.

Multifactor models can thus be used to estimate the return that we should expect from a
particular security, based upon the relationship between that return and the sources of
systematic risk to which it is exposed – eg inflation, economic growth and currency
movements. The rate of required return thus estimated can then be compared with the
estimated expected return based on current market prices to determine whether the asset
looks cheap or dear.
Equivalently, the required rate suggested by the multifactor model can be used to
discount the predicted future cashflows yielded by the security to determine a
theoretical price, which can be compared with the market price to assess cheapness or
dearness.
2.3 Use in passive management
Multifactor models can also be used to identify and control the exposure of a
portfolio to the different risk factors and to change the risk profile of the portfolio
to better match the exposure of the liabilities.
This is because they can be used to examine the relationships between both asset and
liability values and the various economic influences and other risk factors. By
quantifying the impact of the various risk factors upon both assets and liabilities –
ie estimating the coefficients on each factor within the model – such models enable the
investor to select the assets so that their exposure to each risk factor is similar to that of
the liabilities. Consequently, the asset and liabilities should be broadly matched,
thereby reducing the investor’s exposure to mismatching risk.
The same approach can also be used to determine a set of assets that replicate the
expected performance of an index, if it is desired to track the performance of an index
via sampling as discussed in the previous chapter.
Question 21.3
What are likely to be the two key problems associated with the practical use of
multifactor models?

3 Technical analysis
3.1 Introduction
Definition
Technical analysis can be defined as the estimation of future prices and yields based on
the use of past prices, yields and/or trading volumes.
Technical analysis is based on the study of the markets themselves in order to

provide a means of anticipating future prices. This contrasts with fundamental
analysis which is concerned with measures of value. Investors who subscribe to
technical analysis attempt to predict future price movements from the study of
the actual price history and trading volume. They are not concerned with
fundamental issues such as earnings or dividends.
With technical analysis in its pure form, there is no need to refer to the fundamentals at
all. It is therefore concerned purely with predicting future market prices rather than
with considering how those market prices compare to the “true” values of the assets.
However, in practice, technical analysts do also make allowances in their research for
what the “fundamentalists” think.
Scope
Technical analysis can be used for many different assets. It is often used for:
 individual securities
 the level of an entire investment market
 currency values
 commodities, eg gold.
Basic theory
The theory is that future price and yield movements are a function of past prices and
yields (and perhaps trading volumes). Much of this is based on investor psychology,
such as the behavioural finance ideas described in Chapter 6, and the view that history
will repeat itself.

Patterns and trends of past prices, yields and volumes can be used to predict, for
example:
 trading ranges, ie the range within which the price will stay in the foreseeable
future
 sell signals, ie the price is about to fall sharply
 buy signals, ie the price is about to rise sharply.
An example here is the view that “markets usually over-react”, which suggests that a
fall in market prices is likely to be followed by a swift and strong bounce back in prices.
In contrast, a belief that investors are slow to react to changing circumstances may lead
to a belief in long “bull” or “bear” runs. Thus, if prices fall you might expect further
falls. These ideas run counter to the weak-form efficient markets hypothesis discussed
in Subject CT8. Indeed, the use of technical analysis makes sense only if the particular
investment market is believed to be inefficient.
3.2 Methods
There are three main forms of technical analysis:

1. charts
2. mechanical trading rules
3. relative strength analysis.
Chartism
The mostly widely used method is studying charts. A chartist will try to identify
patterns or trends in the behaviour of a chart of a share price or market index.
He will then take action based on the probability that what has tended to follow
the trend in the past will be repeated in the future.
For example, if a share price is above its trend value, then it might be appropriate to sell
it in anticipation of its price returning to the trend value.
There are many different types of chart used by chartists, and some of them have odd
names (eg line charts, bar charts, point and figure charts, candlesticks). Details of these
charts are beyond the scope of the syllabus.

Example method
A chartist might take the following steps:

1. plot price (eg of an index or for a company share) against time for the last three
years, say
2. plot moving averages for the share price over the same period.200-day (40-
weeks) and 20-day (4-weeks) moving averages are quite popular.
3. look at the patterns of the graphs
4. use experience and judgement as a chartist to predict what will happen next.
Some form of fundamental analysis may also be considered at this stage.
As you have probably guessed, the most difficult bit (and the most important bit) is
Step 4.
Question 21.4
The chart below shows both the actual and the mean gross redemption yield of a
Government bond over the last year. Does it suggest that the bond currently looks
cheap or dear?
GRY
of bond
actual
mean
time

Patterns and signals
Many of the buy and sell signals are based on lines of “support” and lines of
“resistance”. These lines might be created from the patterns of past price movements or
they might just be a round number.
If the price moves below the chartists’ support level, then this would be a sell signal.
Resistance levels are similar to support levels, except that they indicate buy signals
when the share price breaks above a resistance level. The area between a resistance
level and a support level is the normal trading zone.
Mechanical trading rules
The subjective element of Chartism is removed in mechanical trading rules.

Under this process trading signals are given by set price movements. For
example a share may be bought if it moves up by x% from its previous low, or
sold if it falls more than y% from its previous high. If x% and y% are too small
then any profits will be lost through the expenses of excessive trading. If the
values are too high then substantial price movements will have occurred before
a trade is executed and so potential profits lost.
In practice, mechanical trading rules can be implemented easily using computer trading.
Relative strength analysis
Relative strength analysis examines the performance of a share relative to the

market as a whole or its own sub-sector. The analysis can be used in two ways.
The first is to attempt to identify a change in the relative strength at an early

stage, ie a company’s share has outperformed the market by 10% over the last
month, and this may be considered unlikely to happen again in the immediate
future.
The second approach is to buy (sell) companies whose shares have out- (under-)
performed in the previous six months. In this case the idea is that shares that
have done well (badly) in the first six months will continue to do well (badly) in
the next six months as other investors see the share doing well (badly) and want
(don’t want) to participate in this extra (under-) performance.
The first approach is therefore based on a belief in mean reversion, whereas the second
relies on momentum effects. Which approach you use therefore depends upon your
beliefs about how markets work!

3.3 The usefulness of technical analysis
Does technical analysis really work?
An argument against the use of charts is that a chartist must be able to identify
the pattern before any other chartists in order to take advantage of the predicted
change in price. The chartist will be forced to anticipate patterns before they are
fully formed, and eventually this competition between chartists will compete the
patterns away. The counter-argument to this point is that if the identification of a
significant chart pattern is a matter of judgement Chartism may still be useful.
Success would depend on the skill of the chartist or an investor’s ability to
differentiate between good chartists and bad.
Is technical analysis really used?
Yes. Many large investment firms have a technical analysis department whose views
influence investment decisions.
Technical analysis is almost exclusively involved with short-term price movements.

Therefore many institutions use technical analysis to assist with decisions on short-term
trading and timing. Fundamental analysis is used for longer-term and strategic
decisions.
What are the advantages and disadvantages of technical analysis to

investors?
The possible advantages of technical analysis (TA) are:

 It is easy to collect the necessary data for TA.
 TA is relatively quick and easy to carry out.
 TA can be helpful with decisions on the timing of investment.
 If you can find a technique that works reliably, TA can be used to make short-
term trading profits. If you correctly predict price movements, you can use
derivative contracts to make very large profits. Investment professionals with
in-depth practical experience and knowledge do use technical analysis.
Question 21.5
Outline the possible disadvantages of technical analysis.

4 Risk budgeting
4.1 Definition
The term risk budgeting has been coined to refer to the process of establishing
how much investment risk should be taken and where it is most efficient to take
the risk (in order to maximise return). Risk budgeting also has a similar
definition in the context of enterprise risk management, where the risk appetite
of an enterprise is allocated between business units or other subsets of the
enterprise.
The idea here being the familiar one that by taking additional risk, it may be possible to
generate additional returns for the investor. In this context, risk is often measured in
terms of tracking error, which we discuss in detail in Section 5. For example, the
investor might decide that a total allowable tracking error of 5% pa is acceptable. This
5% tracking error then represents the risk budget that the investor has available to
allocate or spend across strategic and active risks.
4.2 The risk budgeting process
In the investment context, the risk budgeting process is essentially twofold:
1. deciding how to allocate the maximum permitted overall risk to total fund
active risk and strategic risk – ie how far to depart from the theoretically
“matched” benchmark and how much risk in total the individual fund managers
are allowed in order to out-perform their allocated benchmarks
2. allocating the total fund active risk budget across the component
portfolios – eg how much risk the equity manager can take, how much the
bond manager can take, etc.
So, the 5% pa total allowable tracking error (the risk budget) will first need to be
allocated between strategic risk and total active risk. The total active risk will then need
to be allocated across the individual investment managers.
The key focus when setting the strategic asset allocation is the risk tolerance of
the stakeholders in the fund – how much systematic risk they are prepared to
take on in the attempt to enhance long-term returns.
This might be assessed using downside risk measures such as Value at Risk, which we
discuss further in Section 5. Recall that by deliberately deviating from the matched
benchmark portfolio it may be possible to enhance investment returns.

The key question on active risk is whether it is believed that active management
generates positive excess returns.
In other words, whether it is possible to achieve higher returns purely by selecting

mispriced stocks. In practice, it may be thought that some particularly skilful active
managers may be able to do so in some inefficient investment markets. The allocation
of active risk across investment managers may be based on estimates of the information
ratio that each is thought able to obtain in their respective market. We discuss the
information ratio in Section 5.
Question 21.6
How might you test whether active management does generate positive returns and
what possible problems may arise in doing so?
Risk budgeting is, therefore, an investment style where asset allocations are
based on an asset’s risk contribution to the portfolio as well as on the asset’s
expected return. In this regard, it is a direct application of the Markowitz
perspective on portfolio construction.
Question 21.7
Define what is meant by a “Markowitz perspective” and explain how it is relevant to

risk budgeting.
4.3 Summary of the risk budgeting process
The process can be summarised as:
1. Define the “feasible set” – the set of asset classes that could be included
in the portfolio. Here the risk budgeter will wish to obtain careful
estimates of the volatilities and covariances of each asset class.
A key issue here might therefore be whether the fund is restricted to traditional
asset classes or whether it is able to invest in specialist asset classes such as
private equity.
2. Choose the initial asset allocation using some risk / return optimisation
process, and with a VaR assessment to determine the risk tolerance.
This might involve the following steps:
 using asset-liability modelling to determine the matching portfolio

 performing VaR calculations to determine the total risk budget

 allocating the total risk budget between strategic risk and total active
risk.
 further modelling of investment risks and returns to investigate the
different possible investment strategies.
 presenting the results to the client, who would then need to choose
between the strategies
 allocating the total active risk between the different investment managers
 choosing the investment managers and allocating their benchmarks.
3. Monitor risk exposures (increases and decreases in the values of the

positions) and changes in volatilities and correlations.
4. Rebalance the portfolio in response to changes in the short-term

conditional volatility and correlations of the assets. Allocations are
altered to keep the overall portfolio risk at the level defined as tolerable
for the investor.
In other words, within the maximum permitted tracking error.
Question 21.8
How might VaR be used to determine the riskiness of the portfolio chosen?
A risk budgeting strategy can free the manager to look for alternative
investments that might increase the expected return on the portfolio. Because
the constraint is that the total risk of the portfolio must stay at or below a
targeted level, increased attention is paid to low correlation investments. Small
allocations to such investments can reduce the total risk of the portfolio through
diversification.
Before we can carry out risk budgeting, however, we need to decide how we are going
to measure risk.

5 Measuring risk
5.1 Measures of risk relative to a benchmark
Historical tracking error
Until fairly recently, most attention has been devoted to measuring and
managing active risk. The most usual backwards risk measure adopted is the
retrospective or backwards-looking tracking error – the annualised standard
deviation of the difference between portfolio return and benchmark return, based
on observed relative performance.
Thus, you could obtain the last 36 months’ returns on the actual portfolio and the
benchmark index and calculate each month’s relative return as the difference between
the two. The monthly historical tracking error would then be the standard deviation of
the individual monthly relative returns. If we then assumed that monthly returns are
independently, identically and normally distributed, multiplying the monthly tracking
error by 12 would give the annualised tracking error.
Historical tracking error may be calculated in different ways. The timescale used
can vary (both the total period length and the frequency) and the weightings
attached to different sub-periods can vary. Such features must be considered
when comparing results.
When comparing the tracking error of two funds relative to an index we should make
sure that the data is consistent with respect to:
 the timescale over which the comparison is made
 the number of sub-periods (ie is the data weekly, monthly or quarterly?)
 the weightings attaching to each period (eg constant, exponentially heavier
weighting to more recent data).
Forward-looking tracking error
The equivalent prospective measure is the forward-looking tracking error – an

estimate of the standard deviation of returns (relative to the benchmark) that the
portfolio might experience in the future if its current structure were to remain
unaltered. This measure is derived by quantitative modelling techniques and
depends on assumptions including:
 the likely future volatility of individual stocks or markets relative to the
benchmark
 correlations between different stocks and/or markets.

Note however, that these forward predictions are generally based on volatility and
correlation data that is derived from past performance. Hence there is an element of
backward-looking here too. However, it does allow us to model the current portfolio
going forward, rather than the historical portfolio (which might have changed
considerably over time).
Active money
The deviation from the benchmark portfolio for a specific position is usually
termed the active money of that position in isolation.
For example, if a manager holds 2% of the portfolio in Glaxo/Welcome shares when the
benchmark index holds 1.5%, then the active money position for that share is 0.5%.
Thus, one measure of the portfolio active risk might be simply to sum the absolute
values of the active money positions in each individual holding.
Question 21.9
Why not just sum the actual active money positions in each individual holding?
If all the active money positions are zero, then the fund is being run in a perfectly
passive, index-like fashion.
However, the active money of a particular stock does not provide a complete
picture of the “risk” of such a position versus the benchmark since some stocks
may be much more likely to perform very differently to the benchmark than
others.
In other words, a 0.5% active money position in a share with a beta of one, is not as
risky as a 0.5% active money position in an internet technology share with a beta of
two! If the market performs badly, the internet stock will likely perform twice as badly
as the market. The manager’s 0.5% active money position will behave like a 1% active
money position in a normal stock.

5.2 Information ratio
To combine historical risk and historical return (relative to a benchmark) a

commonly used statistic is the information ratio – the ratio between the relative
return and the historical tracking error.
The relative return, over any quarter say, is defined as the difference between the actual
portfolio return and the benchmark return over that quarter. So the tracking error
represents the standard deviation of the relative return. Relative return is also
sometimes referred to as active return, as it results from the active management of the
portfolio compared to a particular benchmark.
Strictly speaking, the information ratio relates the mean of the relative return to the
historical tracking error, ie the standard deviation of the relative return, where both are
calculated over the same time period. It can therefore be written as:
mean  relative return 

IR 
std devn  relative return 
In practice, fund managers may advertise their services based on the historical
information ratios that they have achieved in the recent past. Additionally, if estimates
of the means, variances and covariances of the prospective returns on different
securities are available, then it will be possible to estimate prospective information
ratios for different portfolio choices.
In addition, the information ratio can play a useful role in allowing us to estimate how
efficiently additional risk can be converted into additional return, as part of the risk
budgeting process.
Question 21.10
What might it indicate if a fund manager is able to generate consistently positive

information ratios over the long term?

5.3 Other measurement issues
Downside risk
The main argument against the use of standard deviation or variance as a measure of
investment risk is that most investors do not dislike uncertainty of returns per se, rather
they dislike the possibility of low returns. Downside risk measures are therefore
sometimes used in practice.
Downside risk measures can involve identifying the worst period under-
performances in a specified past period, looking at the frequency with which
under-performance has been experienced, or calculating the downward semi-
standard deviation (the standard deviation of returns below the benchmark).
In practice, the benchmark could be either the mean return or a benchmark chosen by
the investor. In addition, recall the discussion of downside semi-variance of returns,
shortfall probability and expected shortfall in Subject CT8.
Question 21.11
Explain what are meant by the:

● shortfall probability
● expected shortfall.
Further risk-adjusted measures
Further risk-adjusted measures have been evolved to enable investors to decide

whether or not active risk generates value – for example, those based on CAPM and
discussed in Chapter 15 of this course.
Active and strategic risks
Empirical evidence suggests that the total tracking error associated with active
management and management selection is of the order of 0% pa to 5% pa with a
median figure of about 2% pa. Measurement of strategic risk has been
complicated by the fact that the value of the liabilities may not be well-defined or
objectively determined. However, recent trends toward the adoption of more
market-related approaches to valuing liabilities (such as IAS19 in respect of
pension funds or Solvency 2 for insurers) has meant that liability values have
become more identifiable. With this has come the realisation that funds were
taking much greater strategic risks – anything from 5% to 20% pa.

Question 21.12
Explain, using an appropriate formula, how the strategic risk of a pension fund would
be measured and quantified (for example the range of 5% to 20% given above).
5.4 Value at Risk
Value at Risk (VaR) generalises the likelihood of under-performing by providing a

statistical measure of downside risk. VaR assesses the:
 potential losses on a portfolio
 over a given future time period
 with a given degree of confidence.
It can be measured either in absolute terms or relative to a benchmark. Again,

VaR is based on assumptions that may not be immediately apparent. In
particular, it is frequently calculated assuming a normal distribution of returns.
Example
An investment bank owns equities with a current market value of $1m. The fund
manager wishes to estimate the Value at Risk over a 10-day period at the 5% lower tail
level. She does so assuming that the investment returns on the equities over a 10-day
period are normally distributed with a standard deviation of 5%. The mean return is
assumed to be zero, which assumption is often made in practice when calculating the
Value at Risk over such a short time period.
The distribution of the estimated fund value at the end of the 10-day period is thus
assumed to have a mean of $1m and a 5% lower tail given by:
1m - 5% ¥ 1m ¥ 1.645 = $917, 750
The Value at Risk is therefore:
1m - 917, 750 = $82, 250
The assumption of normality may not be appropriate if the empirical evidence suggests
that returns are actually non-normal. Similar problems may also affect other risk
measures.

For example, if the distribution of returns is “fat-tailed”, or skewed, tracking error

(with its focus on the standard deviations of returns) may be misleading.
This is because if the distribution of returns is non-normal, then it cannot be

summarised purely by its mean and standard deviation. An appreciation of the higher
moments will be needed to fully understand the risks involved. Tracking error was
considered above in Section 5.1.
Unfortunately, portfolios exposed to credit risk, systematic bias or derivatives

may exhibit non-normal distributions. The usefulness of VaR in these situations
depends on modelling skewed or fat-tailed distributions of returns, either in the
form of statistical distributions (such as the Gumbel, Frechet or Weibull
distributions) or via Monte Carlo simulations. However, the further one gets out
into the “tails” of the distributions, the more lacking the data material and,
hence, the more arbitrary the choice of the underlying probability becomes.
If we are trying to use VaR techniques to estimate the worst-case scenario on a (say)
1% basis with a year’s time horizon, then by definition, we will only get a data point in
the 1% tail every 1 in 100 years, ie it has probably not occurred in the period used to
obtain data. Hence the results drawn from the analysis might be somewhat spurious!
There has been much research dedicated to extreme value theory, which tries to
investigate the reliability of such results and involves the use of statistical distributions
such as the Gumbel, Frechet and Weibull. These are three examples of so-called
extreme value distributions, which are often used to model extreme events.
5.5 Stress testing
VaR methodology does not take into account the simultaneous increase in asset
return volatilities and correlations that is often observed during extreme market
events.
One area where this manifests itself is in trying to use VaR techniques to estimate credit
risk in a portfolio. Stochastic modelling of credit risk requires the input of both
likelihood and amount of credit loss for each counterparty and also of the correlation
between defaults of different counterparties. However, in the case of an extreme credit
event, the historical correlations can change dramatically. For example, if one major
bank were to fail, there are likely to be consequences for other major banks, and such
consequences would not have been picked up in the historical correlation data.

The risks that are incurred by extreme market events can be identified and
investigated by the process of financial stress testing. This involves subjecting
a portfolio to extreme market moves by radically changing the underlying
portfolio assumptions and characteristics, in order to gain insight into portfolio
sensitivities to predefined risk factors. This pertains in particular to asset
correlations and volatilities.
There are two types of stress test:

1. to identify “weak areas” in the portfolio and investigate the effects of
localised stress situations by looking at the effect of different
combinations of correlations and volatilities
2. to gauge the impact of major market turmoil affecting all model
parameters, while ensuring consistency between correlations while they
are “stressed”.
A major part of establishing a comprehensive stress testing framework should

therefore focus on constructing stress test scenarios that apply to the specific
portfolio. These scenarios should be tailored to reveal weaknesses in the
portfolio structure in terms of risk exposure and sensitivity, and should thus
focus on the risk factors that the portfolio is most exposed to.
The most important consideration is always to make sure that the likely risks are
modelled as accurately as possible.
Question 21.13
For each of the entities below, describe a typical stress test that management might like
to carry out:
 a commercial bank
 a life insurance company
 the derivatives trading arm of an investment bank.

6 Role of the custodian
6.1 Custodial services
A custodian holds investments securely on behalf of an investor.
The principal function of custody is to ensure that financial instruments are

housed under a proper system that permits investment for proper purposes with
proper authority. The custodian is thereby able to account independently for any
financial transactions.
Custodians are usually banks or other regulated institutions. Fund management

firms, who would at one time have included custody within their function, are
increasingly outsourcing such activities. Custodians offer not only custody of
documents, but also a range of services such as:
 income collection
 tax recovery
 cash management
 securities settlement
 foreign exchange
 stock lending.
Also, the custodian will often exercise voting rights on behalf of the manager or
trustees. However, the custodian has no duty to investigate the propriety of
instructions which appear to be in order (unless a specific monitoring function
has been agreed) – ie the custodian will just do what it is told without question unless
the agreement specifically says otherwise.
Custodian trustees
A custodian must be distinguished from a custodian trustee, who not only has
physical custody of documents but also holds the legal title to the trust assets.
However, a custodian trustee has no power of management over the investments.
Only specified categories of corporation, known as trust corporations, are

empowered to act as custodian trustees.

Overseas markets
Administration of investment activities in overseas markets is often a vital

element of the custodian’s role.
Although the basic process of acquiring and disposing of an asset is essentially

the same the world over, processes are very different in different markets. The
infrastructure, payments system, clearing house and banking / settlement
arrangements in many markets place the investor at varying degrees of risk.
For example, with regard to settlement and liquidity risks.
6.2 Global custodians
A custodian providing international services and assuming responsibility for

custody of assets held abroad is known as a global custodian. Where the global
custodian does not have a presence in a particular country it may appoint a sub-
custodian in the country concerned. Legal opinions are sought prior to the
global custodian entering into an agreement with sub-custodians. Alternatively,
many global custodians now work directly with Central Securities Depositories
(CSDs) in order to:
 eliminate one link in the settlement chain (making processing more
efficient)
 eliminate the potential for sub-custodian error.
However, not all CSDs have all the capabilities that are required by global
custodians, their clients and the various regulatory organisations that oversee
them.
6.3 Independent custodians
Question 21.14
Describe the various services typically provided by a custodian.
In the UK, the great majority of pension schemes use custodians independent of
the employer. The Myners report on UK institutional investment noted that
making independent custody a mandatory requirement would improve security
by making it more difficult for improper use to be made of a pension fund’s
assets.

Chapter 21 Summary
Portfolio construction
Portfolios are constructed to

 reduce risk (often in terms of solvency and stability of cost)
 achieve higher long-term investment returns.
In practice, these two objectives often conflict.
Establishing an investment policy typically involves a two-stage process:

1. establishing the strategic benchmark or investment strategy
2. the tactical implementation of this strategy by the selection of one or more
managers and a decision on the appropriate level of risk that these managers
should take relative to the strategic benchmark.
The risks involved in portfolio construction may include:

 strategic risk – the risk of the strategic benchmark relative to the liabilities
 active risk – the risk taken by the manager relative to his given benchmark
 structural risk – where the aggregate of the individual manager benchmarks
does not equal the total benchmark for the fund.
The use of multifactor models
Multifactor models can be used:

 actively – to estimate the appropriate required return on a share in order to
determine if it is cheap or dear
 passively – to identify a suitable portfolio of shares to match liabilities or to
replicate an index.

Technical analysis
Technical analysis is based on the study of the markets themselves in order to provide a
means of anticipating future prices. It relies on markets being inefficient.
The three main forms of technical analysis are:
1. Chartism – examining charts of past market data
2. mechanical trading rules – whereby trading signals are given by set price
movements
3. relative strength analysis – which examines the performance of a share relative
to the market as a whole or its own sub-sector.
Risk budgeting
Risk budgeting is a process that allocates risk to those areas of the portfolio where it is
most efficient in terms of generating higher returns. It involves:
 deciding how to allocate the maximum permitted overall risk to total fund active
risk and strategic risk
 allocating the total fund active risk budget across the component portfolios.
In practice, the following steps are involved:

 define a feasible set of asset classes
 choose an initial asset allocation using a risk optimiser and a Value at Risk
assessment to determine risk tolerance
 monitor risk exposures
 rebalance the portfolio when necessary due to changes in risk appetite or
changes in underlying volatility and correlation data.
Measuring risk relative to a benchmark
Relative/active return is the difference between portfolio return and benchmark return.
Relative/active risk is most commonly measured using tracking error – the annualised
standard deviation of the relative return. It can be estimated on a forward-looking basis
or a backward-looking basis.
The active money of a position in a particular share holding is the difference between
the portfolio holding and the benchmark holding in that share. It can also be used to
give a crude indication of active risk.

Information ratio
The information ratio is defined as:
mean  relative return 

IR 
std devn  relative return 
Downside risk measures
In addition to downside-semi standard deviation, shortfall probability and the expected

shortfall, commonly used tools to measure downside risk are:
 Value at Risk – which assesses the potential losses on a portfolio over a given
future time period with a given degree of confidence
 stress testing – which can be used to identify and investigate the impact of
extreme market events.
Role of the custodian
Custodians perform a variety of services, including:

 income collection
 tax recovery
 cash management
 security settlement
 foreign exchange
 stock lending.
Global custodians operate internationally and use “sub-custodians” where they do not
have a presence. The Myners report stated that independent custodianship should be
mandatory for UK institutions to make it difficult for improper use to be made of
pension fund assets.


Solution 21.1
The potential problem is that of structural risk. This will arise because the performance
of the median equity pension fund manager will typically differ from that of the
benchmark equity portfolio (eg FTSE All-Share index) used to assess the fund’s
strategic risk – this difference representing the structural risk.
Solution 21.2
A multifactor model of security returns attempts to explain the observed historical

investment returns on security i by an equation of the form
Ri = ai + bi ,1I1 + bi ,2 I 2 + ... + bi , L I L + 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 ... I L are the changes in a set of L factors that explain the variation of Ri
about the expected return ai
 bi ,k is the sensitivity of security i to factor k.
They therefore attempt to model the process generating investment returns as a function
of several sources of systematic risk, which may be macroeconomic variables and/or
company-specific factors.
Solution 21.3
The two key problems are likely to be:

1. identifying the factors that affect the expected return on any particular security
2. estimating the relationships between those factors and the expected returns. The
usual problems associated with time series estimation will all apply here – ie
random variation and the fact that the relationships may vary over time and
consequently estimates based upon past data may not be applicable in the future.

Solution 21.4
Currently the bond’s GRY is above its recent mean value. Assuming that the GRY will
revert to its mean value at some point in the future, this suggests that the bond is
currently cheap.
Solution 21.5
Possible disadvantages could include:

 Relying upon TA might distract the investor’s attention from more important
considerations such as long-term value.
 Instead of making short-term profits you could end up making hefty losses.
 TA might encourage a more active trading strategy increasing expense levels.
Solution 21.6
The simplest method of testing this would be to compare the long-term performance of
a selection of actively managed funds against that of a number of index tracker funds.
The main problems that would arise would be that:

 there may be different constraints on the active managers that affect their
performance relative to the trackers
 the amount of risk may be higher in the active managers’ portfolios
 there will be a “survivorship” issue whereby many poor performing active funds
would cease to gain new business and be wound up – hence there will be a bias
towards those active funds that have performed adequately
 past performance does not act as a good guide to future performance
 the objectives of the active and passive managers (ie the index) may be different.

Solution 21.7
A “Markowitz perspective” on portfolio construction refers to the application of modern

portfolio theory as first developed by Markowitz in his 1957 book called “Modern
portfolio selection”, in which he explains how a portfolio should be built up by a
rational investor. Put simply, portfolio construction should be based around the
following two decisions:
 How much risk can you bear?
 How much return do you require?
Weighing the two considerations against one another enables the investor to build an
appropriate portfolio.
Hence the concept of risk budgeting follows the same two steps, allowing risk to be
allocated where the risk appetite and the desire for return lie.
Solution 21.8
Suppose that portfolio investment returns are assumed to be normally distributed and
that it has been estimated that the 5% lower tail Value at Risk corresponds to a loss of
10% of the portfolio’s value over the next year. Dividing this 10% Value at Risk by the
5% lower tail value of 1.645 from the Normal tables gives a maximum permitted
tracking error of approximately 6% pa.
Both Value at Risk and tracking error are discussed in detail in Section 5 of this
chapter.
Solution 21.9
We cannot just sum the actual active money positions in each individual holding
because they must by definition sum to zero. This is because we can only be
overweight in some securities by being equally underweight somewhere else in the
portfolio.

Solution 21.10
Ideally this indicates that the manager is able to successfully out-perform the
benchmark index by skilfully selecting securities that are similar to those in the index,
but that are mispriced.
Alternatively, it might be the case that he is able to out-perform the index consistently
purely by deliberately investing in higher risk securities, which on average should
produce a return greater than that of the index. However, he may not be generating
excess risk-adjusted returns.
When assessing performance, we would need to determine which of the above

possibilities applies.
Solution 21.11
The shortfall probability is the estimated probability that the fund value or surplus falls
below a pre-specified benchmark level, eg $100m or 10%.
The expected shortfall is the expected amount of the shortfall below the pre-specified
benchmark level given that the fund value or surplus has fallen below the benchmark
level.
Solution 21.12
The strategic risk would be measured as the standard deviation of the relative returns,
where the relative returns would be measured relative to a portfolio deemed to match
the perceived liabilities.
Strategic risk = Std devn  Ra  Rb 
where
 Ra are the actual returns on the strategic benchmark portfolio over the various
time periods
 Rb are the returns on the matching portfolio.
The returns on both the strategic benchmark portfolio and the matching portfolio would
be measured over a number of shorter time periods over the entire measurement period
(for example quarterly over a 5-year period) and the standard deviation of the difference
between these two measures would be calculated.

Solution 21.13
Commercial bank
A commercial bank is exposed to substantial amounts of credit risk and market risk
(particularly with regards to interest rates). As such, useful stress tests might include:
 testing how the asset and liability values respond to a 1% increase in short-term
and long-term interest rates
 testing how the surplus might react to an extreme default event – for example a
0.1% chance of default from all AAA bonds, a 0.2% default probability on all
AA bonds, etc.
 if the bank has a stochastic model of credit risk, it might be worth testing the
effect of increasing default probabilities by, say, 10% and correlations between
holdings by, say, 20%.
Life insurance company
Life insurance companies are exposed to market risk (not just from interest rates but
from the volatility of all asset categories), actuarial risk relative to liabilities, and credit
risk. There are many other tests worthy of carrying out (eg for liquidity risk), however,
the two examples chosen here are:
1. testing solvency in the event of a fall in asset prices (eg 20% equities, 10%
bonds and some allowance for currency depreciation)
2. testing solvency in the event of a 1% default on all assets exposed to significant
credit risk (eg equities and bonds below AA grade).
Derivative arm of an investment bank
In this case we have a complex portfolio of positive and negative positions that should
result in a zero or near-zero exposure to the markets in general. The key here is that
derivatives expose a company to more than just market exposure – indeed if the gamma
(ie rate of change of delta with changes in the underlying asset price) of the assets and
liabilities is not hedged, then the assets and liabilities may become unhedged simply
due to a change in the market level.

Typical tests would be:

 testing the value of (assets – liabilities) for a 10% increase in market volatility
(used to price options)
 testing the value of (assets – liabilities) in the event of a large change in market
levels (allowing for known gamma in the assets and liabilities, and the effect this
would have on hedging efficiency)
 testing the effect of a large rise in short-term interest rates (used to price
options).
Solution 21.14
The services provided by a custodian typically include:
 income collection – collecting the dividends and coupon payments due on stocks
and shares held by the client, and chasing missing payments
 tax recovery – particularly in cases where shares are held in overseas markets
where withholding tax is deducted, but can be reclaimed by the client
 cash management – managing the cash account that is used to settle deals, and
ensuring that the account always has sufficient funds to settle any outstanding
purchases
 securities settlement – the main function of a custodian, which involves the

administration of the actual exchange of cash for securities when a security is
traded
 foreign exchange – settling foreign exchange deals
 stock lending – arranging for shares that are not traded to be “loaned” to other
companies, normally so that the other company can take a short position. Large
fund managers seldom sell all of a holding in a particular company, therefore
there is little risk in lending a portion of a share holding to another company for,
say, two weeks (and it does bring in income).

Chapter 22
Syllabus objectives

(iv) Discuss the uses which an institutional investor might make of financial
futures and options, including over the counter contracts.
(v) Discuss the uses which an institutional investor might make of interest
rate and currency and inflation swaps.
(vi) Discuss the uses which an institutional investor might make of forward
foreign exchange contracts for currency hedging.
(viii) Discuss the problems of making significant changes to the investment

allocation of a substantial portfolio.
(ix) Transition management and asset allocation techniques (including

overlay strategies).

0 Introduction
This chapter concludes our discussion of portfolio management by considering the
many and varied roles that derivatives can play. Derivatives can be used to:
 manage and/or mitigate some of the risks that the investor faces
 generate additional investment returns, typically by taking on board additional
risk
 carry out switches between different assets, whilst avoiding some of the costs
and difficulties associated with buying and selling the underlying assets.
In Section 1 we describe the uses of swaps in general and interest rate and currency
swaps in particular. These include:
 risk management, ie matching assets and liabilities in the way described
previously in Chapter 3
 reducing the cost of borrowing
 swapping exposure between different asset classes without disturbing the
underlying assets.
Sections 2, 3 and 4 next discuss OTC and exchange-traded derivatives, and the uses of
futures and options. These include:
 reducing risk via hedging
 trying to generate additional returns via speculation and arbitraging
 transition management – ie using futures and options to alter the characteristics
of a portfolio without disturbing the underlying assets
 generating additional income by selling options.
In addition, futures can of course be used to create a synthetic index-tracking fund as

described in Chapter 20.
In Section 5, we discuss how currency forwards can be used to hedge currency risks and
also to speculate on currency movements.
Derivatives are complex financial instruments and so in order to reduce the operational
risk associated with using derivatives, appropriate reporting of derivatives exposures is
important. This is discussed briefly in Section 6.
Finally, Sections 7 and 8 describe some of the problems and costs involved in making
major changes to the strategic asset allocation and how some of these problems and
costs can be reduced in practice, both with and without the use of derivatives.

1 Uses of swaps
1.1 Introduction
The three main uses of swaps include:

1. risk management – ie matching assets and liabilities
2. reducing the cost of borrowing
3. swapping exposure between different asset classes without disturbing the
underlying assets.
The first two of these are discussed in this section, the third is discussed in Section 2.4.
1.2 Risk management
An organisation can use swaps to reduce risk by matching its assets and
liabilities. For example a company which has short-term liabilities linked to
floating interest rates but long-term fixed rate assets can use interest rate swaps
to achieve a more matched position. Currency swaps would be used by a
company with liabilities in one currency and assets in another.
The use of swaps to transform the nature of assets and liabilities in this way was
discussed in detail in Chapter 3.
Hedging with currency swaps and/or currency forwards can also be used to make
currencies an asset in their own right (ie to allow managers to separate currency and
country investment decisions). Outright speculation on currency movements is also
possible, but is often considered too risky for many institutional investors.
The disadvantages of using currency swaps include:

 the extra cost of the bid-offer spread compared with a straight spot currency
transaction
 removing the possibility of favourable currency movements, ie market risk
 the introduction of counterparty credit risk
 mismatching real liabilities by eliminating purchasing power parity protection
against unexpected inflation differentials
 the difficulty of hedging unknown future income
 they can only easily hedge a level income stream
 they are only available on fairly large principal amounts.

The first five of the above apply equally to the use of forwards for currency hedging
discussed in Section 4. However, swaps are generally available for longer terms than
forward agreements. This makes swaps more useful for hedging longer-term liabilities,
eg for pension funds and life offices.
Question 22.1
A South African insurance company has invested in a portfolio of floating rate

Eurobonds denominated in Euro in order to match a portfolio of non-profit Rand
denominated policies. Describe the swap arrangement it needs to eliminate the
mismatch.
1.3 Interest rate risk
The most common measure of interest rate risk is PV01 (“Present Value 01”)
which represents the change in value of a stream of fixed payments under a 1
basis point move in interest rates (at all maturities).
PV01 is sometimes called DV01 (“Dollar Value 01”), particularly in the USA.
PV01 does not capture risks such as positive or negative convexity, and to
establish the size of mismatches under these higher order risks other measures
need to be used.
1.4 Reducing the cost of borrowing
Another important use of swaps can be to reduce the cost of borrowing. This is possible
if two companies are able to borrow on different terms in different financial markets.
If one organisation has a comparative advantage in borrowing at a floating rate

while another company has a comparative advantage in borrowing at a fixed
rate, they can use an interest rate swap to reduce the total cost of financing and
both benefit from a lower cost of debt.
Note that comparative advantage here implies that the companies’ relative credit
ratings are different in the long-term and short-term debt markets, assuming that
the long-term and short-term markets operate principally in terms of fixed and floating
rates respectively.

Interest rate swap example
Assume that:
 BP can borrow at 50 basis points over Government bonds or 50 basis points over
6-month LIBOR.
 AB Foods can borrow at 30 basis points over Government bonds. However,
because it is a cyclical company investors worry about its exposure to higher
interest rates. Therefore if it borrows on a floating rate basis it has to pay 80
basis points over 6-month LIBOR.
BP therefore enjoys a comparative advantage at borrowing at the floating interest rate.

This is because it pays the same 50 basis point margin over 6-month LIBOR as it does
over the fixed rate, whereas AB Foods has to pay an additional 50 basis points margin
when borrowing at a floating rate when compared to borrowing at a fixed rate. Thus,
BP can undertaking floating rate borrowing relatively more cheaply than AB Foods is
able to.
Likewise, AB Foods enjoys a comparative advantage when borrowing at the fixed rate.
Note that the absolute numbers do not matter. Reducing borrowing costs via a swap is
based entirely on relative and not absolute borrowing costs, ie comparative as opposed
to absolute advantage.
Suppose that it is agreed that AB Foods pays BP 6-month LIBOR in return for a fixed
payment of the government bond yield minus 10 basis points the following position can
be achieved:
Govt bond -10
LIBOR +50 Govt bond +30
BP ICI
LIBOR +0
Figure 22.1: Interest rate swap between BP and AB Foods

BP is then, in effect, a net borrower of fixed interest at:
+ (LIBOR + 50) – (LIBOR + 0) + (Government – 10) = Government + 40
ie at the Government bond rate + 40 basis points. This is better than the Government
bonds +50 at which it could borrow by itself. In addition, AB Foods is, in effect,
borrowing at LIBOR + 40, rather than LIBOR + 80.
Question 22.2
Show that AB Foods is borrowing at LIBOR +40.
Note that the solution given to the example on the previous page is only one of a
number of possible solutions. Equally possible, is the solution:
 BP borrows at Government bonds +30 (saving 20 basis points)
 AB Foods borrows at 6-month LIBOR + 50 (saving 30 basis points).
In fact, there is a continuum of possible solutions, each involving a total saving of 50

basis points, which is split between the two companies in such a way that each is better
off and so wishes to undertake the swap. In practice, the swap will normally be
arranged via an intermediary, typically an investment bank, who will match up the two
parties as described in Chapter 3. The intermediary will require a share of the profits
from the swap for performing this task and incurring the credit and market risks
associated with the swap.
A similar situation may exist if different companies enjoy a comparative advantage

when borrowing in different currencies. If each borrows in the currency in which they
enjoy the comparative advantage, they can then use a currency rate swap to reduce the
total cost of financing and both benefit from a lower cost of debt.
1.5 Currency
An investor which holds investments in a currency other than that in which its
liabilities are denominated is exposed to variations in the exchange rate as well
as variability in the return achieved on the underlying investment.
If the investor does not want to bear this exposure it can be hedged in various
ways, for example by using forward currency contracts.

1.6 Inflation swaps
An investor which holds an asset that has an income stream that is linked to an
inflation index is exposed to variations in future expectations of the level of
inflation, and for longer-dated inflation-linked payments this can be a source of
significant market risk.
An inflation swap allows a receiver of inflation-linked payments to pay these to a

counterparty in return for receiving a fixed payment. Typical payers of inflation
under inflation swaps will include holders of loans with inflation-linked payments
or leaseholders who receive inflation-linked rental income. Institutional
investors such as pension funds, with inflation-linked liabilities, can use inflation
swaps to receive inflation and thereby hedge the market risk from uncertain
future inflation within their liabilities.
For some time now, pension schemes have been reducing their equity weightings and
increasing their holdings of bonds and liability matching assets. A means of gaining
exposure to index-linked bonds is by means of an inflation swap. They have been
achieving this in two ways:
1. Real rate swaps
2. Synthetic index-linked bonds
Real rate swaps
A real rate swap can allow a pension scheme to capture a credit spread in excess of
index-linked gilt returns and also tailor asset proceeds to match the incidence of the
scheme’s liability cashflows. With this type of swap, the pension scheme is able to
invest the assets in a portfolio of fixed-rate corporate bonds, and swap the fixed
cashflows from the bond portfolio in return for cashflows that match the timing and
inflation characteristics of the pension payments. This approach also allows the
corporate bond portfolio to be managed separately from the inflation swap on an active
or passive basis.
Question 22.3
What is the main risk of this approach compared with holding index-linked gilts and
how can this risk be mitigated?

Synthetic index-linked bonds
This is a variation of the real rate swap that has been used by some pension schemes.
The scheme still holds fixed-interest corporate bonds, but in this case swaps the
coupons and redemption payments for payments that are indexed with RPI in the same
manner as the coupon and redemption payments on an index-linked gilt.
The only difference from the real rate swap, therefore, is that the asset flows are chosen
to mirror the proceeds from a notional portfolio of index-linked gilts, rather than refined
to match the actual liabilities of the scheme.
1.7 Swapping exposure between different asset classes
Swaps can also be used to swap portfolio exposure between different asset classes. This
is discussed in detail in Section 3.4.
Question 22.4
What are the two types of risk involved with a swap?

2 Exchange traded and over the counter markets

The derivatives market can be divided into two distinct marketplaces
 exchange-traded derivatives
 over the counter (OTC) derivatives.
Exchanges have, over time, increased the number of derivative products offered.
In general they focus on standardised derivatives where there are high levels of
supply and demand, and hence high levels of liquidity.
An over the counter derivatives trade is a bilateral transaction between two

counterparties, typically a bank and a client, with each party exposed to credit
risk in respect of their counterpart to the trade. This counterparty risk is
generally mitigated through collateralisation, ie the party who is out of the
money is required to provide collateral in respect of their loss-making position
with their counterpart. Collateral is typically in the form of cash or high quality
bonds, which are subject to “haircuts”.
The swaps market and the market in forward currency contracts are two very
important OTC markets. Investment banks tailor a wide variety of derivatives to
suit the needs of their corporate clients and investors. OTC derivatives can be
significantly less liquid and transparent than exchange-traded derivatives.

3 Uses of financial futures

The uses of futures can be classified under four headings:
1. hedging – ie using futures to reduce risk on an investment portfolio
2. speculation – ie taking high-risk positions with futures with the aim of

making large profits
3. arbitrage – ie making profits by exploiting anomalous pricing between the

financial future and the underlying investments
4. portfolio management – ie using futures to alter the characteristics of a

portfolio without disturbing the underlying assets.
This is also known as transition management.
In addition, futures can of course be used to create a synthetic index tracking fund as
described in Chapter 20.
3.1 Hedging
Recall that the concept idea of hedging was introduced in Chapter 11.
Hedging reduces risk. It involves taking a position in a future (ie long or short)
which is opposite to the position held in the cash market. The idea is that a loss
or profit made in the cash market will be counterbalanced by a profit or loss on
the future.
More specifically, hedging reduces market risk – the risk of unpredictable fluctuations
in the value of a portfolio due to unpredictable fluctuations in the market values of the
constituent assets. Recall the discussion of market risk in Chapter 17.
Protecting against a fall in the market
An investor with a portfolio of equities can protect against a market fall by

selling index futures with a contract value equal to the size of the portfolio. Any
fall in the value of the equities will then be offset by profits on the futures and
vice versa.

Example
Suppose that an investor has an equity portfolio with a market value of £1m and a
dividend yield of 3% pa, when the equity index stands at 4,000. An equity index
futures contract is available based on a unit of trading of £10 per index point and the
six-month future on the equity index has a quoted price of 4,020. In addition, the risk-
free rate of return is 4% pa.
The following table shows the total value of the equity portfolio 6 months later:
 without hedging
 depending on whether the index goes up 10%, remains unchanged or goes down
10% and assuming that the actual equity portfolio moves exactly in line with the
index
 assuming that the total value of the equity portfolio is simply the total of the
capital value of the equities and the dividends received.
% change in index –10% 0% +10%

Final index value 3,600 4,000 4,400
Capital value of index equities £0.9m £1.0m £1.1m
Dividends received £0.015m £0.015m £0.015m
Total value of equity portfolio £0.915m £1.015m £1.115m
Based on the current index value of 4,000 and the unit of trading of £10 per index point,
the investor will need to go short in:
1, 000, 000
= 25 index futures
4, 000 ¥ 10
in order to hedge the £1m equity portfolio. Supposing she does so, then the profit on
settlement of the futures 6 months later will be equal to:
-25 ¥ £10 ¥ ( settlement price - 4, 020)
ie the futures yield a profit if the index value turns out to be less than 4,020.

The combined value of the investor’s equity portfolio and the profit or loss from the
short futures position will then be:
% change in index –10% 0% +10%
Final index value 3,600 4,000 4,400
Total value of equity portfolio £0.915m £1.015m £1.115m
Profit from short futures +£0.105m £0.005m –£0.095m
Total value of equities & futures £1.02m £1.02m £1.02m
Thus, the end result is the same regardless of the movement in the equity market – ie we
have a perfect hedge.
Two things to notice about this are:

1. The overall return on the hedged portfolio was +2% over six months, which
corresponds to the risk-free rate of 4% pa. This is what we should expect given
that we have created a risk-free portfolio.
2. The hedging is unlikely to be this exact in practice, for reasons we will discuss
below.
By hedging, the equities have effectively been sold in the future at a fixed price.
This type of protection is particularly useful when a fund is going to disinvest a
large sum of money in a few months and wants to avoid any future risk. It can
also be used when a manager feels that the market is looking over-priced and
vulnerable to a fall.
A similar approach can be used with bonds. A complication here is that the
bond future may be based on a relatively long (ie 15 years), and hence volatile
bond. The “hedge ratio” (ie how many futures contracts that need to be bought)
needs to be reduced in proportion to the volatility of the 15-year bond to the
volatility of the portfolio to be hedged.
Thus, if the volatility of your own bonds is twice that of the long bond future, then you
will need to buy £2m of futures to hedge each £1m of bonds that you own. This is a
similar idea to that of the optimal hedge ratio mentioned in Chapter 11.

Question 22.5
Investor A holds a bond portfolio with a duration of 12 years. Investor A expects bond
yields to rise by 2% pa at all terms. He calculates that he should sell 100 15-year
notional bond futures to fully protect the value of his portfolio.
Investor B’s bond portfolio has the same market value as A’s, but a duration of 4 years.
If Investor B expects bond yields to fall by 1% pa at all terms, what futures strategy
should he adopt using the 15-year notional bond futures in order to fully protect the
value of his portfolio?
In practice, such hedges will not quite eliminate all risk. In particular, there are
two types of risk that remain:
1. Basis risk
Recall that the basis of a future is the difference between the price of the future and the
cash price of the underlying asset. It arises because agreeing to buy a share now (via a
future) is different to agreeing now to buy a share now. This is because the purchaser of
the future saves money now, which can be invested at the risk-free rate, but misses out
on the dividends paid by the underlying share.
Basis risk therefore relates to the fact that the future basis cannot be predicted with
certainty.
This is because although the price of a future follows the cash price very closely,
the basis may not move exactly as expected. If, for example:
 supply and demand conditions differ in the cash and futures markets
 investors cannot predict with certainty what future interest rates and dividends
will be.
2. Cross hedging
Unless the portfolio to be hedged behaves exactly the same as the underlying
index, the hedge will not be perfect.
For example, where a hedge ratio has been calculated to allow for the different
volatility of a bond portfolio and the notional bond, there is a danger that the
yield curve changes shape so the prices of bonds do not simply move in
proportion to their volatility.
You may recall that this was described as one element of basis risk in Chapter 11.

Basis risk and cross hedging risk can also apply when trying to protect the value of an
equity portfolio.
Question 22.6
Explain why cross hedging risk may apply in the context of hedging a portfolio of US
equities by selling S&P 500 futures.
Question 22.7
Suppose that you are trying to arbitrage the FTSE 100 future by selling the future and
buying a limited number of the shares in the index. How could you select shares so as
to minimise cross hedging risk?
Protecting against a rise in the market
An investor expecting a large cash inflow in the future may wish to protect
against a rise in the market by buying futures.
Suppose that your fund is expecting a large cash inflow in three months’ time. To
protect against a price rise before you can invest the money you could buy sufficient
futures contracts such that if prices did rise you would make a profit on the futures
equal to the extra cost of buying the underlying assets.
Question 22.8
A specialist equity fund invests in UK shares that are particularly sensitive to interest
rates, economic growth and other factors that move the whole of the UK equity market.
This sensitivity is measured by the “beta” of the portfolio, which happens to be twice
that of the FTSE 100.
The fund wants to use FTSE 100 futures to protect against the possibility of a rise in the
price of shares to be purchased with a forthcoming £3,000,000 cash inflow. What
should it do if the current value of the FTSE 100 is 6,429 and the FTSE future is priced
at 6,466? (The unit of trading for the FTSE 100 future is £10 per index point. )

3.2 Speculation
An investor who has a strong view about the prospects for a particular market
can use the highly geared nature of futures to enhance returns. However, the
riskiness of such a policy means that many institutional investors would not
consider using futures for speculation in this way.
Such speculative use of futures might therefore be limited primarily to hedge funds and
private investors able and willing to accept very high levels of risk.
3.3 Arbitrage
Arbitrage means simultaneously taking equal and opposite positions in related

instruments when the prices are out of line. The aim is to make a risk-free profit.
An example is selling futures and simultaneously buying the underlying asset
when the futures price is above its theoretical value.
In practice, such arbitrage opportunities may be difficult to find. Although apparent

price inefficiencies may be easier to identify in less efficient markets (such as unquoted
securities) it may be more difficult to take advantage of them due to a lack of suitable
futures. Thus, there may be risks involved in then trying to make “near-arbitrage”
profits due to cross hedging. In addition, the transactions costs involved are likely to be
higher.
3.4 Transition management and asset allocation techniques
Transition management: the basic idea
With the passage of time, a prevailing purchased portfolio may come to be

viewed as sub-optimal, for example, if the investor’s liabilities change.
In response, the investor could identify a new optimal portfolio and make the
necessary revisions to the current portfolio. However, this process will incur
transaction costs (brokerage commission, price impacts, bid-offer spreads and,
possibly, tax liabilities).
Question 22.9
Explain why using derivatives might avoid or reduce the tax liability suffered by a fund
when changing the split of its assets.

There are also costs of management and administration. These costs must be
weighed against the advantages of any revision to the portfolio, and allowance
made for the possibility of further revisions to the optimal portfolio structure in
the future.
These and the other problems associated with making large switches of assets are
discussed further in Section 6 of this chapter.
Transition management using futures
It may, therefore, be economically more attractive to revise portfolios by

transacting in entire asset classes instead of individual securities. Buying or
selling futures contracts on stock market indices or Treasury bonds is one such
approach. Instead of holding the market directly, the investor takes a long
futures position in the index – a “synthetic” holding of the market portfolio.
Example
For example, it may be decided to switch a significant proportion of the portfolio from
equities to bonds. Selling the equities and buying bonds may take time if the portfolio
is a substantial one and the attempted sale of a large holding in a share with low
marketability may reduce the price. Furthermore the dealing costs will be considerable
and capital gains will be crystallised.
An alternative strategy is to buy bond futures and sell equity futures. This has the
advantage that the decision can be implemented immediately in a very liquid market
with low dealing costs. By using the right number of futures contracts one can achieve
the same re-weighting of effective exposure to the equity and bond markets as from an
actual switch in the cash markets.
If the switch is to be a long-term one, the underlying securities could then be bought
and sold over an extended period giving opportunities to buy and sell at favourable
prices. In addition, selling the shares over an extended period would allow time for
careful analysis of which shares to sell and which bonds to buy.
If the switch is a short-term tactical one, the derivative “overlay” may be maintained for
the full duration of the asset switch. This removes the necessity to incur the costs of
dealing in the underlying securities and the possible tax disadvantages (eg realising a
capital gain). It is particularly advantageous where the fund is holding unmarketable
securities.
Trading in exchange-traded derivatives is usually quicker, cheaper and easier than

trading in the underlying assets, especially where large trades are concerned.

Question 22.10
Can you think of any problems of using futures contracts for a tactical overlay to reduce
equity exposure when the underlying equities are very unmarketable?
Transition management using swaps
A potentially more flexible strategy makes use of the swaps market. By entering
into an equity swap, for example, one counterparty agrees to pay a stream of
variable-size cash payments based on the return on an agreed stock market
index. In return, the second counterparty agrees to pay a stream of fixed-size
cash payments based on current interest rates. The first counterparty has, in
essence, sold stocks and bought bonds while the second counterparty has sold
bonds and bought stocks. Both of them have effectively restructured their
portfolios without having to pay any transaction costs other than a relatively
small fee to the swap bank that set up the contract.
Essentially the equity swap is like a package of over-the-counter equity index futures.
One party will gain an amount related to the increase in a specified index over the time
to expiry of the deal (or lose an amount related to the decrease in the index over the
period). The other party will gain the current fixed interest yield over the period. The
arrangement has the advantage that it can be done in large size and over a long time
period, and costs can be reduced relative to dealing in the futures market. Also the
index can be specified precisely, whereas in the futures market only certain indices are
available.
In addition, it should be clear that a swap will have the disadvantage of credit risk as the
swap counterparty will be a bank (not a clearing house). The swap will also suffer from
lack of marketability as there is no recognised secondary market in the swap.
The equity swaps can be modified to provide international diversification (by

swapping returns on a domestic index for a foreign index) or to move between
market sectors. Similarly, interest rate swaps can be used to modify the shape
of a fixed interest portfolio, swapping floating rate LIBOR returns for fixed
interest returns on long-term bonds.
Question 22.11
How would an investor obtain the “international diversification” mentioned above using
the futures market?
Such swap deals can subsequently be reversed (for a mutually acceptable cash
settlement payment) or closed out by arranging a further offsetting deal.

Question 22.12
How would you calculate an agreeable cash settlement payment to close out a pay fixed
and receive floating interest rate swap prior to its expiry?
Such “overlay” strategies may be employed as a temporary measure to alter the

nature of the portfolio, while appropriate stock sales and purchases are
researched and while suitable trades are arranged. Once cash market
transactions have been made, the overlay position can be unwound.
Alternatively, the overlay strategy can be maintained as a way of allowing regular
rebalancing of the portfolio, at minimum cost.
Such overlays can therefore be used:

 to obtain immediate re-allocation of funds between asset categories (which
would then be unwound as the cash market deals were made)
 as a means of altering the portfolio structure on a medium-term basis (ie the
underlying cash market deals will not take place and the swap will remain in
place until the next restructuring decision is made)
 to change the nature (ie fixed or floating) and/or duration of a fixed interest
portfolio
 to obtain international diversification.
Allocation within an asset class
Instead of buying and selling bonds within the cash market, policy switches can be
imitated using futures. For example, a notional long bond future and a short bond
future could be used to profit from policy switching opportunities.
Matching long-term liabilities (immunisation)
Being dealt on margin, futures are very volatile. This means that bond futures
can be used to match long-term liabilities thus overcoming a major limitation of
the bond cash market.
By “matching”, we really mean immunising by taking advantage of the highly geared

and hence volatile nature of futures. However, matching long-term liabilities is easier if
zero-coupon bonds, or equally if zero-coupon bonds can be created by stripping
coupon-bearing bonds into their individual payments.
However, the yield curve may change by different amounts at different durations. This
means that such “matching” will at best be less than exact.

In order to try and match long-term liabilities many investors purchase long
duration interest or inflation swaps. The swaps market is an OTC market where
investors usually transact with an investment bank (the counterparty). Under the
term of an interest rate swap investors agree to pay the counterparty a floating
rate (typically a rate linked to the cash markets) in return for a fixed rate series of
cashflows. For inflation linked swaps the investor agrees to pay a fixed rate in
return for inflation linked payment. Long duration swaps range between 30-50
years. The purchase of long-duration swaps often forms part of a Liability
Driven Investment (LDI) strategy (Chapter 19, Section 2).
Although long duration interest rate and inflation swaps allow investors to match
long term cashflows better, there are several drawbacks to purchasing swaps
including documentation required (ISDA contracts), counterparty credit risks and
generating the floating rate payable to the counterparty for interest rate swaps.
Consolidating stock selection profits
If a manager believes that he is good at picking individual stocks that will perform
relatively well against the market, but is worried about what will happen to the market
as a whole, futures can help.
An investor can eliminate any profit/loss from market movements leaving only
his stock selection profit or loss by selling index futures at the same time as
buying individual securities.
In other words, the fund manager sets out to deliberately cross hedge in order to make
stock selection profits whilst removing exposure to movements in the market as a
whole. In the US, funds known as “alpha” funds have been set up to do exactly this.
Question 22.13
State the two main uses of futures for most institutional investors.
Question 22.14
Describe the two main risks in using futures for hedging.

4 Using options
In this section we look at the more common types of option strategy. We group the
strategies into:
1. hedging
2. income enhancement
3. trading or speculation
4. arbitrage
5. portfolio (or transition) management.
Question 22.15
Which of the above strategies are possible with futures as well as options?
4.1 Hedging
Option deltas were discussed in Subject CT8.
Protecting against a fall in the market (protective put)
By buying put options on an asset the minimum value of the combined holding
can be fixed at the exercise price of the options. If the value of the asset goes up
the potential profit has only been reduced by the amount of the option premium.
Such a hedging technique applied to a whole portfolio is often known as
portfolio insurance.
Question 22.16
Draw a position diagram showing the overall profit or loss as a function of the
underlying share price at expiry from:
1. holding the underlying asset and selling a future
2. holding the underlying asset and buying a put.

For such a hedge to be effective the value of the options held must increase by
the same amount as the decrease in the underlying asset price. Thus the hedge
ratio (the number of options required for each unit of the asset) will be equal to
the reciprocal of the derivative of the option price with respect to the underlying
asset price. This is known as the “delta” of the option.
Recall that the delta of a derivative is equal to the mathematical partial derivative of the
derivative price with respect to the price of the underlying asset.
Example
Suppose that an at-the-money option’s price changes by about ½ for every unit change
in the value of the underlying security, ie it has a delta of ½. Therefore, if each option
contract is based upon 1,000 shares, in order to hedge movements in 1,000 shares using
at-the-money options, you would need to buy 2 option contracts (based on 2,000
underlying shares). This makes the delta of the combined portfolio zero. Consequently
this technique is sometimes called delta-neutral hedging.
The delta value of an option is a function of time to expiry, as well as the price
relative to the exercise price and the volatility of the underlying security, so to
maintain a fully-hedged position requires continual adjustment of the number of
option contracts held.
This dynamic hedging is necessary if the delta of the overall portfolio is to remain equal
to zero.
Protecting against a rise in the market
Buying a call allows you to benefit if prices rise a lot. This is useful if you are
expecting a cash inflow in a few months’ time and don’t want to run the risk that prices
rise before you can invest. If prices instead fall, you can abandon the option and still
benefit by investing at lower prices. The only cost is the option premium.
Protecting against interest rate changes
Another example of hedging concerns the use of options on short-term interest

rate futures. By buying a put on the interest rate futures a cap can be put on the
interest rate to be paid for future borrowing, while still benefiting from any fall in
rates.

Buying a put gives you the right to sell the future. Recall that selling an interest rate
future is useful if interest rates rise (ie prices of money market bills fall). So if interest
rates rise the profit from exercising the option compensates for the higher cost of future
borrowing. The further interest rates rise, the greater the profit from the option,
matching the increased cost of borrowing.
Question 22.17
The current quoted price of an interest rate future is 99.26, implying a future interest
rate of 0.74% pa. An investor thinks that interest rates are going to rise and so buys a
put options on an interest rate future with a strike price of 99.00 at a price of 0.10.
Suppose that the interest rate future has a price of 98.78 on delivery, how much overall
profit does the investor make on each option (in terms of basis points)?
Question 22.18
Explain how selling call options sets a minimum interest rate for borrowing.
A further strategy is to establish an interest rate collar, setting a maximum and

minimum interest rate by buying puts and selling calls.
Recall the discussion of interest rate collars created using interest rate caps and floors in
Chapter 12.
Question 22.19
Explain how could you use options on short-term interest rate financial futures to set a
collar around the return on lending money.
4.2 Income enhancement
The term covered is used to refer to the position of a writer of an option, who holds an
opposite position in the underlying asset. Conversely, the terms uncovered or naked
refer to the position of a writer of an option who does not hold an opposite position in
the underlying asset.

Covered call
An investor can increase the income of their fund by writing call options on the
assets. In flat or falling markets this enhances the performance of the fund
relative to similar funds which have not executed this strategy. The cost of the
strategy is the sacrifice of all potential gains above the exercise price of the
options that would have been made if the market rose.
Question 22.20
An investment manager describes writing a covered call option as “converting the

possibility of a large capital gain into a certain, small gain”. Explain whether this
description is correct.
Naked call
A naked call arises when you write calls on assets that you do not own. It is an
extremely risky strategy because the maximum loss is unlimited.
Naked put
Like naked call writing this is risky, although the maximum loss is limited to the
exercise price less the premium.
Note that you cannot really have a covered put (except in the sense of holding cash
equal to the exercise price) because you can’t be short of the underlying asset.
4.3 Trading or speculation
There are many possible ways of using options in an attempt to profit from a
view on the future performance of financial securities.
An infinite number of combinations of options can be designed, each of which

will produce a different pattern of profit depending on movements in the price of
the underlying asset. Some of these combinations are recognised by exchanges
and can be traded as a single unit.
Such speculation using options can be highly risky and is not usually
considered appropriate for institutions such as pension funds and insurance
companies. However, such speculation may form a major part of the trading strategy
of some hedge funds.

Simple directional speculation
Directional strategies seek to benefit from the rise or fall in a security or market.
An investor who expects an increase in the price of the underlying security will
purchase calls, while an investor who expects it to fall can buy puts. Compared
with purchasing the underlying securities, buying calls gives a high level of
gearing and low dealing costs. Buying puts makes gains possible in falling
markets for investors who cannot “sell short”, ie sell an asset that they do not own.
Whether you are allowed to short sell depends upon what type of investor you are and
the regulation and legal documentation governing your investment operations.
Spreads
A spread means simultaneously buying and selling calls (or puts) on the same
underlying asset where there is a difference in the exercise price or the expiry date.
Question 22.21
An investor buys a May 460 call for 38p and writes a May 500 call for 17p. Draw a
diagram showing the profit/loss at expiry from this strategy as a function of the
underlying share price.
From the question above, you will see that a spread can give the effect of giving profits
and losses in line with movements in the share price around the exercise prices, but
limiting both the upside and the downside.
Straddles
A unique feature of options is that the price of an option depends on the

volatility of the price of the underlying security. Thus an investor who believes
that they have information which will affect the volatility in a way not yet
anticipated by the market can seek to gain from this information.
For example, a straddle means buying a put and a call on an underlying asset with the
same exercise price and expiry date.
Question 22.22
An investor buys a May 460 call for 38p and a May 460 put for 25p. Draw a diagram
(over the range 350p to 600p) showing the profit/loss at expiry from this strategy as a
function of the underlying share price.

A straddle might be sensible if you are sure that the underlying share price will be
volatile, but if you are not sure which way the price will move. This might be the case
when a company is about to make a major announcement that would affect its share
price, but it is not known whether the announcement is going to be about good news or
bad news.
4.4 Arbitrage
The relationships between the prices of put and call options, short-term interest
rates and the underlying securities mean that different portfolios can be
constructed which give the same return in all circumstances. Investors who can
identify such equivalent portfolios with different prices may be able to make a
profit by buying the cheaper one and selling the dearer one.
It is most likely to be investment banks and market makers that are able to take
advantage of any arbitrage opportunities.
4.5 Portfolio (or transition) management
Call options allow exposure to be gained to upside movements in the price of the
underlying asset. Put options allow exposure to downside risks to be removed.
Therefore calls and puts on different assets can be combined to change a fund’s
exposure either across asset categories or within an asset category.
This use of options to shift the portfolio is similar to the use of futures for the
same purpose.
Question 22.23
Describe how you could use options in a tactical overlay strategy to shift exposure from
domestic equities to government bonds. How does the payoff at the expiry date of the
option from this strategy compare with the payoff from the similar futures-based
strategy?

Question 22.24
A fund manager wishes to protect his equity portfolio against falls in the equity market.
The equity index stands at 4,000. He buys one month puts with a strike price of 3,900
costing 170 each and sells one month calls with a strike price of 4,100 for the same
amount. Draw an intrinsic value diagram for this option strategy. Explain why it offers
protection for the portfolio.

5 Currency hedging
An institution that holds investments in a currency other than that in which its
liabilities are denominated is exposed to variations in the exchange rate as well
as variability in the return achieved on the underlying investment.
If the investor does not want to bear this exposure it can be hedged in various
ways, for example by using forward currency contracts.
5.1 Currency hedging with forwards
Forward contracts are in many ways similar to futures.
Question 22.25
What are the main differences between forward and futures contracts?
A forward currency contract is an agreement to exchange currencies at a

specified date in the future at a rate fixed now. The forward foreign exchange
market in London is very large indeed and is conducted between large banks
using a screen-based quote system and dealing by telephone.
The market is efficient in the sense that the cost of buying one currency directly
with another is the same as the cost of buying that currency indirectly via a third
(ignoring dealing costs).
Example
Suppose that the 6-month forward exchange rates are 3 Swiss francs per £1 sterling and
$1.5 US dollars per £1 sterling. Then in an efficient market, the 6-month forward
exchange rate for Swiss francs in terms of US dollars should be 2 Swiss francs per $1
US dollar (ignoring dealing costs).
Using forwards to hedge
If you are expecting proceeds from a foreign currency investment you may want to sell
the foreign currency forward. By doing this you remove the possibility that a
depreciation of the foreign currency will reduce the domestic currency value of the
expected proceeds. You can lock in to an exchange rate agreed today.

The costs of this are:

 you also remove the possibility that an appreciation of the foreign currency will
increase the domestic currency value of the expected proceeds
 the bid/offer spread on forward deals is normally a little more than the spread on
spot market transactions, so there is a small additional cost for using forwards.
Using forwards to speculate
It is also possible to use forwards to speculate. For example you might think that the
Panamanian Balboa was about to depreciate against the US dollar (eg you suspect that
Costa Rica is about to dig a rival canal). In this case you (assuming that you were
considered creditworthy enough) could enter into a forward agreement by telephoning
the First National Bank Of Panama and agreeing now to sell Balboas forward for dollars
in three months’ time. Note that you can do this even if you have neither assets nor
liabilities denominated in Panamanian Balboas.
Having sent a fax to confirm the deal in writing you can then sit back and wait for three
months (no margin is typically required on forward contracts). To complete your side
of the deal you will have to arrange to buy Balboas, eg by making a spot deal at the end
of the three months. Hopefully the Balboa will have depreciated by this time (by a
bigger amount than was implicit in the terms of your forward deal). If it has, you will
be able to make the spot deal at a more favourable rate than the agreed forward rate,
leaving you with a profit in dollars.
Question 22.26
Explain how to profit from a view that the Western Samoan Tala will appreciate over
the next six months.

Viewing currencies as an asset
The ability to use forwards and other instruments to hedge currencies allows the fund
manager of an institutional investor to separate the decision to invest in a country from
a decision to invest in the currency.
The two basic choices:

1. invest in domestic or overseas assets
2. use currency forwards (or futures or swaps) or do not use them
open up the four possibilities shown in the table below.

Don’t use forwards Do use forwards
Buy domestic Domestic Domestic investment +
assets investment currency speculation
Buy overseas assets Unhedged overseas Hedged overseas
investment investment
If the sole aim is to maximise returns then it could be appropriate to be in any of the
cells in the table above, depending upon the manager’s view of future conditions.
It is important to appreciate that the decision to hedge currency risk on overseas

investments is not a simple “yes” or “no” decision for a fund. It may be appropriate to:
 hedge some currencies but not others
 hedge at some times but not at other times.
Question 22.27
You are the fund manager for an Irish life office. At your monthly strategy meeting
your investment team decides that:
 Japanese growth will increase following a cut in Japanese interest rates
 US growth will be boosted by a surge in productivity.
Suggest how this might affect your investment policy.

Limitations on using currencies as an asset
In practice the average institutional investor with liabilities denominated in the domestic
currency will normally:
 invest the majority of the fund in domestic assets (with no currency transactions)
 invest a significant minority of the fund in overseas assets (unhedged)
 possibly invest a little in overseas assets with the currency risk hedged
 rarely, if ever, invest in domestic assets and speculate by using forward currency
deals.
Out-and-out currency speculation is generally seen as too risky for most investors and
investment managers may be forbidden from doing it. However, they are likely to
enjoy the discretion to decide whether or not to sell forward foreign currency if there is
an associated investment denominated in that currency.
Most overseas exposure by institutional investors goes unhedged.
Question 22.28
List the four main reasons why institutional investors invest overseas and comment on
whether currency hedging helps in each case.
Practical problems with forwards
As an example, a UK investor who holds an overseas bond which will pay a

known amount in say three months’ time can fix the sterling amount of the
proceeds now by entering into a forward contract for the amount of the overseas
currency that will be received. However, an investor who holds an overseas
investment which gives an uncertain return can only hedge the amount of the
expected return. The investor is still exposed to some foreign exchange risk.
For example, if you expect to receive $1m in three months’ time from dividends on a
portfolio of US shares you might sell $1m US dollars forward to a bank. If the
dividends turn out be less than expected (eg $0.9m) then you will be exposed to a rise in
the value of the dollar. This is because you will have to buy the missing $0.1m in the
spot (ie cash) market at the then prevailing exchange rate.
The main problem with using forward contracts to hedge returns from overseas
investments for long-term investors is the fact that many investments are of a
longer term than the contracts available in the market. The forward contracts
will therefore have to be rolled over on expiry at an unknown rate.

Forward rates are quoted in many currencies for terms of up to a year. For terms of five
years only a few of the larger banks will deal in the major currencies (eg sterling/dollar
forwards), although deals are occasionally possible over terms as long as fifteen years.
Currency swaps would normally be used for longer-term hedges.
A further difficulty is the costs associated with the forward contracts. Although
dealing costs are low, particularly on the major currencies, they may be
significant when attempting to hedge smaller amounts, for example dividend
receipts.
Although there may be no commission on forward deals, the bid/offer spread is likely to
be a lot wider on smaller deals.
Question 22.29
In one sentence, state the main difference between a forward currency agreement and a
currency future.
Question 22.30
What are the main disadvantages associated with the use of forwards for currency
hedging?

6 Derivative reporting
To reduce the risk associated with derivatives, appropriate reporting of exposure
is important. This should include:
 listing derivatives individually in an intelligible way within portfolio
valuations (and directly under other holdings in the relevant asset or
assets)
 valuing the derivatives at market value (“marking-to-market”)
 including any additional explanations needed to ensure that the fund’s
exposure is properly understood.
The reason for each of the above should be relatively clear. A holding in equity call
options should be reported alongside the equity market exposure. The valuation in any
portfolio valuation should be the market value, not the nominal value or the book value
which have little or no meaning for derivatives. The report should also show the
effective exposure to equities, which in the case of equity call options would be
calculated as the (total option exposure  the delta of the options). It may also be wise
to show the other Greeks, such as the gamma exposure (the rate of change of the delta
exposure with changes in the underlying). All of the above would need to be clearly
reported to allow proper derivative management to take place, and each derivative
contract should be separately reported.
The report should make clear where the exposure of the portfolio to different
asset classes has been changed through the use of futures or swaps and what
the associated economic exposure is. When reporting on options, a written
explanation of the strategy employed should be given and, where the use of
options is material, a subsidiary option sensitivity analysis should be included.
Question 22.31
List all six “Greeks” or risk management parameters.

7 Changing the strategic asset allocation

The main problems when making large changes to the asset allocation are:
1. the possibility of shifting market prices (both on sale of existing portfolio
and purchase of new assets)
2. the time needed to effect the change and the difficulty of making sure that
the timing of deals is advantageous
3. the dealing costs involved
4. the possibility of the crystallisation of capital gains leading to a tax
liability.
The problems are particularly acute when unmarketable securities are involved,
or where the normal market size for deals in the securities is small.
These problems need to be considered when an asset allocation decision is

made.
Either the institution must accept:

 the losses that will be made in dealing costs and possibly having to realise
unmarketable assets below their true value, or
 that the switch will take a long time.
Neither of these outcomes is particularly attractive, especially if the institution wants to

effect the change rapidly.
A solution
A partial solution to this problem is to use derivatives to gain the required exposure
immediately and then to conduct a gradual sale of the portfolio. Institutions do use this
technique in practice.
Question 22.32
Explain why derivatives contracts may be effective in enabling a more efficient change in
asset allocation.

8 Dealing in the cash market

For transactions in the cash market, transaction costs may be reduced by:
 implementing the transition in stages, rather than attempting it
immediately
 investigating share exchanges between old and new managers
 investigating crossing, whereby an investment bank looks among its
clients for buyers and sellers of stock
 using the investment of cashflows as a way of rebalancing the portfolio.
A share exchange between old and new managers would involve transferring a holding
between the fund management company that originally managed the fund (which
presumably still likes the current holdings in the fund) and the fund management
company that is taking over management of the fund. If the old company still likes the
existing share holdings, they may well be open to “buying” them from the new manager
in exchange for some shares that they have elsewhere that they would be happy to sell
at the current price. By avoiding the market, both new and old managers avoid
bid/offer spreads and commissions (but probably not stamp duty) on the transaction.
Crossing is a process whereby a large investment bank that has many large fund
manager clients, talks to a selection of its clients about some of the stocks that the new
manager wishes to dispose of. Often large holdings of stock can be disposed of more
easily and cheaply in this way rather than by selling many small tranches through the
market – and with less effect on the share price.
The flip side of this type of transaction is that the new manager has to disclose to a
number of companies the shares he is seeking to sell. If he does not manage to get rid
of the stock this can sometimes panic other large institutions with the result that the
share price may sink!
Question 22.33
What is meant by “using the investment of cashflows as a way of rebalancing the

portfolio”?

9 Costs and benefits

Previous sections of this chapter have discussed ways in which derivatives and
similar instruments can be used to help manage an investment portfolio. The
previous sections largely concentrate on the benefits of using the instruments
compared with holding the underlying assets.
As with any financial proposal the costs and benefits must be fully evaluated.
For example a set of interest rate swaptions may be an effective method of
mitigating the risks from a portfolio of guaranteed annuity rate options written by
a life insurance company, but there is no such thing as a no cost deal. The
interest rate risk that is hedged is replaced by counterparty credit risk on the
provider of the swaptions. In turn the credit risk may be limited by collateral
arrangements, but these too have their downsides – the agreements are complex
(legal risk) and commonly involve daily rebalancing (administrative work and
operational risk). All of this is in addition to the cost of the protection itself.
A full analysis of any proposal will consider not only the immediate costs and
benefits, but also the changes in risk profile, and the operational work that will
be involved in implementing the proposed solution. It is only with this analysis
that different solutions to the problem can be compared with each other and with
simply accepting the underlying risk.


Chapter 22 summary
Uses of swaps
Swaps can be used to:

 reduce risk by matching assets and liabilities
 reduce a company’s cost of borrowing, based on the principle of comparative
advantage
 swap exposure between different asset classes without disturbing the underlying
assets.
Each counterparty to a swap faces two kinds of risk:

1. the market risk that market conditions will change so that the present value of
the net outgo under the agreement increases
2. the credit risk that the other counterparty will default on its payments.
All derivatives can be divided into one of two groups:

 over the counter (OTC), or
 exchange-traded
Uses of financial futures and options
Futures and options can be used for:

 hedging to reduce market risk
 speculation aimed at increasing returns
 generating arbitrage profits
 portfolio (or transition) management, ie altering the characteristics of the
portfolio without disturbing the underlying assets.
 synthesizing an index (as described in Chapter 20).
In addition, options can be used to generate additional income.

The use of futures for hedging involves:

 basis risk, as the basis of the future cannot be predicted with certainty
 cross hedging risk, if the actual assets differ from those underlying the future.
When hedging via options, you need to know the hedge ratio, which is equal to the
reciprocal of the delta of the option.
Currency hedging with forwards
Currency forward contracts can be used to hedge the returns from overseas investments.
The main problems hedging with currency forwards is that:
 it is possible only to hedge expected returns
 many investments are of a longer term than the contracts available in the market
and so the forward contracts will have to be rolled over on expiry at an unknown
rate
 it may be relatively expensive to hedge small cashflows (eg from dividends).
Derivative reporting
To reduce the risk associated with derivatives, appropriate reporting of exposure is

important. This should include:
 listing derivatives individually
 valuing the derivatives at market value (“marking-to-market”)
 including any additional explanations needed to ensure that the fund’s exposure
is properly understood.
Changing the strategic asset allocation
The main problems when making large changes to the asset allocation are:
 the possibility of shifting market prices (both on sale of existing portfolio and
purchase of new assets)
 the time needed to effect the change and the difficulty of making sure that the
timing of deals is advantageous
 the dealing costs involved
 the possibility of the crystallisation of capital gains leading to a tax liability.
It may be possible to reduce the extent of some of these problems using derivatives.

Dealing in the cash market
For transactions in the cash market, transaction costs may be reduced by:
 implementing the transition in stages, rather than attempting it immediately
 investigating share exchanges between old and new investment managers
 investigating crossing, whereby an investment bank looks among its clients for
buyers and sellers of stock
 using the investment of cashflows as a way of rebalancing the portfolio.


Solution 22.1
It needs a currency swap of appropriate size and term. Under the swap it wants to pay
variable rate Euros and receive fixed rate Rands.
We would also have some sympathy with the answer “swap out of Euro-denominated
Eurobonds and into South African government bonds”!
Solution 22.2
Under the swap, AB Foods ends up a net borrower at:
+ (Government + 30) – (Government – 10) + (LIBOR + 0) = LIBOR + 40
ie at variable rate + 40 basis points.
Solution 22.3
This approach does involve some counterparty risk, which can be mitigated through
collateralisation.
Solution 22.4
The two types of risk are:

1. the market risk that market conditions will change so that the present value of
the net outgo under the agreement increases
2. the credit risk that the counterparty to the swap will default on its payments.

Solution 22.5
Note that you are given some irrelevant information. The size and direction of the
expected interest rate movements are irrelevant. The answer is:
 To protect a long position in the underlying asset you need to be short in the
future (ie a seller of the future). Investor B is in the same position as Investor A
in this respect.
 If 100 futures contracts are needed for a portfolio with a 12-year duration, then
only 331/3 will be needed for the less volatile portfolio with a 4-year duration.
(Note that this is only approximate because volatility will change as interest
rates change. )
So, go short about 33 futures contracts.
Solution 22.6
The S&P 500 will be a proxy only for most real US equity portfolios. So the price of
the future may behave slightly differently from your actual portfolio because you are
not hedging like with like. The closeness of the hedge is sometimes referred to as
“congruence”. If you hold a portfolio that perfectly replicates the S&P 500 index, the
S&P 500 future will provide a good hedge.
Solution 22.7
To minimise cross hedging risk, we want the “limited number of shares” to perform as
closely as possible to the FTSE 100 index. There are several ways of doing this, but the
aim is to ensure that we have a representative sample of companies in terms of:
 industry grouping
 size – eg maybe one company from each of the top 1 to 10, 11 to 20, 21 to 30
etc.
We might also want a representative range of factors such as:

 level of gearing, price earnings ratio and/or dividend yield
 growth in earnings
 overseas exposure.
In practice, you might use a multifactor model to help you select the appropriate shares.

Solution 22.8
It needs to buy/go long in FTSE 100 futures. Given the beta value of 2 it should buy
twice as many futures contracts as would be required had the beta been 1. (If the
market goes up by, say, 1% we might expect the cost of the shares to be purchased to go
up by 2%. )
2 ¥ 3, 000, 000
Hence we need: ª 93 contracts
6, 429 ¥ 10
Note that the shares to be purchased are clearly different from the average of the
FTSE 100, so there will be significant cross hedging.
Solution 22.9
Suppose a taxed fund has an equity portfolio that has a current market value of $100m,
but was purchased many years previously for $10m. The latent capital gain would be
$90m, which would incur a large taxable gain if it were realised.
Suppose that the manager wishes to switch out of equities into bonds for a month for
fear that the equity market may fall by 10%. If he sells equities and buys bonds, he
realises a gain of $90m. If he sells equity futures and buys bond futures, he realises
nothing. If the equity market does fall by 10% he can buy back the equity futures at a
lower price, realising a small gain (in the order of 10%  £100m ). Hence he has
avoided the potential large gain on the portfolio – or at least he has delayed realising the
large gain for another 30 years!
Solution 22.10
If the equities are very unmarketable, then they won’t be included in the index upon
which the index future is based. So the use of futures will represent a cross hedge. For
example, the price of the stocks held could fall whilst the short equity futures position
also showed a loss. This would happen if the price of large company shares increased
whilst unmarketable (small company) shares fell.
Solution 22.11
This could be achieved by selling futures on the domestic equity market index and
buying a variety of futures on international equity market indices.

Solution 22.12
You would need to value the outstanding payments on the swap at the current interest
rates in the way described in Chapter 11. The swap consists of two components:
 a series of fixed interest payments to the expiry of the swap (which could be
valued by discounting them using current spot rates)
 a series of floating-rate payments to the expiry of the swap (which is very like a
bank account and will have a value of close to zero).
The difference between these two amounts will be an agreeable payment.
Solution 22.13
There are several plausible answers to this question. One possibility is:
1. speculating
2. hedging.
Given that speculating is too risky for many institutional investors a better answer may
be:
1. hedging
2. portfolio (or transition) management
Solution 22.14
Basis risk is the risk that the basis (ie difference between cash and futures price) of the
future may not move exactly as expected, and so the residual profit/loss from hedging
cannot be predicted with certainty.
Cross hedging risk is the risk that unless the portfolio to be hedged behaves exactly the
same as the underlying index, the hedge will not be perfect. Again, this means that the
profit/loss on the futures position may not exactly match the loss/profit on the cash
position.
Solution 22.15
All of them apart from income enhancement.

Solution 22.16
Profit profile:
1. holding the underlying asset and selling a future
2. holding the underlying asset and buying a put (no limit to profit)
Profit
asset + buy put
asset + sell future

Break even
strike price share price at expiry
Buying the future removes all of the exposure (if we ignore cross hedging and basis
risk). In contrast, the put limits downside risk whilst leaving most of the upside profit
potential.
Solution 22.17
As the option is in-the-money at expiry, the profit at expiry is equal to:
99.00 – 98.78 = 0.22
The overall profit from the strategy is therefore equal to this amount less the initial cost
of the option, ie:
0.22 – 0.10 = 0.12
ie 12 basis points.
NB As each basis point corresponds to $25, so the actual cash profit is equal to $300
for each option purchased.

Solution 22.18
Selling a call gives someone else the right to make them the buyer and you the seller of
a future. Selling an interest rate future is bad news if interest rates fall and money
market bill price rises. So if interest rates fall the loss from having the option exercised
against you cancels the benefit of lower interest rates on future borrowing. The further
interest rates fall, the greater the loss from the option, matching the reduction in the cost
of borrowing.
Solution 22.19
You could set a maximum and minimum interest rate for lending by buying calls and
selling puts.
Buying a call gives you the right to buy the future. Buying an interest rate future is
useful if interest rates fall. So if interest rates fall the profit from exercising the option
compensates for the loss of interest on lending. The further interest rates fall, the
greater the profit from the option, matching the loss of interest on lending. This gives
the minimum.
Selling a put gives someone else the right to make you the buyer of a future. Buying an
interest rate future is bad news if interest rates rise. So if interest rates rise the loss from
having the option exercised against you cancels the benefit of higher interest rates on
lending. The further interest rates rise, the greater the loss from the option, matching
the increase in the interest earned on lending. This gives the maximum.
Solution 22.20
Writing a covered call means writing a call option when you own the underlying asset.
If the price of the underlying asset goes up a lot, the call option will be exercised and
you will have to sell the underlying asset. You will only have received the option
premium (plus the gain in price up to the exercise price), rather than the full capital gain
on the underlying asset.
However, there is little protection in this strategy against downside risk. If the
underlying asset price falls, the option will not be exercised. You will suffer the loss in
the value of the underlying asset. You will have gained by the amount of the option
premium, but this may not be enough to compensate for a large fall in the value of the
underlying asset.
Thus there is some truth in the manager’s statement, but the strategy does not guarantee
an overall gain. There is no gain if the market falls heavily.

Solution 22.21
Profit profile for a spread. Maximum profit of 19p (– 21 + 500 – 460) and maximum loss
of 21p (– 38+17).
profit
20
break-even
–20
loss
460 500 share price at expiry
Solution 22.22
Profit profile for a straddle. Unlimited profit potential. Maximum loss of 63p.
profit
50
break-even
–50
loss
350 400 450 500 550 600 share price at expiry

Solution 22.23
The most obvious strategy is to buy puts on an equity index and call options on a
government bond future. If your view is correct (ie that government bonds outperform
equities) it will be slightly less profitable than the futures-based strategy (selling equity
index futures and buying government bond futures). However, if your view is incorrect
the loss will be much less than with the futures-based overlay.
Solution 22.24
Intrinsic value diagram
400
300
200
Profit on stategy
100 put
call
0
net
3600
3700
3800
3900
4000
4100
4200
4300
4400
-100
-200
-300
-400
Index level at expiry
It is clear that the net position offers downside protection for an investor. If the market
falls and the investor’s portfolio begins to make losses, then the option strategy makes a
corresponding profit. Of course there are no free lunches, and by selling calls to finance
the strategy the investor makes losses when the market rises, offsetting any gains he
may make on his portfolio.

Solution 22.25
A forward contract is like a future except that:

 It is a non-standardised contract between two parties. For example, a currency
forward could be arranged in any two currencies, for any amount, with any
delivery date.
 It is an over-the-counter contract arranged with a bank acting as market maker,
rather than on a recognised exchange.
 Whereas most futures get closed out prior to the delivery date, a forward
currency arrangement normally results in delivery (although the customer can
normally negotiate an earlier or later settlement with the bank with which it
made the forward agreement).
 An institutional investor will arrange a forward directly with a bank, whereas for
futures it will go to a derivatives exchange broker who will buy and sell futures
on its behalf.
 The counterparty to a future is the clearing house. With a forward it will usually
be a bank.
 No margin is required for forwards.
Solution 22.26
1. Ring the Second National Bank of Western Samoa and agree to buy Tala six
months forward.
2. Subsequently sell Tala on the spot market at the end of the six months. (Or, at
any stage during the six months you could sell Tala forward with the same value
date as the original forward and thus lock into the profit to date. )
Solution 22.27
Assuming that you have the investment freedom:

1. The higher growth may lead you to increase your exposure to both Japanese and
US equities.
2. You may be worried about a fall in the Yen caused by the cut in interest rates,
therefore you might sell Yen forward to cover part of your exposure to Yen.
3. Increased productivity should strengthen the US Dollar. Therefore you would
probably leave your US Dollar exposure unhedged.

Solution 22.28
1. Maximising returns. Hedging has a small cost, which should reduce expected
returns (although a skilled manager might use selective hedging to enhance
returns further).
2. Diversification. Sometimes exposure to overseas currencies adds an extra
dimension to diversification which hedging would remove.
3. Overseas liabilities. Hedging would introduce a mismatch.
4. Hedging domestic inflation. The argument here is that currency movements (ie
along the purchasing power parity path) will compensate for differential
inflation rates. Hedging removes this benefit because you lock in to a forward
exchange rate and no longer get protection from unexpected inflation.
Solution 22.29
A forward contract is a non-standardised contract between two parties traded on an

“over-the-counter” market, whereas as a future is an exchange-tradable and
standardised contract.
Solution 22.30
The main disadvantages of using forwards to hedging currencies include:

 the extra cost of bid-offer spread compared with a straight spot currency
transaction
 the need to rollover short-term forwards to remain hedged over longer periods
 removing the possibility of favourable currency movements (ie market risk)
 counter-party credit risk
 mismatching real liabilities by eliminating purchasing power parity protection
against unexpected inflation differentials
 the difficulty of hedging unknown future income.

Solution 22.31
The “Greeks” are all mathematical partial derivatives of the derivative price f with
respect to a particular factor that influences the price of the derivative. The six Greeks
are:
∂f
● delta, D = , where S is the price of the underlying
∂S
∂2 f
● gamma, G = , where S is the price of the underlying
∂S 2
∂f
● kappa k = , where s is the volatility of the price of the underlying
∂s
∂f
● theta, q = , where t is time
∂t
∂f
● rho, r = , where r is the risk-free rate of return
∂r
∂f
● lambda, l = , where q is the constant, force of the dividend yield.
∂q
Solution 22.32
Derivatives contracts may help because:

 investors can create large “exposure” through derivatives
 the main derivatives markets are well-developed (ie efficient and very liquid)
 dealing expenses are usually much lower
 positions can be taken quickly, allowing more time to change the exposure in the
underlying cash markets.
Solution 22.33
Invest new cashflows into the asset categories that the manager intends to build up,
thereby increasing the exposure slowly and without the dealing costs that are associated
with selling the existing holdings.





the course.

ST5-23: Taxation Page 1
Chapter 23
Taxation
Syllabus objective
(b) Describe the typical ways in which investment returns are taxed and the effect of
the taxation basis on investor behaviour.
0 Introduction
Taxation can have a major impact on the behaviour of investors. This is because the
taxation of investment returns will reduce the amount of money they have available to
meet their investment objectives. All else being equal, investors will therefore wish to
minimise the present value of the tax they pay in order to maximise the investment
returns that they receive after tax. This can be done by avoiding tax and/or delaying its
payment.
Fundamental aspects of taxation were introduced in the Core Reading for

Subject CT2.
The two sections in this chapter consider the taxation of investments and corporate
taxation respectively.

Page 2 ST5-23: Taxation
1 Taxation of investments
1.1 Tax issues affecting investment decisions
Taxation of investment return is one of the major factors considered by investors

in selecting investments. Each investor, individual or institution, will attempt to
maximise after-tax returns (subject of course to risk constraints) and will
therefore attempt to find tax-efficient investments.
Factors that need to be considered are:

 the total rate of tax on an investment
 how the tax is split between different components of the investment
return – in practice, this usually means between income and capital gains
 the timing of tax payments
 whether the tax is deducted at source or has to be paid subsequently
 the extent to which tax deducted at source can be reclaimed by the
investor
 to what extent losses or gains can be aggregated between different
investments or over different time periods for tax purposes.
In other words we need to know the effective rate of tax once we have allowed for the
time at which tax becomes payable and the extent to which tax paid on an asset can be
offset against other tax liabilities.
Question 23.1
Investor A is subject to the following tax regime:

 45% tax on investment income from asset type X, deducted at source
 20% tax on realised capital gains from asset type X, paid one year after the gain
is realised.
Calculate the net expected return to the investor from an investment in an asset of type
X purchased for 100 that will give:
 one income payment of 5 after one year
 an expected capital value of 110 after two years, at which point it will be sold.
State any assumptions that you make.

All else being equal, the aim of the investor is to maximise the net rate of return
obtained from their investment after allowing for any tax due. The impact of taxation
upon the return obtained is greater the higher the amount of tax paid and the earlier the
actual payment of tax falls due. Investors therefore prefer to pay as little tax as
possible, as late as possible, so as to reduce the present value of tax payments and so
they will often seek ways to minimise their tax liability and/or to defer it.
The impact of the above factors will in practice depend upon a number of things.
These factors will be affected by:

 the overall tax system, eg tax rates and exemptions
 particular rules for individual types of asset
 the investor’s own status (individual or particular type of institution)
 the investor’s financial position
 the tax-efficiency of the vehicle used to hold the assets.
“The investor’s own financial position” may affect both the tax rates and the basis for
taxation. Many tax systems are progressive, ie marginal tax rates increase as the
investor’s income increases. Conversely, a regressive tax system is one in which
marginal tax rates decline with income.
Where an investment vehicle (eg a collective investment vehicle) is used to hold an

asset the investor may need to consider both the tax paid by the investment vehicle on
the underlying assets and also any further tax due on the investor’s ownership of the
units in the investment vehicle.
The possible permutations of the above factors can make tax planning extremely
complicated. Even the tax authorities find it hard to predict accurately the
effects of changes to the rules because the market may adapt to new regulations
in unpredicted ways.

Example
One example of how investment markets react to the tax environment in which they
operate is provided by the existence of split-capital collective investment vehicles.
These are investment funds that offer investors a choice of two types of share capital –
one providing an entitlement to the income earned by the fund and one providing an
entitlement to the capital gains.
All else being equal, investors wish to avoid paying tax, as it ultimately reduces the
amount of money they have available in their hand to meet investment objectives.
Consequently, investors who are taxed more heavily on income than on capital gains
will tend to prefer investments that provide most of the investment return via capital
gain as opposed to income (and vice versa). Thus, the share capital that provides an
entitlement to income will tend to appeal to investors facing low or zero tax rates on
income – though there are also likely to be other factors affecting the investment choice.
Conversely, the share capital that provides an entitlement to capital gains will tend to
appeal more to investors who are taxed less heavily on capital gains (or have less need
for income).
1.2 Taxes on income and capital gains
Rates and allowances
Many tax systems distinguish between income and the increase in value of a
capital asset. It is possible for the rates of tax to be different for income and
capital gains and each may be subject to a separate annual tax-free allowance.
Furthermore, investment income may be subject to a different rate of tax than
“earned” income, ie wages and salaries earned by working.
For example, in the UK the annual capital gains tax allowance is about 50% higher than
the annual income tax allowance applicable to the total of earned income and
investment income.
Taxes on capital gains
In some tax systems, tax on capital gains is only charged on the increase in the
real value of an asset, that is, after allowing for the effects of inflation. This is
usually achieved in practice by increasing or indexing the purchase price originally paid
in line with a price index, tax then being payable only on any excess of the sale price
over the indexed purchase price. However, the computations involved with this can
quickly become complicated.

Capital gains tax is usually payable on disposal of an asset, in contrast to income

tax, which is usually payable very soon after the income is received.
This can lead to investors attempting to defer tax liabilities by avoiding the
crystallisation of a capital gain. Derivatives can be used to reduce exposure to
an asset rather than selling the asset itself.
By using derivatives the investor’s effective exposure to the underlying assets can be
changed in almost exactly the same way as if the underlying assets themselves were
changed. However, because the underlying asset is not actually sold, past capital gains
are not crystallised and a tax liability is avoided (or at least deferred until the asset is
ultimately sold). Instead tax is paid only on any capital gains during the lifetime of the
derivative trade.
The existence of an annual tax-free allowance can also lead to investors selling
and repurchasing assets to crystallise a gain in order to take advantage of their
annual allowance.
This process is sometimes known as “bed and breakfasting”. If the gain from selling
and repurchasing is less than the annual exemption then no tax liability will be incurred.
If subsequent capital gains are taxed on the basis of the repurchase price, rather than the
original purchase price, the eventual tax liability will be reduced. Any tax saving
should be compared against the extra transaction costs involved. Also, tax authorities
may insist on a minimum period between selling and repurchasing for the crystallisation
of the gain to be effective. In this case the investor will be taking a risk that the asset
increases in price between the time of sale and the time of repurchase.
Question 23.2
Suppose the annual capital gains tax allowance is $10k and the rate of tax is 30%. An
investor buys some shares in Company X for $60k and sells them two years later for
$80k.
(i) How much capital gains tax will she pay on the sale?
(ii) Suppose instead that she sold the shares for $68k after one year, bought them
back immediately and then sold them again after two years for $80k. How much
tax would she save by doing this?
A further variation on the treatment of capital gains is to make the rate of tax depend
upon the length of time for which the asset has been held. If tax rates decrease over
time, long-term investment might be encouraged. If rates increase over time, more
frequent turnover of portfolios might be encouraged.

The different ways in which income and capital gains are taxed can distort the
market, even within a particular asset class. For example, if income is taxed but
capital gains are not, taxable investors will prefer assets which produce a lower
level of income over high income investments. Tax-exempt investors, who are
indifferent between income and capital gains, will then find high coupon bonds
more attractive because taxpayers have bid up the price of low coupons. This is
just one example of the effect of tax on investment markets.
The actual price of an asset at any time will reflect the impact of taxation on the net
return that it provides to the marginal investor, who is just willing to pay that price in
order to purchase it. The impact of taxation upon the return to the investor is therefore
one of several reasons why the actual value that an investor places upon a particular
asset may differ from the market value and, consequently, why assets may be valued
using bases other than market value.
The distinction between income and capital gains can cause problems because it
can be difficult to classify investment return as income or capital gain for some
instruments. An example of this occurs when bonds are stripped to provide a
series of instruments, each providing a single payment.
Stripping a bond means that each coupon payment and the redemption proceeds can be
traded independently. Each individual coupon payment is then an investment that
provides a certain single payment at a known point in time. Consequently, there is little
distinction between the stripped coupon payable at time t and a zero-coupon bond
providing a return of capital at time t.
Taxing total return
An alternative to taxing income and capital gains separately is to tax the total
return on an investment. This avoids some of the problems of separate taxation
but, unless tax is only due when an asset is sold, valuations will be needed in
order to calculate the total return. The problem then arises as to who performs the
valuations, when and on what basis.
Also, investors can face the problem of having a tax bill but no income with
which to pay it. Thus, taxation of total return is only likely to be feasible for
marketable assets, which could then be sold to pay the tax liability.

Other forms of taxation
Other forms of taxation that may be incurred by the investor include:

 a tax on the purchase of assets, this is known as stamp duty in many countries.
For example, in the UK, it is paid on the purchase of shares and property. In
some countries, the rate of stamp duty on property can be of the order of several
percent.
 withholding taxes payable on investments held overseas, which will generally be
at different rates to those applying to domestic investments. The overseas
investment income of domestic residents (private or corporate) is typically
subject to tax both in the country of origin and in the investor’s own country.
However, the existence of double taxation agreements between countries means
that tax paid in overseas countries can be often be offset against domestic tax.
Normally, however, gross investors, who are not subject to tax on domestic
returns, are unable to reclaim taxes on investments paid overseas.
Question 23.3
In a particular market there are two investors. Investor A is subject to tax at 50% on
income and 20% on capital gains. Investor B is subject to tax at 40% on income and
30% on capital gains.
There are also two types of investment available, each offering a similar total pre-tax
return and similar features, except that:
 Investment X provides a low level of income
 Investment Y provides a high level of income.
Assuming that Investors A and B have similar levels of wealth and that the quantity of
Investment X available is similar to the quantity of Investment Y, which type of
investment is Investor B likely to choose?

2 Corporate taxation
2.1 Dividend policy
Company profits can be distributed to shareholders or retained within the

company. The way in which retained profits and distributions are taxed will
influence investors’ preferences for dividends or the increase in share values
which should follow from retained profits or the company buying back its own
shares.
In other words, different tax rates on retained profits and distributed profits may
influence the level of equity dividends paid by companies. As before, investors will
tend to prefer whichever minimises their liability to tax.
For example, a system which makes dividends attractive from a tax point of view
to a significant number of investors can lead to pressure on companies to pay a
high rate of dividends.
Governments may attempt to make the system as neutral as possible or may

take a view on the desirability or otherwise of dividends and manipulate the
system accordingly.
2.2 Taxation of debt and equity
The tax treatment of interest payable on corporate loans will also affect the
relative attractiveness of debt and equity finance and hence companies’ choices as
regards capital structure.
In many countries, interest on corporate loans is payable out of pre-tax profits, whereas
equity dividends are paid out of post-tax profits. This difference in tax treatment may
induce a preference for debt finance over equity finance where the company would
otherwise be neutral between the two alternatives.

2.3 Corporation tax systems
Corporation tax systems vary from country to country. So it can be important for
the investor to be familiar with the tax system of a particular country before choosing to
invest in companies that operate in that country.
There are three main systems.
1. Classical
In the classical system of corporation tax, company profits are taxed twice: once
in the hands of the company and once in the hands of the investor. In other
words, the company pays tax on its profits, dividends are then paid out of post-tax
profits and the investor is taxed on those dividends
The investor may be subject to income tax on distributions and capital gains tax
arising from increases in the share price.
2. Split-rate
The split-rate system is similar to the classical system but different rates are
levied on distributed profits and retained profits.
This system is often used when income and capital gains are taxed at different
rates. Thus, a higher level of income tax than capital gains tax would be coupled
with a higher tax rate on retained profits than on distributed profits.
Question 23.4
Why might a government operate a split-rate system of corporate taxation?
3. Imputation
In the imputation system the company has to deduct some of the tax payable by
investors on distributions and pay it directly to the government. This amount
can then be set off against the total corporation tax bill of the company.
The tax deducted by the company is “imputed” to the shareholder who may be
able to reclaim it if they are not liable to tax. If the rate at which they are liable to
tax is greater than the rate imputed they may have to pay some more tax on their
dividend.

The exact details of the system can become quite complicated. For example,
some classes of tax-exempt investor may be able to reclaim the imputed tax
while others may not.
Example
An imputation system of the above form operated in the UK until the late 1990s. It
involved a system of tax credits, which worked broadly in the following way.
If a company paid a (net of tax) dividend of £80 out of post-tax profits, this was deemed
to be equivalent to a gross (ie pre-tax) dividend of £100. The shareholder then received
a dividend cheque for £80 from the company plus a tax credit of £20 (ie 80/0.8 – 80).
The company that paid the dividend would then pay corporation tax to the government
equal to the amount of the tax credit. At the end of the tax year, the company then
calculated its corporation tax liability based upon its gross profits for the year, which
liability it was then able to reduce by the amount of tax it had already paid.
Depending upon their own tax position, the recipients of the dividend would:
 then reclaim the tax credit – if they were gross investors, exempt from tax. So
they ended up with £100.
 be liable for no further tax in respect of that dividend – if basic-rate taxpayers,
so they ended up with £80.
 be liable for additional tax in respect of that dividend (at a rate equal to the
difference between their own marginal rates of tax on income and the 20% rate
at which corporation tax was deemed to have been deducted) – if higher-rate
taxpayers. So with a higher tax rate of 40%, higher-rate taxpayers ultimately
ended up with £60.

Chapter 23 Summary
Taxation of investments
Taxation of investment return is one of the major factors considered by investors in

selecting investments. All else being equal, both individual and institutional investors
will attempt to maximise net of tax returns. This will depend upon:
 the total rate of tax on an investment
 how the tax is split between income and capital gains
 when the tax is paid
 whether the tax is deducted at source or has to be paid subsequently
 the extent to which tax deducted at source can be reclaimed by the investor
 the extent to which losses or gains can be offset between different investments
or over different time periods for tax purposes.
These factors will be affected by:

 the overall tax system, eg tax rates and exemptions
 particular rules for individual types of asset
 the investor’s own status (individual or particular type of institution)
 investor’s financial position
 tax-efficiency of the vehicle used to hold the assets.
Income and capital gains taxes
Income and capital gains may be taxed very differently. Any difference in tax treatment
may distort the market and will influence the investor’s preference between the two
elements of investment return. Alternatively, the investor’s tax liability may be based
upon the total return obtained.

Corporate taxation
The three main systems of corporation tax are:

1. the classical system – under which company profits are taxed both in the hands
of the company and the investor
2. the split-rate system – which is similar to the classical system except that
different rates are levied on distributed profits and retained profits
3. the imputation system – under which tax paid by the company is deemed to
cover part of the investor’s tax liability.
The interaction of the taxation of investment returns and corporate profits can be very
complex.

Solution 23.1
The equation of value to solve for the net expected return i is as follows:
(1  0.45)  5 110 0.2  (110  100)

100   
1 i (1  i )2 (1  i )3
ie
2.75 110 2
100   2

1 i (1  i ) (1  i )3
Solving this by interpolation gives a net expected return of approximately 5.4% pa.
Note that an initial estimate for i can be obtained using the approximation:
(1  i )t  (1  it ) .
Assumptions might include:

 income and capital gain (including money owed to the tax authority) can be
invested at the same net rate
 expenses can be ignored
 there is no indexation of capital gains, nor any personal tax allowances
 no change in the tax basis or rates.
Solution 23.2
(i) Tax on gain without bed & breakfasting
Capital gain = 80 – 60 = $20k
Taxable gain = capital gain – annual allowance = 20 – 10 = $10k
Tax payable = taxable gain  tax rate = 10  0.30 = $3k

(ii) Tax on gain with bed & breakfasting
Capital gain in 1st year = 68 – 60 = $8k
As this is less than the annual allowance, no tax is payable.
Capital gain in 2nd year = 80 – 68 = $12k
Tax payable = (12 – 10)  0.30 = $0.6k
So her tax saving is equal to $2.4k.
Solution 23.3
Both investments give a similar gross return. However, because investors are taxed
more heavily on income than on capital gains they would prefer the return to come
mainly from capital gains, ie Investment X. Both investors will be prepared to pay
more for investment X than Investment Y.
However, the tax preference for Investment X is particularly strong for Investor A (50%
v 20%) and so Investor A will be prepared to pay even more for Investment X than
Investor B would be prepared to pay. Consequently, Investor B will tend to hold
Investment Y.
Solution 23.4
A split-rate system with a lower rate of taxation on retained profits than on those
distributed as dividends might be used by a government whose objective is to promote
investment and hence economic growth. This is achieved by using the split-rate system
– with a lower tax rate on retained profits – to encourage companies to retain a higher
proportion of their profits, as retained profits will have a higher value to investors than
dividends. The profits thereby retained can then be used to fund investment projects,
leading to an increase in output and economic activity.

ST5-24: Glossary Page 1
Chapter 24
Glossary
Syllabus objective
There are no syllabus objectives for this chapter.
0 Introduction
This chapter contains a short glossary of terms that may be relevant to Subject ST5.
Most of these are taken from the earlier subjects. The most useful definitions to learn
are probably the investment ratios, a knowledge of which has been required in the ST5
exam. Definitions of the principal terms in the Subject ST5 course can, of course, be
found using the index that appears immediately before Chapter 0.

Page 2 ST5-24: Glossary
1 Glossary of terms
This chapter contains a list of terms. Please note that it is not intended to be
exhaustive and students will need to have the detailed knowledge from earlier
subjects where appropriate.
Activism
Active engagement and intervention (by voting or otherwise) by investors with

the companies in which they have holdings, in order to monitor or influence the
management of such companies.
Actuarial risk
The risk of not being able to meet liabilities as they fall due (ie mismatching
assets and liabilities).
Alpha
A measure of a stock’s, or fund’s, outperformance, adjusted for the level of risk

taken.
So, for a comparison with the market, alpha is given by:
(r - rf ) - b (rm - rf )
Where r is the stock’s/ fund’s rate of return, rf is the risk free rate and rm is the
market rate of return. The risk adjustment is the same as in the CAPM model.
Alpha fund
A label used by fund managers to describe funds that are more aggressive in
trying to outperform the market.
American option
An option that can be exercised on any date before its expiry.
See Chapter 1 for more detail.
Amortisation
The writing-down of the value of intangible assets (such as goodwill, advertising

and R and D) over time.

Anomaly switch
A technique used in the active management of a bond portfolio. Anomaly

switching involves moving between stocks with similar volatility, thereby taking
advantage of temporary anomalies in price.
Arbitrage
The simultaneous buying and selling of two economically equivalent but

differently priced portfolios so as to make a risk-free profit.
Recall that derivative pricing is based on the assumption that markets are arbitrage-free
and so there are no arbitrage opportunities.
Arithmetic index
An index constructed as the arithmetic average of the prices of the constituent

investments. The prices are often weighted and the average is usually multiplied
by a factor chosen to give a convenient starting value for the index. The factor is
periodically altered so as to maintain a continuous index value when it is
necessary to alter the constituents or the weights.
Recall from Chapter 14 that such indices cannot be used for valid performance
measurement.
Backfill
To add an investment fund's past history into a performance database. Since

only successful funds will seek to be added to the database, this will tend to
improve the reported returns (“backfill bias”).
Beta value
A measure of a stock’s volatility relative to movements in the whole market.

Usually defined as the covariance of the return on the stock with the return on
the market, divided by the variance of the market return.
Recall that beta measures the systematic risk of a security or a portfolio.

Chain-linking
Adjusting an investment index so that it reflects the investment performance of

its constituents (and not injections or withdrawals of funds into or out of the
market itself).
Close out
The process of establishing an equal and opposite derivative or asset position in

order to neutralize or offset the risk of an existing position.
Collateral
Assets that are given as security for a loan as a fall-back measure to be used in
the event of default. By taking collateral, the creditor has an additional source of
repayment should its counterparty be unable to perform on its obligations.
Contingent liability
A liability dependent on other events.
Credit spread
A measure of the difference between the yield on a risky and a risk-free security.
It is a measure of the risk premium a credit-risky corporate or sovereign entity
must pay to attract capital. Credit spreads are used widely as references for
credit derivatives.
Cyclical company
A company whose fortunes are very closely linked to the state of the economy.
The share price, relative to the rest of the market, will therefore depend on the
current state of the economy and any (discounted) expected future changes in
the economy.
Defensive company
A company whose fortunes are reasonably immune to the state of the economy.
Any security that exhibits less volatility than the market as a whole (ie its beta is
less than 1.0), providing lower, but more stable, returns.

Deflators
Stochastic discount factors which can be applied to a series of cash flows under
a set of realistic scenarios to produce market-consistent valuations of assets
and liabilities. Sometimes referred to as “state-price deflators”.
Dividend cover
The number of times that the dividend payments are covered by earnings for the
relevant period. Defined as:
earnings per share

dividend per share
It is the inverse of the payout ratio. Care needs to be taken that the tax treatment
of the earnings and dividend figures are consistent.
Downside risk
The risk that something bad will happen and a loss will occur. The risk of
something going wrong. A risk whose outcome is adverse.
Economic good
A consumable item that is useful to people but is scarce in relation to its

demand, so that human effort is required to obtain it.
Enterprise value
The combined total market capitalisation of a firm's debt and equity. This may
also be computed as the sum of expected future net cash flows, discounted at a
firm-specific discount rate.
Equitable
Characterised by fairness. Thus an ownership interest in assets that is

conveyed via title and which is considered fair and just by the courts, but which
may not represent a strict legal right (eg the interests of a beneficiary in a trust)
are of an equitable nature.
Eurobond
An international bond issued by a company or government, often in a currency

other than the currency of the borrower. The bonds are traded internationally
through banks, and not in the traditional bond markets.

European option
An option that can only be exercised at expiry.
Event risk
The risk of loss due to single events that are unlikely but may have serious
consequences if they do occur. The events are either largely or entirely outside
the control of the organisation. Such losses do not follow traditional stochastic
processes.
Exchange traded funds
An exchange traded fund (ETF) is a collective investment vehicle that is traded

on a securities exchange at a price that is closely related to its net asset value
and is quoted in real time. It combines the valuation feature of a unit trust with
the tradability of an investment trust. ETFs are generally managed as index-
tracker funds and, not being shares, do not incur stamp duty on purchases.
Fiduciary
Proceeding from trust or confidence. Also, an individual, corporation or

association to whom certain property is given to hold in trust. The property is to
be utilised or invested for the benefit of the property owner, to the best ability of
the fiduciary.
Floating rate note (FRN)
A Eurobond with a variable rate of interest. FRNs are usually medium-term

bonds.
Forward Rate Agreement (FRA)
A forward contract where the parties agree that a certain interest rate will apply
to a certain principal amount during a specified future time period.

Futures contract
Like a forward contract, this is a contract to buy (or sell) an asset on an agreed
basis in the future. However, futures contracts are standardised contracts that
can be traded on a recognised exchange.
Geometric index
A geometric index is based on the geometric mean of the ratio of the share
prices.
Recall from Chapter 14 that such indices cannot be used for valid performance
measurement.
Interest cover
A calculation made for loans issued by companies. The interest cover is the
number of times that the profit of the company (before interest payable and tax)
covers the interest on the loan (including the interest on prior ranking loans).
In-the-money
An option with a positive intrinsic value is in-the-money.
Infrastructure
The basic facilities, services and installations needed for the functioning of a
community or society.
Intermediate goods (and services)
Goods and services used up in the course of production of 'final' goods and
services.

Intrinsic value
For a call option, the greater of zero and the amount by which the market price of
the underlying asset exceeds the exercise price.
ie max [ ST - K , 0]
For a put option, the greater of zero and the amount by which the exercise price
exceeds the market price of the underlying asset.
ie max [ K - ST , 0]
Investment grade bond
A bond rated at least Baa (by Moody’s) or BBB (by Standard and Poor’s).
Investment trust
Investment trusts are public companies whose function is to manage shares and
investments. They have a capital structure in the same way as other public
companies and can raise both loan and equity capital. Most have quoted shares
allowing small investors to gain exposure to the portfolio held by the investment
trust.
These are described more fully in Subjects CT2 and CA1.
ISDA
The International Swaps and Derivatives Association, representing the interests

of the over-the-counter derivatives marketplace, which has produced a number
of Master Agreements regarding terminology, settlement procedures,
counterparty risk management, etc.
Iterative
Characterised by repeating or being repeated.
Mandate
The terms of a commission or order.

Marking to market
The practice of revaluing an instrument to reflect the current values of the

relevant market variables.
Net asset value per share
The book value of the shareholders’ interests in a company, usually excluding

intangibles such as goodwill divided by the number of shares in issue.
Non-recourse
A loan, the servicing or repayment of which is dependent solely on the

profitability of the underlying project and not on any other funds potentially in
the possession of the borrower.
Notional portfolio
A portfolio which is created only notionally to serve as a benchmark for

investment performance appraisal. Typically, such a portfolio will have weights
set to closely mirror the fund's objectives.
Notional principal
The principal used to calculate payments in an interest rate swap. The principal
is “notional” because it is neither paid nor received (although for currency
swaps the full notional is typically exchanged on trade date and at final maturity).
Open ended investment company (OEIC)
An investment vehicle very similar to an investment trust but with the open
ended characteristics of a unit trust.
These are described more fully in Subject CA1.
Out-of-the-money
An option with no intrinsic value is described as being out-of-the-money.

Over-the-counter (OTC) option
Privately negotiated derivative contracts offered by dealers directly to end-users.

(See Traded options.)
Par yield curve
A plot of coupon value on the y-axis against term to redemption on the x-axis.
For each term, the coupon that would be required for a fixed interest bond of that
term to be issued at par is plotted.
Recall that par yields are mentioned in Chapter 11.
Payoff
The cash realised by a holder of a derivative at the end of its life.
Payout ratio
Dividends divided by earnings per share. The inverse of dividend cover.
Price earnings ratio
The ratio of a share’s price to its net earnings.

ordinary share price
PER =
earnings per share
The earnings per share used can be historic or prospective.
Principal-agent problems
Where people (principals), as a result of lack of knowledge, cannot ensure that

their best interests are served by their agents.
Rack-rented
Rent that would be received for a property if it were subject to immediate open-
market rental review.

Redemption yield
The gross redemption yield (the word gross is often omitted), or yield to
maturity, is the rate of return at which the discounted value of all future
payments of interest and capital is equal to the “dirty” price of the bond. The net
redemption yield allows for taxation of the amounts received by the investor.
Recall that this is also referred to as the bond yield in Chapter 11.
Relationship banks
A model of banking where a financial institution attempts to provide its clients

with a full range of products and services, and to engage in a continuous and
detailed dialogue about business requirements, in order to create a long-term
business relationship.
Remuneration
Payment to a person for work done.
Return on capital employed (ROCE)
Profit before interest and tax divided by capital employed, expressed as a

percentage. An indicator of a company’s efficiency in generating profit from its
asset base.
Reverse yield gap
The long-dated gilt yield minus the equity yield.
Reversion interest
The interest of a freeholder or long term leaseholder, to whom the property will
revert on expiry of a lease.
Rights issue
A rights issue is where a company issues further shares, at a given price, to

existing shareholders in proportion to their existing shareholdings. For
example, a 1-for-5 rights issue allows each shareholder to buy one new share for
each five currently held. The purpose is for the issuing company to raise more
money.

Running yield
The annual income on an investment divided by its current market value.

Important examples are the flat yield on gilts, the gross dividend yield on
equities and the rental yield on property.
Scrip issue
A scrip issue (sometimes called a capitalisation or bonus issue) is a further

issue of new shares to existing equity shareholders. They receive free a number
of shares in proportion to their holdings.
Settlement
The payment of an account. Completing a stock transaction by delivering the

required stock certificates and/or funds. Closing out a brokerage account.
Share buy-backs
Repurchase, by a company, of its own shares in the market. Usually a tax-

efficient means of returning capital to shareholders.
Share split
In a share split existing shares are split into two shares of half the original
nominal value. No new money is raised and no reserves are capitalised.
Shareholder value
The present value of all expected current and future cashflows available to
shareholders.
Short-selling
Selling, in the market, shares that have been borrowed from another investor.
Sovereign debt
Fixed income stock issued by a national government (in order to finance

expenditure not covered by taxation). The loans outstanding of individual
countries, usually negotiated by their respective governments.

Specific risk
The risk of holding a share which is unique to the industry or company and can
be eliminated by having a suitably diversified portfolio of shares of differing
types of companies. This is sometimes also referred to as alpha, unsystematic
or residual risk.
Split-capital investment trust
An investment trust where the ordinary share capital consists of income shares
and capital shares. Holders of income shares receive all or most of the
distributed income while holders of capital shares receive little or no income but
receive the residual value of the assets after income shares have been redeemed
at a fixed value when the trust is wound up.
Spot interest rate
The n-year spot interest rate is the geometrical average of the interest rates that
are expected to apply over the next n years. It is the redemption yield on an n
year zero-coupon bond. (See zero-coupon yield curve.)
Recall from Chapter 11 that spot rates are also referred to as zero rates.
Spread
The difference between a market maker’s bid and offer prices. Often referred to
as bid-offer spread.
Strip
A bond strip is a tradable security consisting of one of the payments constituting

a coupon paying bond. In effect it is a zero-coupon bond.
Sub-sovereigns
Fixed income stock issued by government agencies, supranationals and

government guaranteed organisations.
Supersector
A sector comprising several lesser sectors.

Systematic risk
The risk of the individual share relative to the overall market which cannot be
eliminated by diversification. It is measured by the beta factor. A share with a
beta greater than 1 is said to be aggressive, ie the price of the share is expected
to do better than the market when prices rise. Conversely, a share with a beta
less than 1 is a defensive stock, ie its price will be expected to fall by less than
the market when prices fall.
Tick size
The size of the minimum movement in a quoted price (eg 0.01 for gilts).
Tick value
The change in the value of a futures contract when the price changes by one
tick.
Time deposit
A deposit that requires notice of withdrawal (or where a penalty is charged for
withdrawals on demand).
Total return index
A performance measure that allows for coupon or dividends as well as changes

in market values.
Total return indices are discussed in detail in Chapter 14.

Tracking error
The annual standardised deviation of the difference between portfolio return and
benchmark return.
Trade cycle
The periodic fluctuations of national output around its long-term trend.
Traded options
Option contracts with standardised features actively traded on organised

exchanges. (See over the counter options.)
Unit trust
An open-ended investment vehicle whereby investors can buy “units” in an

underlying pool of assets from the trust manager. If there is demand for units,
the managers can create more units for sale to investors. If there are
redemptions (sales by investors), the managers will buy in units offered to them.
Unit trusts are trusts in the legal sense.
These are described more fully in Subjects CT2 and CA1.
Warrant
An option issued by a company. The holder has the right to purchase shares at
a specified price at specified times in the future.
Working capital
Current assets minus current liabilities. A measure of a company's short-term

operating resources.
Yield curve
A plot of yield against term to redemption. Usually the yield plotted is the gross
redemption yield on coupon-paying bonds but other yields can be used. (See
par yield curve, zero-coupon yield curve.)
Zero-coupon bond
A bond where the sole return is the payment of the nominal value on maturity.

Zero-coupon yield curve
A plot of redemption yields against term to redemption for (usually hypothetical)

zero-coupon bonds.
This is discussed in more detail in Chapter 11.

2 End of Part 6
What next?
of Chapters 21 and 23.
of your revision.
Time to consider – “rehearsal” products
Mock Exam A / AMP and Marking – There are three separate mock exam papers that
you can attempt and get marked. A recent student survey found that students who do a
mock exam of some form have significantly higher pass rates. Students have said:
“Overall the marking was extremely useful and gave detailed comments on
where I was losing marks and how to improve on my answers and exam
technique. This is exactly what I was looking for – thank you!”
And finally ...
Good luck!





the course.

ST5: Q&A Bank Part 1 – Questions Page 1
Part 1 – Questions
Introduction
The Question and Answer Bank is divided into 7 parts. The first 6 parts of the Question
and Answer Bank include a range of short and long questions to test your understanding
of the corresponding part of the Course Notes, whilst the last part contains a set of
exam-style questions covering the whole course. For each part the questions may
require knowledge from earlier parts of the course.
We strongly recommend that you use these questions to practise the techniques necessary
to pass the exam. Do not use them as a set of material to learn but attempt the questions
for yourself under strict exam-style conditions, before looking at the solutions provided.
This distinction represents the difference between active studying and passive studying.
Given that the examiners will be aiming to set questions to make you think (and in doing
so they will be devising questions you have not seen before) it is much better if you
practise the skills that they will be testing.
It may also be useful to you if you group a number of the questions together to attempt
under exam time conditions. Ideally three hours would be set aside, but anything from
one hour (ie 35 marks) upwards will help your time management.
The Q&A Bank contains a mixture of shorter questions and longer exam-style questions.
You may not come across many shorter questions in the exam, but they are a good test of
understanding and will help to build your knowledge for answering the exam-style
questions.

Page 2 ST5: Q&A Bank Part 1 – Questions
Question 1.1
(i) Explain what is meant by a total return swap and describe the two main uses of
total return swaps. [3]
(ii) Explain how the credit exposure of an interest rate swap will be expected to
change over the life of the swap for the receiver of the floating rate when the
yield curve is upward-sloping. [4]
[Total 7]
Question 1.2
(i) Suggest the most suitable type of bank loan for the following companies:
 Company A is buying a major new item of equipment. It is raising the required

finance by a new corporate bond issue, but the proceeds from this issue will not
be available until some time after payment for the equipment is due.
 Company B requires a bank loan to help with its day-to-day cashflows. The
company’s business involves irregular inflows and outflows of cash.
 Company C is leading the project to construct many of the new venues and
facilities required by Tokyo to host the Olympic Games in 2020. [3]
(ii) On comparing the interest rate it would pay on a bank loan with that it would
pay if it instead issued commercial paper, Company D finds that the bank loan
interest rate is higher. However, the company treasurer of Company D decides
to take out a bank loan rather than issue commercial paper. Explain the possible
reasons for the treasurer making this decision. [4]
(iii) List the sources of short-term borrowing available to companies other than the
various types of bank loans. [1]
[Total 8]

Question 1.3
(i) Describe the following money market instruments and the similarities and
differences between them:
 Treasury bills
 repo agreements. [8]
(ii) List other types of money market investment. [2]

[Total 10]
Question 1.4
MCK shares are priced at $70. The following table shows the current market prices of
four one-year traded options available on the shares.
Strike price = $80 Strike price = $100

European call $5 $1
European put $11 $26
(i) Draw a diagram showing the overall profit or loss at expiry obtained by buying
one call with a strike price of $80 and selling one call with a strike price of $100.
Explain briefly when this strategy might make sense. [3]
(ii) Draw a diagram showing the overall profit or loss at expiry obtained by buying
one put with a strike price of $100 and selling one put with a strike price of $80.
Explain briefly when this strategy might make sense. [3]
(iii) Determine the overall profit or loss obtained by undertaking both of the above
option strategies simultaneously and comment briefly on your answer. [2]
[Total 8]
Question 1.5
(i) Describe briefly the main advantages and disadvantages of private equity as an
asset class. [6]
(ii) Describe a typical pattern of cashflows for an investor in a private equity fund.
. [4]
[Total 10]

Question 1.6
Describe the major types of hedge fund and indicate their likely relative levels of risk.
[10]
Question 1.7
(i) Explain what is meant by securitisation. Your explanation should refer to the
range of assets on which securitisations may be collateralised. [6]
(ii) Describe the role of the special purpose vehicle in the securitisation framework.
[3]
(iii) Describe what is meant by a collateralised debt obligation. [5]

[Total 14]
Question 1.8
(i) List the four main classes of investor. [2]
(ii) List the factors that will influence the investment needs of the members of these
classes. [3]
[Total 5]
Question 1.9
(i) Describe briefly the main forms of government policy that may affect the
commercial and economic environment. [10]
(ii) Describe how a cut in interest rates is likely to affect the economy. [5]
[Total 15]
Question 1.10
(i) You overhear a derivatives broker saying “An FRA is an off-balance-sheet

instrument.” Explain what this means. [4]
(ii) Describe the main differences between an interest rate swap and a swaption. [5]
[Total 9]

Question 1.11
(i) Define:
(a) a swap
(b) a forward rate agreement
(c) structured notes. [4]
(ii) Describe the relationship between FRAs and interest rate swaps. [2]
(iii) An oil company has decided to raise finance by issuing a bond whose payments
are linked to the price of North Sea oil. Explain why the company might choose
to raise finance in this way. [3]
[Total 9]
Question 1.12
(i) Explain how and why a clearinghouse operates a system of margin payments for
futures contracts. [5]
(ii) An investor takes out a long position in five equity index futures, at 12 noon on
6th January, when the futures price is 9,600. The index futures is traded on the
basis of $10 per index point and the initial margin payment is set at 10% of the
contract value of each future.
Complete the table below showing how the investor’s margin account balance
will vary subsequently.
Margin
Daily Cumulative
Date and time Futures price account
gain/loss, $ gain/loss, $
balance, $
12 noon 6th January 9,600
Close on 6th January 9,620
[3]
[Total 8]

Question 1.13
An investment analyst maintains a database of hedge funds and their past performance
which is used to produce annual hedge fund return figures.
(i) Describe three possible biases that may be present in the return figures the
analyst produces. [3]
The investment analyst has five hedge funds in the database showing the following data:
Hedge fund Value of fund at Value of fund at

1 January 2014 1 January 2015
(£m) (£m)
A 1.00 0.95
B 1.00 1.90
C 1.00 0.00
D 1.00 0.95
E 1.00 0.40
(ii) Calculate the return achieved over 2014 by an investor splitting its money
equally between the five funds at the start of the year. [1]
(iii) In using the database to produce past performance figures for the year, the
analyst excludes any funds that have “failed” (ie that have no value at the end of
the year). Calculate the annual return for 2014 that the analyst will quote on this
basis. [1]
In the period between 1 January 2015 and the date of publication of the results of the
analysis, the investment analysis receives data in respect of two hedge funds that are not
currently included in the database. The relevant details are:
Hedge fund Value of fund at Value of fund at

1 January 2014 1 January 2015
(£m) (£m)
F 1.00 0.50
G 1.00 1.50
(iv) Calculate the annual return for 2014 that the analyst would quote if both of these
funds were to be added to the database. [1]

In actual fact, only Hedge Fund G applies to be added to the analyst’s database.
(v) Calculate the annual return for 2014 that the analyst will now quote. [1]
Hedge Fund A is an event-driven fund investing exclusively in small infrequently-

traded companies. The hedge fund has realised that the price it has obtained on selling
some of its shares recently has been considerably lower than the valuation it had placed
on them. It therefore decides on a unilateral 20% decrease in its valuation at the year-
end, giving a new value of £0.76m.
(vi) Calculate the annual return for 2014 that the analyst will now quote. [1]
[Total 8]
Question 1.14
An investment bank is considering whether to design and offer a “junk bond” swap
contract to its clients. The swap would make payments based on the total return
provided by a sub-investment grade corporate bond index, which the bank would
construct and calculate itself, in return for floating interest rate payments.
(i) Outline the main features of the swap that the bank would need to consider when
designing it. [4]
(ii) Discuss the types of investors that might wish to enter into this swap contract. [3]
(iii) What other factors would the bank need to consider in deciding whether to offer
the swap? [6]
[Total 13]
Question 1.15
(i) Distinguish between direct and reciprocal currency exchange rates. [1]
(ii) The current direct spot exchange rate for US Dollars in London is £0.625.
Given that 3-month (convertible quarterly) interest rates in the US and the UK
are currently 2% and 1% pa respectively, calculate both the spot rate and the
implied 3-month forward exchange rate for US Dollars on a reciprocal basis. [2]
(ii) An investor thinks that UK inflation is likely to jump up higher than the market
currently expects in the short term. Explain how she could use a currency
forward to exploit this view. [2]
[Total 5]

Question 1.16
(i) Explain why it sometimes suggested that oil and gold both offer a
“counter-cyclical” investment. [3]
(ii) Outline the main argument for a long-term investment in oil. [3]
[Total 6]
Question 1.17
Infrabuild plc, a multinational construction firm, has agreed to undertake the

construction of a tram network in a large capital city with a substantial financial sector.
It will be fully responsible for the construction of the tram network and subsequently
will supply and operate the trams that run on the network. The construction phase is
expected to last for five years and cost in the region of $1 billion. After this, the firm
will receive 90% of the revenues from the continuing operation of the tram network, the
other 10% going to the local city government. The firm will be responsible for 100% of
the operating and maintenance costs.
(i) Outline the main investment characteristics of this investment from Infrabuild’s
point of view. [4]
(ii) Describe the main risks that Infrabuild faces in undertaking this investment. [7]
[Total 11]

ST5: Q&A Bank Part 1 – Solutions Page 1
Part 1 – Solutions
Solution 1.1
(i) Total return swap
A total return swap is an agreement between two parties to exchange the total return
from one asset (or group of assets) for the total return on another. In particular, the
underlying assets are often bond or equity indices. [1]
To enable a financial institution to achieve diversification by swapping exposure to one

type of asset for exposure to another type of asset, eg from equities to bonds, without
trading the underlying assets. [1]
To enable a financial institution to avoid breaches of internal credit limits relating to

exposure to a particular type of asset by swapping exposure to that type of asset for
exposure to a different type of asset, eg if the underlying assets are corporate bonds. [1]
[Total 3]
(ii) Swap credit exposure (upward-sloping yield curve)
With an upward-sloping yield curve, the floating rate receiver will:

 have a net outflow in the early years [½]
 expect a net inflow in later years [½]
The net present value of the expected cash flows should be (approximately) zero at
outset. Therefore the credit exposure is zero at outset. [½]
Immediately after the first payment (a net outflow) the remaining payments will have a
positive value to the floating rate receiver. Consequently there will be a small credit
exposure. [½]
As the second, third, fourth... net outflows occur, the value of the remaining payments
will increase. Consequently the credit exposure gradually builds up. [½]
In the middle of the life of the swap the outstanding payments should have a large
positive net present value to the floating rate receiver. Therefore the credit risk is large.
[½]
As the number of outstanding payments reduces their present value will fall and hence
the credit exposure falls. [½]

Page 2 ST5: Q&A Bank Part 1 – Solutions
The credit risk reduces back to zero immediately after settlement of the final payment.
[½]
[Total 4]
Note that this assumes that interest rates change in the way that was expected at outset.
Solution 1.2
(i) Bank loans
Company A: bridging loan, ie will be repaid from the proceeds of the bond issue [1]
Company B: a line of credit, either evergreen or revolving [1]
Company C: international bank loan, ie from a bank or syndicate of banks overseas [1]
[Total 3]
(ii) Reasons for choosing a bank loan over the issue of commercial paper
Possible reasons for the treasurer choosing a bank loan over the issue of commercial
paper include:
 Company D may not meet the minimum standards required of companies issuing
commercial paper. [1]
 The minimum issue size for commercial paper may be much more than the
amount Company D wishes to borrow. [1]
Company D may be concerned to maintain a good working relationship with its bank. It
may be reliant on the bank in the future when circumstances are less favourable.
Therefore, the company may choose to always have some proportion of its finance from
the bank in the hope of being treated more favourably by the bank in the future as a
regular customer. [2]
[Total 4]
(iii) Other sources of short-term borrowing
 Commercial paper
 Factoring – recourse and non-recourse
 Bills of exchange [½ for any two, 1 for all three]

Solution 1.3
(i) Money market instruments and their similarities and differences
Treasury bills are securities issued by the national government when it wants to borrow
over a short term. [½]
Commercial paper refers to short-term unsecured securities issued directly by

companies, ie without financial intermediation. [½]
Repo agreements are a form of secured lending. The investor buys Treasury bills and at
the same time enters into an agreement to sell them back again at an agreed later date at
an agreed (higher) price. [1]
All three are forms of short-term lending but typical terms differ slightly:
 Treasury bills – typically 3-month (91-day), 6-month (182 day) and one-year
forms [½]
 commercial papers – typically for a few (eg 3 to 6) months [½]
 repo agreements – very common for these to be overnight agreements, but can
be up to 3 months. [½]
All are liquid investments:

 Treasury bills – are extremely liquid as there is an active secondary market [½]
 commercial paper – fairly liquid (though much less so than Treasury bills) as
dealers (or the issuer) will repurchase [½]
 repo arrangements – there is no secondary market, so liquidity depends on the
original term. As many arrangements are on an overnight basis, these are
extremely liquid. [½]
They differ in the way the return is expressed:

 Treasury bills and commercial paper are issued at a discount and redeemed at
par. The return is quoted as a discount rate. [½]
 Under a repo arrangement, the repurchase price is set higher than the selling
price and the difference quoted as the repo interest rate, ie an effective interest
rate rather than a discount rate. [1]

The borrower (and hence the security of the investment) varies:

 Treasury bills are the most secure, being issued by the national government. [½]
 The security of commercial paper depends on the creditworthiness of the issuing
company. Ratings agencies publish ratings for commercial paper. [½]
 Repos are very secure because of the double protection of the creditworthiness
of the other party, typically a money market dealer, and the collateral. [½]
[Total 8]
(ii) Other types of money market investment
 Government agency securities

 Local authority securities
 Bank time deposits and call deposits
 Certificates of deposit
 Bills of exchange
[½ for any two, then ½ for each subsequent point]
Solution 1.4
(i) Overall profit or loss from one call at $80 and minus one call at $100
Allowing for the premium of $5 paid at outset, the payoff function from buying one call
with a strike price of $80 is:
+ c80 = + max [ S - 80, 0] - 5
where S is the share price at the strike date.
Similarly, the payoff function from selling one call with a strike price of $100 is:
-c100 = - max [ S - 100, 0] + 1

So, the overall profit at expiry is given by:

 if S > 100 , profit = + ( S - 80) - 5 - ( S - 100) + 1 = + 16
 if 100 > S > 80 , profit = + ( S - 80) - 5 - 0 + 1 = + S - 84
 if S < 80 , profit = + 0 - 5 - 0 + 1 = - 4
Profit, $
+16
80
0
84 100 Share price
-4 at expiry
[2 for correct diagram]
This strategy will generate a profit provided that the share price at expiry is $84 or
more. It therefore makes sense if the investor thinks that the share price is going to rise
significantly (by more than 20%) from its current level of $70. However, the potential
loss should this not the case is limited to a maximum of just $4. [1]
[Total 3]
(ii) Overall profit or loss from one put at $100 and minus one put at $80
The payoff function from buying one put with a strike price of $100 is:
+ p100 = + max [100 - S , 0] - 26
and the payoff function from selling one put with a strike price of $80 is:
- p80 = - max [80 - S , 0] + 11

So, the overall profit at expiry is given by:

 if S > 100 , profit = + 0 - 26 - 0 + 11 = - 15
 if 100 > S > 80 , profit = + (100 - S ) - 26 - 0 + 5 = + 85 - S
 if S < 80 , profit = + (100 - S ) - 26 - (80 - S ) + 11 = + 5
Profit, $
+5
85
0
80 100 Share price
at expiry
-15
This strategy makes sense if the investor thinks that the share price is likely to remain
below $80. The investor needs to be fairly confident that this will be the case, as the
potential loss of $15 should they be proved wrong greatly exceeds the maximum
potential profit of only $5. [1]
[Total 3]

(iii) Overall profit or loss from both strategies
The overall profit at expiry from undertaking both option strategies simultaneously is
given by:
 if S > 100 , profit = + 16 - 15 = + 1
 if 100 > S > 80 , profit = + ( S - 84) + (85 - S ) = + 1
 if S < 80 , profit = - 4 + 5 = + 1
ie it is always +$1 regardless of the share price at expiry. [1]
This possibility of risk-free profits implies that there an arbitrage opportunity exists.
This must be due to a mispricing of the options relative to each other. [1]
[Total 2]
Note that it is standard with these questions to ignore interest, taxes, expenses and other
frictional costs.
Solution 1.5
(i) Main advantages and disadvantages of private equity
Advantages
Out-performance – there is evidence to suggest that private equity funds have

outperformed over long periods, although the data supporting this is subject to
survivorship bias. [1]
Diversification – private equity returns are only loosely correlated with returns on other
assets and as such private equity may be able to improve portfolio returns without
increasing portfolio risk. [1]
Disadvantages
High risk – the risk varies according to the type of private equity being considered
(eg venture capital investment are generally more risky than investment in development
capital). [1]
Specialist expertise is required to choose the most appropriate investments, as each

private equity investment will have its own unique characteristics. [1]

Lack of liquidity – investors often have to agree to restrictions on when and to whom their
investment may be sold. Even where this is not the case, private equity is an unquoted
investment and there is no easy way to sell. (Note however that the secondary market in
the UK is growing.) [1]
Assessment of past returns – analysing historical data for private equity returns is
complicated by a number of biases, eg survivorship bias. [1]
[Total 6]
(ii) Typical pattern of investors’ cashflows in a private equity fund
Investors’ cashflows broadly follow the shape of a j-curve. [½]
The investor can first be called upon for cash from the first closing date of the fund. [½]
Investors can then be called upon for subsequent funds during the specified investment
period of the fund. This will typically be in the form of tranches in the region of 5 to 10%
of the amount the investor has said it is prepared to invest (ie the committed amount).
The investment period would typically last 3 or 4 years. [1]
As the investments made by the fund manager start to make returns, these returns are
distributed to investors, or possibly reinvested, in line with the terms of the fund. [½]
A fund may start paying distributions to investors before the full amount of their
commitment has been invested. In this case, even if there are still regular new
commitments, a fund may be generating net positive cashflows for the investor. [1]
At the agreed end of the fund’s life (if, as is commonly the case, it has been established as
a fixed-term fund) the proceeds from selling any remaining investments may be
distributed to the investors or the investments transferred to a new fund. Alternatively,
the term of the original fund may be extended. [1]
[Maximum 4]

Solution 1.6
Types of hedge fund
Global Tactical Asset Allocation funds
These concentrate on economic change around the world and sometimes make
extensive use of leverage and derivatives. [1]
These funds will take a combination of long and short positions that reflect the hedge
fund manager’s views on how macroeconomic factors such as the levels of international
asset markets, interest rates and currencies will move. [1]
The funds may also borrow (ie gear up) or use derivatives to speculate on the fund
manager’s views. [½]
These views will depend on economic trends globally and major international events.[½]
Event-driven funds
These trade securities of companies in reorganisation and / or bankruptcy (“distressed”

securities) or companies involved in a merger or acquisition (“risk arbitrage”). [1]
The aim is to profit from share price movements resulting from anticipated corporate
events, eg mergers and acquisitions. [½]
The risk that the merger or acquisition does not go ahead is referred to as deal risk and
is generally uncorrelated to overall market movements. [½]
Market-neutral funds
These simultaneously enter into long as well as short positions at a market or sector
level , while trying to exploit individual security price movements. [½]
These funds invest to exploit pricing inefficiencies in the markets to make stock
selection profits. [½]
The extent of market-neutrality varies between funds. Funds may be beta neutral and/or
currency neutral. They may also be neutral in some more stringent ways – eg by equity
sector, size of company. [½]
Multi-strategy funds
These invest in a range of investment strategies to provide a level of diversification. [1]

Multi strategy hedge funds will use a combination of the above on the same set of
assets. [½]
So, for example, a multi-strategy fund might short-sell equities, investing in more
property, whilst simultaneously focusing on event driven strategies for its property
portfolio. The idea is that this increases diversification, which can help to smooth
returns. [½]
Relative levels of risk
Although an exact ranking would depend on the precise strategy a particular fund was
executing, a typical order, from most risky to least risky would be:
 global tactical asset allocation funds
 event-driven
 market-neutral.
Multi-strategy funds can have any level of risk depending on which strategy they adopt
at any particular time. [1]
Global funds tend to be most risky as there is generally greater scope for profits (or
losses) by taking positions on whole sectors of the markets rather than on individual
stocks. [1]
Both event-driven and market-neutral funds attempt to profit from anomalously priced
stocks. Market-neutral funds will tend to be the less risky as (by definition) they are
structured to be insensitive to movements in the overall level of the market. [1]
[Maximum 10]

Solution 1.7
(i) Securitisation
Securitisation is the issue of securities, usually bonds, which are serviced and repaid
exclusively out of a defined element of future cashflow owned by the issuer. [½]
Securitisation therefore converts a portfolio of often unmarketable assets into a

structured financial instrument which is then negotiable. [½]
The bondholders have no claim on any other cashflow or assets of the issuer. [½]
The scope of securitisation has grown rapidly and now includes classes such as:
 residential and commercial mortgage-backed securities (MBS) – where the
payments are collateralised on the interest and capital payments made under
mortgages used to buy property [1]
 credit card receivables (CCABS) – collateralised on the payments made by
credit card holders [½]
 collateralised loan, bond and debt obligations (CLO, CBO and CDOs) –
collateralised on existing bank loans and bonds. [1]
Other classes of assets have also been used to create asset-backed securities, eg student
loans. [½]
A UK life insurance company has based a securitisation on the expected future profits
from its in-force business. [½]
The key requirement for an asset to be used as the basis of a securitisation is that it
generates a reasonably predictable income stream. [½]
Securitisations are set up in such a way that the underlying assets and their associated
future cashflows are expected to comfortably cover the interest and capital payments of
the asset-backed security with ample margin to spare. [1]
[Maximum 6]
(ii) Role of the special purpose vehicle
The framework of a securitisation is that the original issuer sells the assets that are to be
the basis of the securitisation to a Special Purpose Vehicle (SPV). [½]
The SPV is a separate legal entity, usually a company in its own right. [½]

It is typically set up to be “bankruptcy remote” in the event of the failure of the

borrower (which provides reassurance for investors). Likewise the SPV investors have
no recourse to the original company should the SPV default. [½]
The SPV then raises the funds to purchase the assets by issuing debt securities, such as
bonds, to investors. [½]
The cashflows received on the secured assets (the receivables) are transferred into the
SPV and used to meet the principal and interest payments on the debt. [½]
In addition, the SPV may grant security over the receivables to investors in order to
secure its obligation to repay principal and interest. [½]
[Total 3]
(iii) Collateralised debt obligation
A collateralised debt obligation is a particular type of securitisation or asset-backed

security under which the new securities are backed by a portfolio of bonds, and the
cashflows from this portfolio are divided up into tranches and assigned to the different
new securities created. [1]
The new securities are designed to have different credit risk features and returns. [½]
For example, the cashflows from the underlying debt portfolio might be used to create:
 a bond with a fixed coupon rate whose coupons are paid first. This is termed the
senior debt. [½]
 a bond whose coupons are paid as long as there is enough left after the payments
to the senior debt is made. This bond would carry a lower credit rating, and is
often known as the mezzanine piece or tranche. [1]
 a claim on the residual cashflows from the original portfolio after the two classes
above are paid. This third tranche might be a high-yield speculative bond, or it
might be considered as an equity claim. [1]
An advantage of such an arrangement for the issuer is that it may enable it to raise funds
more cheaply as the different tranches may be attractive to the different risk and return
preferences of different investors. [1]
[Total 5]

Solution 1.8
(i) Main investor classes
Investors may be classified as:

 households [½]
 financial intermediaries, eg insurance companies [½]
 businesses [½]
 foreign investors. [½]
[Total 2]
(ii) Factors influencing investment needs of the different investor classes
The investment needs of the different classes of investor will depend on their:
 liabilities – their nature, term, currency and certainty
 need for liquidity
 moral and ethical stance
 appetite for risk
 need for stable asset values
 tax position
 level of investment expertise. [½ each, maximum 3]

Solution 1.9
(i) Main forms of government policy
The main forms of government policy that may affect the commercial and economic
environment are:
 Monetary policy – the control of some measures of the money supply and/or the
level and structure of interest rates. [1]
 Fiscal policy – decisions on the level and structure of taxation and government
expenditure and hence the fiscal deficit. [1]
 National debt management policy – the manipulation of the outstanding stock of

government debt instruments held by the domestic private sector, in order to
influence the level and structure of interest rates or the availability of liquid
reserve assets to the banking sector. [1]
 Exchange rate policy – directed towards achieving some target for the exchange
rate of the domestic currency in terms of foreign currencies. [1]
 Prices and incomes policy – aimed at influencing the rates of wage and price
inflation. [1]
 Taxation – decisions on the overall level of taxation and its distribution between
personal direct, indirect, corporate and other (eg stamp duty). [1]
 Competition policy – aimed at maintaining an appropriate operating environment

for companies, eg by limiting monopoly powers. [1]
 Labour policy – decisions that determine the flexibility of labour and the
bargaining power of organised labour, eg minimum wage legislation. [1]
 Social policy – relating to the provision and financing of health services, welfare
benefits and state pensions. [1]
 Government incentives for investment – eg tax breaks/subsidies for research and

development. [1]
[Total 10]

(ii) Effects on the economy of an interest rate cut
The overall effect of an interest rate cut is likely to be an increase in economic activity.
[½]
The reasons for this include:

 Consumer expenditure would be expected to increase because:
– mortgage interest payments would fall resulting in more income being
available for expenditure [½]
– cheaper credit would reduce the effective cost of goods and services [½]
– low interest rates may result in lower levels of saving (and so higher
levels of spending!). [½]
 Capital project investment by businesses is likely to increase, as the resulting

lower cost of borrowing would reduce the opportunity cost of investing. [1]
 Lower levels of interest on existing corporate debt will increase profits for those
companies with (floating rate) debt finance. [1]
 Lower interest rates are likely to lead to devaluation of the domestic currency.
This will make domestically produced goods more attractive overseas, ie tend to
increase exports. Similarly, volumes of imports are likely to be reduced. [1]
[Total 5]
Solution 1.10
(i) FRA as off-balance sheet instrument
An FRA is a forward rate agreement. (Two parties agree to make payments to each
other over a future time period, based on an agreed interest rate and an agreed sum. [1]
In practice, the principal amount of the payment does not change hands. Only the net
amount due is paid. [1]
As a result, such an arrangement does not appear as either an asset or a liability in the
organisation’s balance sheet. [1]
This means that potentially there could be a large expected cashflow (either positive or
negative) that would be “invisible” to an outsider looking through the company’s
accounts. [1]
[Total 4]

(ii) Differences between a swap and a swaption
An interest rate swap is an agreement between two parties to exchange variable rate
interest payments for fixed rate interest payments on an agreed principal over an agreed
period. [1]
The same contract can be used to exchange fixed-for-floating or floating-for-fixed,

simply by interchanging the roles of the two parties. [½]
Once the contract has been signed, there is no choice involved. Both parties are
committed to exchanging interest payments throughout the term of the contract. [½]
The profitability (or otherwise) of a swap is determined by the movements in the

underlying interest rate over the lifetime of the swap. [½]
Payments under an interest rate swap will continue until the end of the term. [½]
A swaption is an option on an interest rate swap. It gives the purchaser a choice

whether to exercise the option to enter into a swap on a specified future date on
specified terms. [1]
The profitability (or otherwise) of a swaption is determined by the movements in the

price of the corresponding interest rate swap. [½]
Swaptions can be settled “in cash” on the exercise date (by the holder paying the market
price of the corresponding underlying swap), with no further commitment. [½]
[Total 5]
Solution 1.11
(i)(a) Definition of a swap
A swap is an agreement between two parties to exchange a specified series of cashflows

over a specified period in the future, based on an agreed principal amount. [1]
The swap agreement defines the dates when the cashflows are to be paid and the way
that they are to be calculated. [½]
Although a wide range of different types of swap is available, the most common are
interest rate and currency swaps. [½]

(i)(b) Definition of a forward rate agreement (FRA)
A forward rate agreement (FRA) is a forward contract where the parties agree that a
specified interest rate will apply to a specified principal amount during a specified
future time period. [1]
(i)(c) Structured notes
Structured notes are non-standard securities that are structured so as to meet the
particular risk and return requirements of investors – ie the interest payments are not
fixed but vary in some pre-specified way. Structured notes often contain embedded
options and/or provide payments that vary in some pre-specified way. [1]
(ii) Relationship between FRAs and interest rate swaps
An interest rate swap is equivalent to a collection of FRAs. [½]
The first exchange of payments is known at the time a swap is negotiated. The future
exchanges of payments are a series of FRAs. [½]
Although a swap is generally constructed to have zero initial value, this does not mean
that each individual FRA will have zero value. The individual FRAs will have positive
or negative value depending on the level of the fixed interest rate in the swap agreement
and the forward rate of interest. [1]
[Total 2]
(iii) Why oil company might issue structured note
The revenues of the oil company will be linked directly to the price of North Sea oil. [½]
By issuing a bond whose payments are linked to the price of North Sea oil, the oil
company is in effect matching its income and outgoings. [½]
It is therefore reducing its own exposure to fluctuations in oil prices and thereby
reducing the likelihood that it will default on its borrowing. [½]
In addition, it may be that there are investors who require an investment whose returns
are linked to the value of North Sea oil, eg a user of oil whose costs increase when oil
prices rise. This bond issue may therefore appeal to them as a convenient way of
indirectly gaining exposure to the returns from North Sea oil. [1]

If either of the above are the case, then the company may as a consequence be able to
borrow more cheaply by offering a bond structured in this way than by issuing a
straightforward fixed interest bond. [½]
[Total 3]
Solution 1.12
(i) How and why clearing house operates system of margin payments
Margin is the collateral that each party to a futures contract must deposit with the
clearinghouse. It acts as a cushion against potential losses, which the parties may suffer
from future adverse price movements. [1]
When the contract is first struck, initial margin is deposited with the clearinghouse. [½]
Margin may be in the form of cash (on which the clearinghouse will pay interest) or in
the form of acceptable securities (eg the underlying asset or Treasury bills). [½]
Minimum initial margin is generally set by the clearinghouse to be between 5% and

20% of the contract’s value. [½]
The amount of margin is subsequently changed on a daily basis through additional

payments of variation margin to reflect changes in the value of the futures contracts. [½]
This variation margin ensures that the clearinghouse’s exposure to credit risk is
controlled. This exposure can increase after the contract is struck through subsequent
adverse price movements. [1]
For example, the holder of a long futures position will be required to deposit additional
variation margin, equal to the fall in the value of the contracts held, following a fall in
the price of the futures. [½]
This is because the (unrealised) loss of the long futures holder represents a gain to the
clearing house, which would therefore incur a credit loss should the futures holder
default on its obligations under the contract. [½]
This process of adjusting the variation margin each day to reflect movements in the
market is known as marking to market. [½]
[Maximum 5]

(ii) Margin account balance
Date and time Futures price Daily Cumulative Margin

gain/loss, $ gain/loss, $ account
balance, $
12 noon 6th January 9,600 0 0 48,000
Close on 6th January 9,620 +1,000 +1,000 49,000
Close on 7th January 9,575 –2,250 –1,250 46,750
Close on 8th January 9,508 –3,350 –4,600 43,400
[¼ for each of the numbers in bold]

[Total 3]
In the table, the initial margin is calculated as:
5 contracts × 9,600 points per contract × $10 per point ×10% = $48,000
The daily gain over the afternoon of 6th January is calculated as:
5 contracts × 20 point gain per contract × $10 per point = $1,000
Solution 1.13
(i) Possible biases in hedge fund past performance figures
Survivorship bias
This occurs when the data does not realistically reflect survivors and failures, for
example if failed funds are retrospectively excluded then average returns will be
overestimated and volatility will be underestimated. [1]
Also, when a fund is added to a database, the analyst may “backfill” that fund’s
performance history. This will also tend to put more emphasis on survivors than
failures. [½]
Selection bias
The funds with a good past performance history are more likely to apply for inclusion in
the analyst’s database. Backfilling will then cause a significant upward bias. [1]

Marking to market bias
If the underlying securities held are relatively illiquid, funds will typically use either the
latest reported price or their own estimate of the current market price for valuation.
This can lead to underestimation of true volatilities and correlations of returns. [1]
[Maximum 3]
(ii) Return achieved by investor
4.2
- 1 = - 16% [1]
5.0
(iii) Return quoted by analyst
4.2
- 1 = 5% [1]
4.0
(iv) Adding two new hedge funds
6.2
- 1 = 3.3% [1]
6.0
(v) Adding just one new hedge fund
5.7
- 1 = 14% [1]
5.0
(vi) Revaluing a hedge fund
5.51
- 1 = 10.2% [1]
5.0

Solution 1.14
(i) Main features of the swap
The main features of the swap will include:

 the range of principal amounts that it would offer [½]
 the range of terms that it would offer, eg 3 years, 5 years [½]
 the frequency of the swap payments, eg quarterly or annually [½]
 the currency in which the payments would be made, presumably the domestic
currency [½]
 the interest rate (LIBOR?) on which the floating payments would be based [½]
 the margin over and above LIBOR, eg +¼%, required in order to generate the
bank’s required profit margin [½]
 the features of the index itself, including:
– the features of the corporate bonds included, ie their durations, average
credit ratings, coupon levels
– the method of constructing the index, eg weighted or unweighted
– how bonds that go into administration are allowed for
– the rules for changing the constituent bonds. [½ each]
[Maximum 4]
(ii) Investors that might wish to enter into this swap contract
Such a swap product might appeal to:
 investors that wish to hedge some of the market and credit risks that they face on
their existing sub-investment grade corporate bond (junk bond) portfolios. In
particular, such a swap would effectively enable them to transform all or part of
their existing junk bond exposure into cash, thereby removing the associated
market and credit risks. [1]
 investors that do not currently have any exposure to junk bonds, but would like
to do so indirectly, perhaps because:
– they lack the specialist expertise to invest directly in such bonds
– they wish to avoid the costs of direct investment in junk bonds,
particularly if they wish to obtain only a small degree of exposure to it
– regulation or the legal documentation that governs their operations
prevents them from investing directly in junk bonds. [2]
[Total 3]

(iii) Other factors the bank would need to consider
The key factor will be whether the bank anticipates that it will be able to make a profit
by designing and offering the swap. [½]
The anticipated profits will depend upon:

 the margins on the floating interest rate that it is able to charge/pay to clients –
presumably the rate charged will exceed that paid [½]
 the likely volume of sales of the swap … [½]
… which in turn will reflect:
– investors’ desire to invest in junk bonds or to hedge existing junk bond
exposures, as influenced by fashion, peer pressure and/or regulation [½]
– the level of expected returns from junk bonds [½]
– the expected rate of default on junk bonds. [½]
These will influence both the likely demand for the swap to adjust junk
bonds exposure and the net cashflows the swap is likely to produce. [½]
– the existence of similar swaps in the marketplace already [½]
 the costs of designing and marketing the swap. [½]
The bank will also need to consider the risks involved, which mean that actual the
profits could differ from those anticipated. [½]
For example:
 design and marketing costs could turn out to be greater than anticipated [½]
 there is a possibility of counterparty default and losses on those swaps actually
undertaken [½]
 sales could be much less than anticipated, meaning that initial design and
marketing costs are not recouped [½]
 sales could be much greater than anticipated, meaning that the bank faces a
much greater exposure to the market and credit risks inherent in the swap than it
anticipates
 the volatility of the profits produced by the swap would be much greater than
anticipated if market conditions (ie short interest rates and long bond yields) are
more variable than expected [½]
 there may be operational risks associated with the possible mis-design and/or
mismanagement of a new and complex product [½]
[Maximum 6]

Solution 1.15
(i) Direct and reciprocal exchange rates
A direct (or normal) exchange rate is quoted in terms of domestic currency per unit of
foreign currency, whereas a reciprocal (or indirect) exchange rate is quoted in terms of
foreign currency per unit of domestic currency. [1]
(ii) Spot rate and implied 3-month forward exchange rate on reciprocal basis
The reciprocal (or indirect) spot exchange rate is the reciprocal of the direct spot
exchange rate:
£0.625 : $1 ﬁ £1: $1.60 [1]
The (reciprocal) 3-month forward exchange rate is:
1 + i$ 1 + 0.005
F =S¥ = $1.60 ¥ = $1.60399 , ie £1: $1.604 [1]
1 + i£ 1 + 0.0025
Note that the (reciprocal) forward rate (ie in terms of dollars per pound) is more than
the spot rate to reflect the fact that the sterling interest rate is lower than the dollar
interest rate.
(iii) How she could use a currency forward to exploit her view
If UK inflation did jump up unexpectedly in the short term, then the market would
subsequently expect the Bank of England to increase the bank base rate in order to
prevent inflation rising too far above its inflation target. [½]
The Bank of England’s inflation target is currently 2%. Note that even if bank base rate
didn’t immediately rise, other short-term interest rates would be likely to rise in
anticipation of such an increase at some point in the near future.
Consequently, the higher expected returns on UK sterling deposits would lead to an

increased demand for sterling. [½]
This would in turn lead to a rise in the value of UK sterling against other currencies. [½]
The investor should therefore go long in UK sterling in order to exploit her view,
perhaps by using a currency forward. [½]
[Total 2]

Solution 1.16
(i) Oil and gold as “counter-cyclical” investments
A counter-cyclical investment is one that generally performs well when other

investments perform poorly, eg in times of economic recession or high inflation. [1]
Oil is sometimes said to be counter-cyclical because whilst a rapid rise in the oil price is
good for oil companies and investors in oil, the resulting increase in production costs
generally reduces profits for other companies and hence returns to non-oil investors. [1]
Gold is sometimes said to be counter-cyclical because historically, during times of

economic uncertainty, investors have turned to gold in the belief that it will broadly
hold its value in the long term. Gold is often termed as a “safe haven” investment. [1]
[Total 3]
(ii) Main argument for very long-term investment in oil
The main argument for very long-term investment in oil stems from straightforward
supply and demand considerations. These considerations suggest that the price of oil is
likely to escalate rapidly at some point in the future. [1]
The supply of oil is relatively limited because it is a natural resource. Some discovered
oil fields remain unexploited because the cost of extracting this oil is likely is not
commercially viable. [1]
The demand for oil seems likely to increase hugely over the coming decades, due to
both the industrialisation and the rise in consumption in India and China. These two
countries account for about 40% of the world’s population and they are both rapidly
developing. [1]
[Total 3]

Solution 1.17
(i) Main investment characteristics of the investment in the tram network
The investment is extremely large ($1 billion), though Infrabuild may be able to reduce
the size of its exposure to the investment by raising money from other investors. [1]
The investment will require a large upfront initial investment. It will probably then be
several years before a positive net cashflow is received and it may then be many years
more before the initial investment is recouped. [1]
The investment is therefore a very long-term one. [½]
The return on the investment is likely to be broadly linked to inflation. This is because
the costs involved in both construction and operation are likely to rise at least to some
extent with the general level of prices. [1]
The tram network is a “single-purpose” investment, in the sense that once it is

constructed it cannot be used for any other purpose. This lack of flexibility increases
the riskiness of the network as an investment. [1]
[Maximum 4]
(ii) Main risks that Infrabuild faces in undertaking this investment
The costs of financing the construction may be higher than anticipated due to higher
than expected interest rates during the construction period. [½]
The construction costs may well exceed the estimate of $1 billion. [½]
This may be because:

 the cost of construction materials and/or labour rise more quickly than
anticipated [½]
 additional and unforeseen construction costs arise, eg due to a failure of
construction materials and / or processes, or the need to undertake additional
work (eg to relocate under-street utilities) [½]
 of delays in constructions (for the reasons noted below). [½]
Construction may take longer than five years, thus increasing the time until positive net
cashflows are received and payback is achieved. [½]

This could be due to:

 bad weather, eg snow or extreme heat [½]
 disputes with labourers and sub-contractors [½]
 legal disputes with the city council over design etc [½]
 unexpected construction difficulties or additional construction work required. [½]
Once the trams are in operation, running costs could be higher than forecast … [½]
… perhaps because of:

 higher than expected costs and prices in general [½]
 unforeseen maintenance problems with either the network or the trams. [½]
Tram usage and hence operating revenues could be lower than anticipated … [½]
… due to:
 poor economic conditions generally, eg a recession [½]
 particularly poor economic conditions in the capital city, eg due to a slump in the
financial sector on which the local economy is heavily dependent [½]
 the public choosing to continue to use the existing public transport network,
coupled with a move to more working at home [½]
[Maximum 7]

Question 2.1
(i) Explain what is meant by the separation of the ownership and management of a
company and outline the main advantages and disadvantages of this
arrangement. [6]
(ii) List four key factors that will influence the investment needs and objectives of
shareholders. [4]
[Total 10]
Question 2.2
(i) Explain what is meant by the term horizontal merger. [1]
(ii) Explain, with the aid of an example, why two firms might undertake a horizontal
merger. [5]
[Total 6]
Question 2.3
(i) Explain fully what is meant by the term long-term financial planning. [8]
(ii) Distinguish between fixed capital and working capital and discuss the
complexity of the investment decision faced by a company investing in fixed
capital or working capital. [6]
[Total 14]
Question 2.4
(i) Define anchoring and explain how it is related to the notion of market efficiency.
[3]
(ii) Explain how myopic loss aversion might reduce the likelihood of a young
individual investor achieving her long-term investment objective. [4]
(iii) Explain why investors’ estimates of the probabilities of future events may be
subject to a number of biases. [4]
[Total 11]

Question 2.5
(i) Discuss the issue of overconfidence within the context of behavioural finance.[4]
(ii) List the different ways in which the range of options presented to investors may
influence their choices. [5]
(iii) In the 1970s inflation and interest rates were a lot higher than they are currently
are in the UK. At that time, many life insurance companies issued pension
contracts which included guarantees that annuity rates would not fall below a
guaranteed minimum level whatever happened to interest rates subsequently. In
the 1990s, however, interest rates fell to much lower levels, so that many of
these guarantees began to bite causing financial difficulties for some companies.
Explain how this situation can be explained with reference to the ideas of
behavioural finance. [5]
[Total 14]
Question 2.6
(i) Describe the issues trustees should consider when reviewing an investment
manager’s performance relative to a stipulated benchmark. [5]
(ii) Outline the areas covered in a Statement of Investment Principles. [4]
(iii) Explain why the investment decisions of a pension scheme might be delegated to
an investment sub-committee and set out the main responsibilities of such a sub-
committee. [6]
(iv) Regulation is being introduced to govern the appointment of new trustee

members to the investment sub-committees of pension schemes. What areas
ought such regulations to cover? [5]
[Total 20]
Question 2.7
(i) Discuss the merits of incentivising managers through share option packages. [3]
(ii) Outline the primary responsibilities of company directors. [6]

[Total 9]

Question 2.8
(i) Explain (giving examples where necessary) the impact of environmental and
ethical considerations on the actions of:
(a) companies
(b) providers of investment products and services
(c) investors and trustees. [8]
(ii) Define financial intermediation and disintermediation and outline the advantages
of each. [4]
(iii) List the principles that are likely to underlie the regulation of the relationship
between financial service providers and their clients. [5]
[Total 17]
Question 2.9
A developing country wishes to introduce a department to regulate competition and

monopolies. Outline the points you would make in a report covering the following
areas:
(i) the reasons why companies merge [7]
(ii) the underlying principles and considerations to be taken into account in drafting
regulation. [5]
[Total 12]
Question 2.10
(i) Explain why the government may consider it necessary to regulate the process of
company takeovers. [3]
(ii) Discuss the merits of having a self-regulatory system for takeovers versus a
system regulated by the government. [5]
(iii) Outline the areas of the takeover process that are usually regulated. [4]
[Total 12]

Question 2.11
Explain the rationale and the merits of the government introducing the following
investment restrictions on pension funds:
(i) requiring that all funds hold a minimum of x% of government bonds [4]
(ii) requiring matching of liabilities by currency [3]
(iii) imposing ethical restrictions [3]
(iv) imposing admissibility restrictions [3]
(v) restricting the holding of derivatives [3]
(vi) restricting self-investment [2]
(vii) requiring trustees to prepare a Statement of Investment Principles. [3]

[Total 21]
Question 2.12
(i) Define the term corporate governance and explain how a company can
demonstrate good corporate governance. [7]
(ii) Outline the motives behind the development of international financial reporting
standards. [5]
[Total 12]

Question 2.13
(i) Explain why it is necessary to regulate financial services markets? Why is this
need greater than for other markets? [3]
(ii) Discuss the factors that determine the appropriate extent of regulation for a
financial services market. [6]
(iii) List the sources of information from which a personal investor might obtain
additional information to help with her investment choice. [3]
(iv) Given the existence of the sources of information that you mentioned in (iii),
explain why informational asymmetries might still present problems in financial
services markets. [3]
[Total 15]
Question 2.14
The Financial Services Action Plan (FSAP) aims to help establish both a single
wholesale market and an open and secure retail market for financial services in the
European Union.
(a) List the specific objectives of the FSAP with respect to these aims.
(b) Outline what the following directives incorporated within the FSAP aim to
achieve:
 Market Abuse Directive 2003
 Insurance Mediation Directive 2002
 Taxation of Savings Income Directive 2003.
[6]





the course.

Solution 2.1
(i) Separation of ownership and management
The separation of the ownership and management of a company occurs when the people
who own the assets of a company (typically the shareholders) are different to the people
responsible for the management and running of the company (the managers). [1]
Ownership of the company can be transferred quickly and easily without affecting the
operational activities of the company – simply by the transfer of shares. [1]
The separation gives the company the freedom to hire full-time professional and
specialist managers, who are likely to have more expertise at running the particular
company than the individual shareholders. [1]
Principal-agent problems will arise if the interests of the owners (as principals) and
managers (as agents) diverge. [1]
Principal-agent problems give rise to agency costs … [½]
… which include the costs associated with monitoring the actions of others … [½]
… and seeking to influence their actions ... [½]
… and also the lower returns to the principals than would be the case if the company
was run exactly in line with their best interests. [½]
[Total 6]

(ii) Four factors influencing the investment needs and objectives of shareholders
The investment needs and objectives of shareholders will vary according to the
following four factors:
1. their attitude towards risk, ie how risk-averse or otherwise they are [1]
2. their time preference and consumption needs, ie the extent to which they desire
wealth now as opposed to in the distant future in order to fund the purchase of
goods and services in the immediate (rather than the distant) future [1]
3. balance between the need for income – to fund ongoing commitments – and for
capital growth – to fund future commitments [1]
4. their tax position – in relation to the tax system and their personal circumstances
both now and in the future. [1]
[Total 4]
Solution 2.2
(i) Explain the term horizontal merger
A horizontal merger occurs when two firms engaged in similar activities – for example,
two training companies – join together to form a single firm. [1]
(ii) Why two firms might undertake a horizontal merger
A horizontal merger might be undertaken between two property developers, say, to:
 benefit from economies of scale, such as sharing core services common to both
organisations – eg management, marketing, research, head office space [1]
 exploit complementary resources – eg one property developer builds properties
mainly in the north, whereas another undertakes developments mainly in the
south [1]
 access opportunities only available to larger organisations – eg bidding for very
large construction projects [1]
 eliminate inefficiencies – eg inefficient management or building sub-contractors
[1]
 to reduce their total tax bill, if they face very different tax positions. [½]
 increase their size and so reduce the threat of takeover by a third developer [½]
 reduce their cost of raising new capital. [½]
[Maximum 5]

Solution 2.3
(i) Long-term financial planning
Long-term financial planning is concerned with the assessment of the company’s

requirements for capital to finance its business operations over the long term and the
raising of the company’s required long-term capital – ie long-term loans, debt and
equity. [1]
It is primarily a responsibility of the finance function within the organisation, liaising

with senior management to ensure the production of a financial plan that is consistent
with business plans. [1]
The financial plan will also have to consider non-operational issues such as the
possibility of breaching financial covenants and the impact of additional borrowing on
credit ratings. [1]
“Long-term” planning commonly looks 3 to 5 years ahead – although for capital

projects 10 or 12 years would not be unusual. [½]
The development of financial plans should begin by consideration of an organisation’s

business plans – its anticipated product development and sales objectives. [½]
These will typically need to consider the organic development of existing activities, and
also plans for new developments (whether expansion or retrenchment). [½]
Sensitivity analysis should begin at this stage, by exploring business plans under a range
of possible scenarios. [½]
Once the business plans have been developed, they can be converted into financial plans
starting with the forecast of future cashflows. [½]
Analysis of the anticipated need for working capital and growth in fixed assets, together
with considerations of tax, dividend and interest payments, will enable the financial
manager to plan for capital budgeting and structure, ie both the amount and type of
capital that must be raised. [1]
Once again, sensitivity analysis will be needed in order to allow for possible changes in
the financial environment. [½]
Financial planning therefore focuses on the sources and uses of funds as well as the
implications for borrowing and financial structure. [½]

An iterative process will be involved as the financial implications of the business plan
are explored. [½]
[Total 8]
(ii) Fixed and working capital
Working capital is the company’s short-term assets and short-term liabilities. In

practice, it is sometimes interpreted as the net difference between short-term assets and
short-term liabilities. [1]
It includes, cash, short-term securities held, trade receivables (or debtors) and
inventories (of raw materials, finished and unfinished goods) less trade payables, other
creditors and tax and dividends due. [1]
Investment in working capital is largely routine and involves few complications or risks
– because of its short-term nature. [½]
Fixed capital or capital goods are long-term assets that are used to produce goods and
services on an ongoing basis – eg machinery, plant, etc. It is not used up directly in the
production process, but is likely to depreciate over time, due to wear and tear and
obsolescence. [1]
Investment in fixed capital, however, often involves complex choices between:

 alternative capital assets [½]
 dates of commencement [½]
 methods of financing. [½]
Fixed capital is typically long-term and indivisible and so fixed capital outlays often
have a serious bearing on the direction and pace of a firm’s growth. [½]
As such, they determine the opportunities open to a firm and the directions in which it
can move. [½]
[Total 6]

Solution 2.4
(i) Anchoring and market efficiency
In the context of behavioural finance, anchoring refers to the fact that individuals will
tend to base their perceptions on past experience or “expert” opinion, which they then
amend to allow for evident differences to the current conditions. [1]
However, investors’ views are anchored by past experience or “expert” opinion and so
tend not to change to fully reflect the impact of new information as soon as it arrives. [1]
As a result, the full impact of new information will not be reflected immediately in asset
prices. [½]
The existence of pervasive anchoring may therefore lead investment markets to be

inefficient. [½]
[Total 3]
(ii) Myopic loss aversion and achievement of long-term investment objective
Myopic loss aversion suggests that investors are more risk-averse when considering
investment returns over shorter rather than longer periods of time. [½]
Consequently, the investor’s investment choice will be influenced by the time horizon
she considers when making that choice. [½]
For a young individual investor, the main investment aim might be to ensure an
adequate provision of income for retirement. [½]
She can therefore afford to take a long-term investment view and should invest largely
in assets that are expected to produce the highest long-term investment returns. These
would normally be equities. [1]
If she instead takes a view that is too short-term when making investment decisions,
then myopic loss aversion suggests she is likely to make choices that are overly
cautious. [½]
In particular, she is likely to invest less heavily in assets with volatile returns such as
equities, than is consistent with her investment aims. [½]
This may have a detrimental effect on the long-term investment returns that she actually
achieves and so reduce the likelihood of her achieving her long-term investment
objective. [½]
[Total 4]

(iii) Biases in probability estimates
Investors’ probability estimates might be affected by:
 anchoring – which suggests that investors base their perceptions on past

experience or “expert” opinion, which they amend to allow for evident
differences to the current conditions. So their estimates may not objectively
reflect all of the available information. [1]
 a 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. In particular, experiments suggest
that individuals are prone to underestimate the probability that a negative event
may occur. [1]
 representative heuristics – people find more probable that which they find easier
to imagine. As the amount of detail about an event increases, its apparent
likelihood may increase, although the true probability can only decrease steadily.
[1]
 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. [1]
[Total 4]
Solution 2.5
(i) Overconfidence
People tend to overestimate their own abilities, knowledge and skills. [½]
Moreover, studies show that the discrepancy between accuracy and overconfidence
increases (in all but the simplest tasks) as the respondent is more knowledgeable! [½]
Overconfidence could therefore be a potentially serious problem in fields such as

investment where most of the participants are likely to be highly knowledgeable. [½]
Moreover, the available evidence suggests that even when people are aware that they
are overconfident they remain so. [½]

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. [1]
 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). [1]
[Total 4]
(ii) How the range of options presented to investors may influence their choices
The framing effect refers to the fact that choices may be influenced by the way in which
the choices are presented or framed. [½]
The primary effect refers to the fact that people are more likely to choose the first option
presented. [½]
The recency effect refers to the fact that in some instances, the final option that is
discussed may be preferred! [½]
The gap in time between the presentation of the options and the decision may also
influence the choice. [½]
Other research suggests that people are more likely to choose an intermediate option than
one at either end. [½]
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. [1]
Status quo bias refers to the fact that people have a marked preference for keeping things
as they are. [½]
Regret aversion refers to the fact that by retaining the existing arrangements, people
minimise the possibility of regret – the pain associated with feeling responsible for a loss.
[½]
Ambiguity aversion refers to the fact that people are prepared to pay a premium for rules.
[½]
[Total 5]

(iii) Explain situation with reference to behavioural finance
This situation can partly be explained by reference to overconfidence. [½]
As interest rates were very high for a prolonged period in the 1970s, it was widely
assumed that interest rates would not fall to much lower levels in the future. [½]
It was therefore believed that the annuity rate guarantees were unlikely ever to be invoked
and so the future cost of offering the guarantees would be negligible, or even zero. [½]
The guarantees were therefore offered without the companies funding and reserving
sufficiently for the possible associated cost, which was thought unlikely to ever
materialise. [½]
Even when interest rates did fall, anchoring and adjustment may have lead the companies
to believe that it was only a temporary fall and that interest rates would soon rise back to
their “normal” levels. [1]
There may also be some element of confirmation bias involved too. This is because for
many years subsequently, interest rates remained at levels above those necessary to
invoke the annuity rate guarantees, reinforcing the view that the guarantees were unlikely
ever to be invoked. [1]
Looking back after the event, there may now be an element of hindsight bias coming into
play, as with hindsight, and given the great unpredictability of future economic conditions
over long time horizons, it seems a lot more obvious that interest rates would at some
point fall low enough to invoke the guarantees. [1]
[Total 5]
Solution 2.6
(i) Considerations when reviewing investment manager’s performance
The scope of the mandate will be important, in particular the restrictions in the mandate,
and the extent to which the investment manager had the scope to move away from the
benchmark strategic decision. A meaningful measure would be the “Information Ratio”
– this measures the level of out-performance relative to the benchmark per unit of active
risk taken. The higher the information ratio, the greater the skill of the investment
manager. [1½]
Care needs to be taken when comparing with other funds to ensure they have been
subject to the same constraints. [½]

The trustees need to decide on the performance criteria. These can include:
 absolute return achieved (perhaps versus expectations from running an asset
liability model) [½]
 performance versus a notional fund (eg the strategic asset benchmark) to assess
the quality of sector and stock selection [½]
 performance by asset sector versus an appropriate index to assess the quality of
stock selection [½]
 performance relative to other fund managers. [½]
The trustees should consider when and how often the performance will be measured
(too frequent can encourage the manager to take too short-term a view). [½]
Performance should also be looked at net of tax and net of expenses to assess the tax
efficiency of investment choices and the level of investment expenses. [½]
Trustees should always be aware that past performance is not necessarily a guide to the
future. [½]
[Maximum 5]
(ii) Statement of Investment Principles
Details of the mandates given to investment managers and advisors, focusing on the
scope of decision making by different parties (eg trustees for the strategic asset
allocation and investment managers for stock selection). [1]
The investment objectives of the fund. [½]
The fund’s strategic asset allocation and how it was determined. [½]
Any risk controls in place and the scope for tactical asset allocation decisions to move
away from the strategic asset allocation benchmark. [½]
The fee structure in place to remunerate investment managers and advisors, and why
this structure was selected. [½]
Any investment restrictions imposed by the trustees or regulation, for example

restrictions on self-investment. [½]
The ethical investment policy of the trustees. [½]

[Total 4]

(iii) Explain delegation of investment decisions and set out main responsibilities
The investment decisions of a pension scheme might be delegated to an investment sub-

committee to ensure that effective decisions are made by a group of trustees with the
skills, information and resources necessary to take them effectively. In practice, it is
unlikely that all of the scheme trustees will have access to such skills and information.
[1]
A main responsibility of an investment sub-committee is setting an overall investment

objective for the pension fund that reflects the sub-committee’s judgement of what is
necessary to meet the fund’s liabilities, whilst taking an appropriate degree of risk. [1]
In practice, key elements of this will be:

 the determination of appropriate strategic asset allocation to meet those
objectives [½]
 the determination of an appropriate investment management structure to help
meet those objectives [½]
 the employment of suitable investment managers to implement the strategy
decision. [½]
The sub-committee must also determine a mandate for each manager, setting out
specific objectives, benchmarks and risk parameters that are consistent with the
overall objectives. [½]
The sub-committee is also responsible for:

 employing investment consultants to help them make the above decisions and
questioning the advice given to them by the consultants [½]
 employing a suitable custodian to hold the assets and provide the required back
office functions [½]
 assessing the performance of the fund against the objectives, including both the
performance of the individual investment managers and themselves as decision
makers [½]
 producing a Statement of Investment Principles, which can be sent out to scheme
members. [½]
This should set out the aims and principles underlying the management of the
pension fund and report on the extent to which the aims have been achieved and
the principles complied with. [½]
[Maximum 6]

(iv) Regulations for an investment subcommittee
The regulations ought to cover:

 the qualifications of the individual sub-committee members, to ensure that each
trustee has relevant investment-related qualifications [½]
 the past investment experience of the individual trustees, to ensure that each
trustee has a sufficient number of years of relevant past experience and so can
contribute effectively to the investment decision making. [½]
However, trustees who fail to meet the criteria with regard to the above, might
be allowed to serve as committee members provided an approved course of
training is followed within a prescribed time period of joining. [½]
 continuing professional development whilst serving as a trustee. For example,
this might relate to the regular attendance of relevant training courses. [½]
 the independence of the committee, so as to ensure it takes an objective view of
the investment decision in the best interests of the scheme members. For
example, the management of the sponsor might be allowed only a limited
number/minority of members on the sub-committee. Equally it might be a
requirement to have a staff representative. [1]
 the number of meetings per year, so as to ensure that the strategy and other
decisions are reviewed regularly. [½]
The regulations might also include:

 a requirement to ensure that collectively the trustees have a sufficient body of
experience and knowledge to question the advice provided to them. For
example, the committee ought to include trustees with specialist knowledge of
each of the main asset classes, including specialist asset classes such as
unquoted securities. [1]
 a restriction on the length of service on the sub-committee, so as to ensure that
the committee is “refreshed” with new members from time to time and also that
its members remain sufficiently independent of the sponsoring company. [½]
[Total 5]
Award marks for other sensible and relevant points.

Solution 2.7
(i) The merits of incentivising managers through share option packages
+ An attractive share incentive scheme can help attract and retain quality
management as part of the overall remuneration package. [½]
+ Such a package encourages managers to act in shareholders interests, this is in

line with good corporate governance. [½]
+ It may be more tax-efficient to offer share options than additional salary or other
benefits. [½]
– It is difficult to devise a package with enough downside risk to the management.

[½]
– Management may focus on actions to increase short-term value, rather than on

improving the company’s long-term prospects. This can be to the detriment of
all stakeholders. (In the extreme case management may act to artificially
increase the share price.) [½]
– The option is not appropriate if the shares are tightly held by a few investors, or
not listed and restrictions need to be imposed on when management may sell
shares. [½]
[Total 3]
(ii) The primary responsibilities of company directors
The directors’ primary aim is to ensure the solvent trading and long-term future of the
company. [½]
In addition, they need to demonstrate good corporate governance by acting in the best
interests of stakeholders rather than in their own interest. Stakeholders include
shareholders, employees, customers and suppliers. [½]
Good governance will be demonstrated by:

 seeking to improve shareholder value, and acting in the best interests of
shareholders in times of takeover, merger or share issue [½]
 ensuring the solvent operation of the business to ensure the long-term financial
and career prospects of employees [½]
 not seeking to make excessive profits from customers (this is particularly a risk
in the case of monopolies). (The government may also have a role to play in
protecting customers against this risk.) [½]

 paying appropriate recompense to suppliers, this is particularly a risk where

monopolies operate. (The government may have a role to play in protecting
suppliers.) [½]
The directors need to ensure that they comply with all legislation and should be open
and honest in their dealings with all parties. [½]
The directors will be responsible for:

 ensuring timely accounts are produced in line with regulation and give a true and
fair view of the performance of the company [½]
 choosing appropriately skilled and experienced management to run the company
[½]
 setting the dividend levels, balancing the need to return money to shareholders
against the need to reinvest for the long-term interests of the business. [½]
Non-executive directors are likely to have responsibility for appointing new board
members and for setting the remuneration packages of executive directors. [½]
Non-executive directors are likely to have a key role in the audit committee checking
the operation of the company and its finances. [½]
[Maximum 6]
Solution 2.8
Impact of environmental and ethical considerations
(i)(a) Companies
Environmental and ethical considerations are increasingly important to investors.

Companies are thus encouraged to act in a socially responsible way in order to attract
investors and hence be able to raise capital at the lowest possible cost. (Although this is
offset in part against the costs of following an ethical policy.) [1]
Company management need to clearly set out their approach on environmental, ethical
and moral grounds and may come under pressure from investment managers to improve
performance where it falls short. [1]
If the company is listed it must publish information on its environmental and ethical
stance – often called Corporate Social Responsibility (CSR). [1]
[Total 3]

(i)(b) Providers of investment products and services
Clients increasingly focus on environmental and ethical concerns, hence investment

product and service providers will seek to provide socially responsible investment (SRI)
products to meet their needs. [1]
The investment products offered will have various degrees of stringency in the
definition of socially responsible; ranging from products explicitly developed with a
strongly ethical stance to informal arrangements. [1]
SRI requires investment managers to consider a company’s ethical stance, in addition to

its financial performance, before investing in its shares. [½]
Investment managers will need increased contact with companies to ensure a socially
responsible policy is encouraged and adhered to, and changes made as necessary. [½]
[Total 3]
(i)(c) Investors and trustees
Private investors are increasingly concerned that the companies they invest in take a
socially responsible stance. This extends to such issues as human rights abuses and the
impact on terrorism (following September 11). [1]
Trustees stance towards socially responsible investment will be driven by both the
views of the beneficiaries and by regulation. [½]
UK and German law requires pension scheme trustees to state their social investment
policy and similar regulation is being developed in France and Sweden. [½]
[Total 2]
(ii) Financial intermediation and disintermediation
Financial intermediation is the process of channelling funds between those who want to
lend and those who want to borrow. Financial intermediaries sell their own liabilities to
raise funds that are used to purchase the liabilities of other corporations. [1]
The advantages of bringing borrowers and lenders together through financial

intermediation include:
 the pooling of the resources of a number of lenders enables larger amounts to be
invested [½]
 intermediaries diversify risk by lending to many borrowers [½]

 the volumes of business financial intermediaries undertake results in them

building up expertise and also in economies of scale (eg lower dealing costs). [½]
Disintermediation refers to the situation where ultimate borrowers and lenders come
together directly. [½]
This will be desirable for a borrower if they are able to borrow more cheaply by
borrowing directly rather than via intermediaries. This may be the case if, for example,
a company has a good credit rating. [1]
In addition, investors may benefit from reduced costs and retain a greater degree of
control over their investments. [½]
[Maximum 4]
(iii) Principles underlying regulation of the financial service provider
The principles underlying regulation of the financial service provider in relation to its
dealings with clients are:
 integrity and fair dealing
 demonstration of skill, care and diligence in all dealings
 adherence to high standards of market conduct
 gaining sufficient information from the clients to understand the clients’
circumstances and investment requirements
 comprehensive and timely provision of appropriate information to clients to
enable them to make a balanced and informed decision
 avoidance of conflicts of interest wherever possible and dealing with them
appropriately when they do arise
 safe custody and protection of the clients’ assets
 the holding of sufficient finance to be able to meet business needs and risks
 adequate training and supervision of staff, and proper record keeping and
compliance
 adherence to regulation and requirement to deal with regulators in an open and
co-operative manner. [½ each, total 5]

Solution 2.9
(i) Reasons for company mergers
The main reason for companies merging is to benefit from economies of scale, where
they are both involved in the same line of business. This is particularly important due to
technological advances. (Often referred to as horizontal merger.) [1]
Some mergers involve combining a company with its supplier or its sales force (called
vertical integration). Such mergers aim to reduce costs, improve co-ordination of
supplies and simplify administration. [1]
A merger may be carried out to increase the operation’s market share. This may lead to
an increased influence on the industry pricing process. [½]
If a company wishes to expand into another business area then merging with another
company can prove an effective and quick way to achieve this objective. [½]
Mergers can lead to increased diversification away from the core business and hence
reduced risk. (These are referred to as conglomerate mergers.) [1]
A merger could be opportunistic, if another company is believed to be undervalued. [½]
A possible reason for a merger is to use surplus cash – however this course of action
should be taken only after considering the alternative of returning money to
shareholders. [½]
A merger could be undertaken in order to eliminate inefficient assets, such as under-

performing management or departments. [½]
The motivation for a merger could be to increase the size of each business and so reduce
the possibility that each could be taken over by a hostile third party. [½]
Alternatively, the aim could be to reduce the costs of obtaining finance, both via
economies of scale in the issue costs and also by obtaining a lower cost of capital. [½]
Occasionally the merger can enable the company to gain tax advantages. [½]
[Total 7]

(ii) Principles underlying regulation of mergers
The regulation should aim to ensure that:

 all shareholders are treated fairly (in particular minority shareholders) [½]
 the rights of employees of the two companies are protected (including pension
benefits) [½]
 customers are protected, in particular individuals who will have less bargaining
power [½]
 suppliers are treated fairly. [½]
The aim is to have regulation that is simple to understand and apply, so as to minimise
costs. The regulation should not be so onerous so as to discourage appropriate mergers.
[½]
The regulation should be generic enough to apply to as many industries as possible

without needing modification – although special regulation may be needed for certain
industries (in particular natural monopolies). [½]
The regulation must have set procedures and timescales, set so as not to hold up deals
inappropriately. [½]
The scope of the regulation needs to be considered, will it apply to all mergers or only
certain industries or large scale mergers? [½]
The regulation needs to be able to deal with cross-border mergers. Ideally the
regulation should not be too far out of line with that in other countries. In addition the
mechanism for determining whether a cross-border merger represents a monopoly needs
to be agreed. [1]
A decision needs to be made as to who will carry out the regulation. Will it be self-
regulated, regulated by the state or a combination of the two? [½]
[Maximum 5]

Solution 2.10
(i) Reasons for regulating the takeover process
Regulation can act to protect the interest of all shareholders, in particular minority
shareholders, ensuring they are treated fairly. [½]
Regulation can make the takeover process transparent to all stakeholders. [½]
This helps ensure management act in the interests of stakeholders rather than
themselves. Such transparency can also highlight issues of competition or potential
monopolies that need to be addressed. [½]
Regulations can ensure the takeover process follows a timely pattern, with adequate
time periods for relevant parties to make decisions, and for other parties to get involved
if necessary. [½]
Regulation can ensure any conditions attached to offers are reasonable. [½]
All of the above points help to encourage confidence in the stock market and hence
encourage investment. [½]
[Total 3]
(ii) Self-regulatory versus state regulated
A self-regulatory approach means the regulations are enforced by practitioners in the

field. [½]
The self-regulatory process is likely to include:

 a legislative framework [½]
 a central controlling body [½]
 self-regulatory organisations [½]
 external auditors. [½]
Self-regulation has the advantages of:

 the input of experts who are aware of the features of the particular takeover [½]
 reducing the cost to the state, or the listing authority itself [½]
 the process should be faster. [½]

Self-regulation has the disadvantages of:

 risk that it can be expensive for companies to finance [½]
 risk that the regulation is designed for the big players [½]
 risk of insufficient regulation and a lack of market and public confidence. [½]
[Maximum 5]
(iii) Areas regulated in takeover process
Notification – via a requirement that takeover bids are bought to the attention of the
company’s management or advisors. [1]
Shareholder information – via a requirement that information is circulated to all

shareholders within a prescribed timescale. [1]
Timescales
 a requirement that an offer document is produced within a prescribed timescale
[½]
 regulation of the offer period and that of subsequent offers [½]
 regulation of the time-period left for shareholders to make up their mind after the
offer becomes unconditional. [½]
Conditions – regulation of the conditions that can be attached to offers, to ensure that
they are reasonable and fair to all parties. [1]
[Maximum 4]
Solution 2.11
(i) Holding a minimum of x% in government bonds
This restriction aims to ensure funds hold sufficient low-risk investments with stable
market values hence protecting the security of members’ benefits. (It also acts as a
ready source of investors for government borrowing!) [1]
Such a restriction leads to assets being a good match for some liabilities (those of a
fixed nature), but a poor match for other liabilities (eg any salary-linked liabilities). [1]
This restriction may lead to the fund achieving a lower long-term investment return than
under some other strategies (eg equity-based strategy). [½]

The demand for (and hence the price of) bonds will increase (unless supply increases in
line). Bonds may end up expensively priced relative to the fundamentals and the
current inflation outlook. [½]
This restriction may lead to reinvestment risk for schemes that have a net positive
cashflow. [½]
Schemes with a significantly different investment strategy will incur switching costs
and large scale selling of other asset sectors may depress their market prices. [½]
[Total 4]
(ii) Matching of liabilities by currency
The rationale is to remove the risk of adverse currency movements between the
scheme’s assets and liabilities. [1]
The impact on the fund depends on the current level of overseas holding. It is likely
that the majority (often all) liabilities are denominated in the domestic currency. [½]
Schemes may need to sell overseas investments and invest in domestic assets, so
increasing the demand for domestic assets, or alternatively hedge the currency exposure.
[½]
Any reduction in overseas investment will reduce diversification and the resulting
portfolio would be expected to have higher long-term volatility in value if overseas
holdings were reduced. [1]
[Total 3]
(iii) Ethical restrictions
The rationale is to encourage socially responsible behaviour on the part of companies.

The government will feel that this meets its remit of paternalism and social
responsibility. [1]
The trustees will need to assess the current ethical stance of the companies the fund
invests in – and adjust its strategy as necessary, or put pressure upon the companies to
alter their approach. [1]
(Arguably) the return on ethical funds is lower than on standard investment funds, due
to the restriction of the range of allowable investments – hence increasing the cost of
benefit provision. [1]
[Total 3]

(iv) Admissibility restrictions
Admissibility restrictions operate by encouraging investment in certain assets without

the restriction of a more prescriptive policy. Such an approach steers the trustees
towards a certain strategy, whilst acknowledging that the strategy may not be suitable
for all schemes. [1]
Admissibility restrictions will be more acceptable to funds since they are less
prescriptive than an outright restriction on holding. [1]
The impact on a scheme depends upon the degree to which the scheme’s current
investments are admissible and the solvency position of the fund. A well-funded
scheme will be more relaxed about the admissibility restrictions, a less well-funded
scheme will want to move quickly to hold admissible assets. [1]
[Total 3]
(v) Restricting the holding of derivatives
The government may be concerned that derivatives are risky investments (in particular
when used for speculative purposes) and hence are an unsuitable investment for a
pension fund to hold. [1]
However derivatives can be used in other ways, for example to hedge risk. As an
alternative the regulation could be framed to only exclude the holding of derivatives for
speculative purposes. [1]
Also the derivatives market may be more liquid than the underlying asset class,
eg commodities. So it may be more appropriate to invest in derivatives. [1]
[Total 3]
(vi) Restricting self-investment
The rationale behind this regulation is to remove concentration of risk, ie the risk that
the company gets into difficulty and perhaps employees lose their jobs. This has the
knock-on effect of jeopardising the security of pension benefits. [1]
The impact on the fund depends upon the level of self-investment and the ease with
which it can be disposed – this can be difficult for thinly-traded companies. (Note that
self-investment extends to include loans and property that the company rents from the
scheme, as well as shares.) [1]

(vii) Statement of Investment Principles
Such regulation will encourage trustees to focus on an appropriate approach to

investment, in particular making sure it is suitable for the individual scheme. Such a
requirement also ensures the mandates between the trustees and investment managers
are clearly set out. [1]
It encourages trustees to focus on a socially responsible policy. [½]
Such a requirement improves transparency, enabling beneficiaries to understand and

question the approach taken. [½]
Such regulation may be felt to be more suitable and better tailored to individual schemes
than more prescriptive regulation. [½]
The effectiveness of this step depends in part on the actions taken against trustees if
they do not meet their responsibilities. [½]
[Total 3]
Solution 2.12
(i) Corporate governance
Corporate governance refers to the managerial decisions made in the company in

relation to its stakeholders. Stakeholders are any group that has a relationship with the
company and will be affected by its actions. [1]
Key stakeholders are the shareholders, employees (and pensioners), customers,

suppliers and even the state. [½]
In order to demonstrate good governance the company’s directors must make

decisions (and be seen to make decisions) in the interests of stakeholders rather than
management. [1]
A company can demonstrate good corporate governance through:

 management remuneration packages being structured so as to reward when
management act in the interests of stakeholders (for example, bonuses linked to
the share price) [½]
 management having the required training and expertise [½]
 management meeting all its legal obligations (for example timely and fair
accounts are produced) [½]

 management ensuring transparency in its actions, eg in relation to share issues or

takeovers [½]
 meeting regulatory requirements in relation to competition and fair trading
controls and regulation of monopolies [½]
 meeting any ethical, social or environmental responsibilities [½]
 the use of non-executive directors to:
– represent shareholder interests and give an unbiased view [½]
– be responsible for setting executive director pay awards [½]
– audit the company’s activities and financial statements. [½]
[Total 7]
(ii) Development of IFRS
The main motive behind the development of IFRS is to have one set of financial
reporting standards acceptable to all listing authorities in the major financial centres and
which all investors would use. [1]
This would:
 make it easier for companies to obtain listings on different stock exchanges as
they would not have to produce multiple sets of accounts [½]
 help investors make consistent comparisons between companies listed on
different exchanges. [½]
Such standardised information helps investors to make informed choices, and hence
reduces the risks they face. This reduction in risk should ultimately reduce the cost of
capital. [1]
In doing so, the IFRS aim to develop accounts that are reliable, transparent and
standardised. [1]
The need for the standardised information provided by international financial reporting
standards (IFRS) has arisen from the globalisation of capital markets. [1]
[Total 5]

Solution 2.13
(i) Need for regulation of financial services markets
To ensure confidence in the financial system as a whole, by guarding against the

dangers of problems in one area spreading to other parts of the system, and the damage
that would be done by a systematic financial collapse. [1]
To compensate for the asymmetry of information, expertise and negotiating strength

that often exists in financial transactions, particularly in retail markets where the
consumer will generally be a lot less well-informed than the financial services provider
and/or intermediary. [1]
The need is greater because:

 Company failures elsewhere in the economy are likely to:
– be less contagious between firms in other industries
– have less serious consequences for the economy as a whole. [½]
 The financial consequences for the individual of inappropriate decisions are
likely to be large, long-term and difficult to rectify. [½]
 Lack of information will be less of a problem in other markets where the goods
and services traded are themselves less complex. [½]
[Maximum 3]
(ii) Extent of regulation for financial services
The appropriate extent of regulation for a particular financial services market will be
that which maximises the absolute value of the benefits relative to the costs. [1]
Thus, the greater are the benefits relative to the costs, then the greater will be the
appropriate extent of regulation and vice versa. [½]
In theory at least this will occur when the marginal benefits of regulation are equal to
the marginal costs over the relevant time period. [½]
In practice, this might not be the case as it may not be possible to quantify the costs and
benefits precisely. [½]

The benefits stem primarily from the:

 correction of market inefficiencies, such as a lack of information on behalf of
participants, which may lead them to make inappropriate decisions [½]
 protection of the consumers of financial products, eg to ensure that they are not
deceived [½]
 maintenance of confidence in the financial system, in order to ensure the growth
of financial services markets for the greater good of society. [½]
The costs of regulation include the:

 direct costs incurred by the regulator in administering the regulatory framework
and by the regulated firms in complying with the regulation. [1]
 indirect costs, such as:
– a reduction in the level of care taken by investors and advisors [½]
– a reduction in the consumer protection mechanisms developed by the
market itself [½]
– reduced product innovation and competition, resulting in higher charges
for financial services and/or a reduction in the range of services offered.
[½]
[Maximum 6]
(iii) Potential sources of information
 financial advisors, eg stockbrokers, actuaries, specialist financial advisors

 the financial services providers themselves, eg a sales representative of an
insurance company or a bank manager
 the financial press, including specialist investment magazines
 books
 trade associations
 consumer associations
 the internet
 friends, relations and colleagues – informed or otherwise!
[½ each, maximum of 3]

(iv) Persistence of problems
Although relevant information is widely and freely available, so that the informational
advantage to the provider can be reduced:
 The consumer might be unaware that it is.
In particular, it is difficult to obtain information up to the point at which the
marginal cost and benefit of additional information are equal, if you do not know
what the marginal benefit of additional information is. [1]
 It will normally cost money to obtain the information. [1]
 The information might be misleading, incomplete or incorrect. [1]
[Total 3]
Solution 2.14
(a) Specific objectives of the Financial Services Action Plan (FSAP)
The specific objectives of the FSAP with regard to a single wholesale market include:
 enabling companies to raise finance on competitive terms on an EU-wide basis
 providing investors and intermediaries with access to all markets from a single
point of entry
 allowing investment service providers to offer their services across borders
without encountering unnecessary barriers
 establishing a sound and well-integrated prudential framework for investment by
fund managers
 creating a climate of legal certainty so that securities trades and settlements are
safe from unnecessary counterparty risk.
The specific objectives with regard to an open and secure retail market include:
 giving consumers the information and safeguards they need to participate in the
single financial market
 removing unjustified barriers to the cross-border provision of retail financial
services
 creating the legal conditions for electronic commerce on a pan-European scale
 enabling consumers to make small-value cross-border payments without
excessive charges.
[½ for each]

(b) Aims of FSAP directives
The Market Abuse Directive 2003 aims to harmonise the rules on the prevention of
insider dealing and market manipulation. [½]
The Insurance Mediation Directive 2002 aims to regulate intermediaries selling

insurance products and covers the authorisation and capitalisation of intermediaries and
brokers. [½]
The Taxation of Savings Income Directive 2003 aims to prevent cross-border tax
evasion by individuals. [½]
[Total 6]





the course.

Question 3.1
A friend has asked you about the formulae F0 = ( S0 - I )e rT and F0 = S0e( r - q )T .
Explain the context in which these two formulae are used and highlight the difference
between the two formulae. [3]
Question 3.2
A 10½-year Government bond that pays an annual coupon of 5% has a quoted price of
102.82%.
(i) Assuming that the forward bond price volatility is 10% pa, and that the 6-month
and 1-year annual effective spot rates are 4.22% and 4.38% pa respectively, use
Black’s model to calculate the price of a 1-year European call option on the
bond with a strike price of 103%. [5]
(ii) State the put-call parity relationship and use it to calculate the price of a 1-year
European put option on the bond with the same strike price. [3]
(iii) Use Black’s formula to confirm your answer in (ii). [2]
(iv) State the two approximations involved in Black’s model. [1]

[Total 11]
Question 3.3
Explain the sense in which an interest rate floor can be viewed as a portfolio of call
options on zero-coupon bonds. [5]

Question 3.4
Two years ago an investment bank had a view that short-term interest rates were likely
to fall. It therefore decided to speculate on this view using interest rate futures.
(i) Calculate the effective annual interest rate implied by the quoted price for 3-year
interest rate futures at that time of 95.02%. [2]
(ii) Suppose that the bank entered into 12 such contracts and that the quoted price of
each has since risen to 95.29%. Calculate the profit or loss that the bank would
make if it closed out its futures position today. [4]
(iii) Explain how and why the 3-month forward rate at the date the futures contracts
were entered into would have differed from the futures interest rate you
calculated in (i). [5]
[Total 11]
Question 3.5
The 1-year and 2-year continuously-compounded spot rates are currently 4.22% and
4.38% pa respectively. In addition, the price of a 3-year Government bond with a 6%
annual coupon is 103.83%.
(i) Calculate the prices of a 1-year Government bond paying an annual coupon of
6% and a 2-year Government bond paying an annual coupon of 8%. [2]
(ii) Estimate the 3-year and 4-year spot rates. [2]
(iii) Describe the broad pattern of forward rates over the first three years, as implied
by the current pattern of spot rates. Do not calculate the forward rates. [2]
(iv) Calculate the 3-year par yield. [2]
(v) Define the instantaneous forward rate at term 2 years and estimate its current
numerical value. [3]
[Total 11]

Question 3.6
Suppose that the following pattern of continuously-compounded spot rates applied on

1 September 2014.
Maturity date Spot rate %

1 September 2015 5.20
On 1 September 2014, SBR Bank agrees a forward rate agreement (FRA) with another
party under which it will earn interest on a principal of $10m over a one-year period
starting on 1 September 2018 at the then current forward rate over that same period.
(i) Determine the agreed rate of interest over the forward period (to three decimal
places). [2]
(ii) Calculate the subsequent value of the FRA to SBR on 1 September 2015
assuming that the (continuously-compounded) spot rate applicable over the
period to any future maturity date has increased by exactly 0.1% pa by that date.
Comment on your answer. [4]
[Total 6]
Question 3.7
You are an analyst working for a merchant bank that is responsible for the first public
share offering of a company. You have been asked to quote a price range for the share
offer.
(i) Describe the process you will follow to determine the price range. [5]
(ii) List the information you will require to value the company. [3]
(iii) Give two reasons why you might recommend a price range lower than the fair
market value. [2]
[Total 10]

Question 3.8
(i) In the context of interest rate caps and floors, distinguish between flat and spot
volatilities. [2]
(ii) Consider a 5-year interest rate cap with a cap rate of 6% pa, a principal of $50m
and a tenor of one year.
(a) Use the following information to calculate the value of the caplet in the
final year of the cap.
Interest rate volatility 18% pa

Annual effective spot rate at all terms 6.2% pa
(b) Use the same information to calculate the value of the caplet in the third
year of the cap and comment on your answer. [9]
(iii) Calculate the value of a FRA under which Bank A earns 6% pa fixed on a
principal of $50m for a 1-year period starting in 4 years’ time. Hence determine
the value of a floorlet based on the same principal, fixed rate and time period as
the caplet in (ii)(a). Comment on your answers. [6]
[Total 17]
Question 3.9
Describe how the PER of defensive and cyclical companies are likely to vary over the
course of an economic cycle. [5]

Question 3.10
(i) State and justify a formula relating the price of a forward contract to the price of
an underlying share that pays a continuous dividend stream. Define all terms
used and state any assumptions required. [6]
(ii) (a) An 18-month forward contract is available on an equity index. The index
currently stands at 4,400 and has a continuously-compounded dividend
yield of 3.2% pa. Calculate the price of a forward contract on the index
if the continuously-compounded risk-free rate is 3.75% pa.
(b) Three months later the index value has risen to 4,800, the dividend yield
has fallen to 2.95% pa and the risk-free rate is now 4% pa. Calculate the
total return from the forward over the three-month period and comment
in detail on how this return compares to that which would have been
obtained from having invested in the index instead. [12]
[Total 18]
Question 3.11
Suppose that the 1-year and 4-year continuously-compounded spot rates are currently
5.11% and 5.62% pa respectively and that a 1-year European put bond option with a
strike price of 85.00% is available on a 4-year zero-coupon bond.
(i) Calculate the modified duration of the 4-year zero-coupon bond. [2]
(ii) An options dealer quotes a forward yield volatility for the bond option of 16%.
Calculate the forward price volatility of the zero-coupon bond and hence the
price of the put option on the bond. [8]
[Total 10]

Question 3.12
(i) The following table shows (hypothetical) annual effective LIBOR spot rates on
1 January 2015. Use these spot rates to find the (annual effective) forward rates
at 1 January 2015 for the 1-year and 2-year forward periods beginning on
1 January 2017.
Maturity date Spot rate % pa

1 January 2016 3.98
1 January 2017 4.02
1 January 2018 4.10
1 January 2019 4.18
[2]
(ii) (a) Define the swap rate and forward swap rate.
(b) Show that the forward swap rate for a 2-year forward interest rate swap
beginning on 1 January 2017 is 4.3385% pa. [5]
(iii) (a) Consider a swaption on a 2-year “pay 4.0% pa fixed and receive
floating” interest rate swap, with a strike date of 1 January 2017. The
underlying swap involves annual payments based on a principal of $20m.
State the formula used to value a swaption and use it to calculate the
value of this swaption at 1 January 2015, assuming that the annual
volatility of the swap rate is 0.20.
(b) Explain whether your answer would be higher or lower if you assumed
an annual volatility of 30% instead. [7]
[Total 14]

NB This final question is of a more technical nature than is likely to come up in the
Subject ST5 exam and so it is probably not worth spending too long attempting it.
However, the material on which it is based does appear in the Subject ST5 Core
Reading.
Question 3.13
A company is partly financed by a non-interest-paying bond that is due to be repaid in

T years’ time at its face value F . The value of the company at time t is Vt .
(i) Explain why DT , the magnitude of any default that might occur at time T on
the bond, can be taken to be:
DT = max ( F - VT , 0) [3]
(ii) If Vt can be assumed to follow geometric Brownian motion with volatility

parameter s , write down a formula for Dt , the value at time t of any possible
default. [2]
(iii) Hence show that the value of the bond, allowing for the possibility of default, is:
Fe ( ) F (d 2 ) + Vt F ( - d1 )
- r T -t
where r is the risk-free rate, and d1 and d 2 are appropriately defined. [3]
(iv) Explain how the factor F (d 2 ) in the expression in (iii) can be interpreted. [1]
(v) The company A2Z Ltd has a bond of the type described above and the same
assumptions can be made. You are given that:
 the bond has a face value of £10 million and a remaining life of 5 years
 the value of the company’s underlying assets is currently £25 million and
has a volatility parameter of 25% pa.
 the risk-free force of interest is 5% pa.
Calculate the current value of the bond allowing for the possibility of default. [3]
(vi) If the current value of the company were to drop by a small amount dVt , state
by how much the value of the bond would change. [2]
[Total 14]





the course.

Solution 3.1
These formulae are both used for valuing a forward contract on an asset whose current
price is S0 . In both cases, r is the risk-free continuously-compounded rate of interest
and T is the term to the settlement date. [1]
Both formulae allow for the asset generating an income stream before time T . The
formula F0 = ( S0 - I )e rT assumes that the income will consist of known fixed amounts
with a present value of I (as for example with a fixed-interest bond). [1]
The formula F0 = S0e( r - q )T assumes that the income will be proportional to the value
of the asset (as for example with a dividend-paying share) and is earned at a
continuously-compounded rate q . The income is reinvested in the asset, ie it is used to
buy more shares. [1]
[Total 3]
Solution 3.2
(i) Price of the call option
As the bond has 10½ years until maturity, it must be six months since the last annual
coupon of 5 was paid. The accrued interest on the bond must therefore be:
½ ¥ 5 = 2.5 [½]
Hence the current dirty price of the bond is given by:
clean (quoted ) price + accrued interest = dirty price
ie 102.82 + 2.50 = 105.32 [½]
Also, the present value of the coupon to be paid in 6 months’ time, which will not be
received by the option holder, is:
5
I = = 4.8977 [½]
1.0422½
So, the forward price of the bond (at the option strike date of T = 1 ) is equal to:
F0 = ( B0 - I ) (1 + s1 ) = (105.32 - 4.8977 ) ¥ 1.0438 = 104.8208 [½]

Thus, recalling that:

 the strike price is X = 103
 forward bond price volatility is s = 0.10
We have:
(
Ê ln (104.8208 /103) + 0.102 ¥ 1/ 2
d1 = Á
) ˆ˜ = 0.22523 [½]
ÁË 0.10 1 ˜¯
d 2 = d1 - s T = 0.22523 - 0.10 1 = 0.12523 [½]
So:
F (d1 ) = 0.58909 [½]
F (d 2 ) = 0.54983 [½]
The call option price is therefore given by:
call = P (0, 1) [ F0 F(d1 ) - X F(d 2 )]
1
= ¥ [104.8208 ¥ 0.58909 - 103 ¥ 0.54983]
1.0438
= 4.902 [1]
[Total 5]
(ii) Put-call parity relationship
Recall that the put-call parity relationship states that for European options with the same
strike date, strike price and underlying asset:
put + underlying = call + cash
where the underlying pays no income and the cash amount is equal to the discounted
present value of the option strike price. If the underlying pays income before the option
strike date, as it does here, then we need to deduct the present value of this income from
the left-hand side of the equation. [1]
So, here:
 price of underlying excluding income is B0 - I = 105.32 - 4.8977 = 100.422

 price of call is 4.902

103
 discounted present value of strike price is = 98.678 [1]
1.0438
And the value of the European put is therefore:
put = -100.422 + 4.902 + 98.678 = 3.16 [1]

[Total 3]
(iii) Using Black’s formula to value the put
Black’s formula for the put option price is:
put = P (0, 1) [ X F( - d 2 ) - F0 F( - d1 )]
with d1 and d 2 exactly as before. [1]
Remembering that:
F ( - d1 ) = 1 - F (d1 )
this gives:
1
put =
1.0438
[103 ¥ (1 - 0.54983) - 104.8208 ¥ (1 - 0.58909)]
which is equal to the 3.16 found in part (ii). [1]

[Total 2]
(iv) Two approximations in Black’s model
The two approximations involved in the model used in (i) (Black’s model) are:
1. The (current) expected value of the bond price at the option strike date is equal
to the forward price of the bond. [½]
2. The stochastic behaviour of interest rates is ignored when using interest rates to
discount future values. [½]
The model also involves other assumptions, eg that the bond price at the strike date has
a lognormal distribution with variance proportional to the term to the strike date, but
the above two are the approximations highlighted in the Core Reading.

Solution 3.3
Recall that an interest rate floorlet provides a payoff at time tk +1 of:
L d k max ( RX - RK , 0) [½]
where:
 L is the principal amount
 d k is the tenor of the contract
 RX is the floor interest rate
 RK is the variable interest rate (usually LIBOR), on which the floor is based. [½]
Recall also that RK , the floating rate, is compounded with a frequency corresponding to
the length of the tenor and so the effective interest rate from tk to tk +1 is RK d K . Thus,
the above payoff at time tk +1 has the same present value as a payoff at time tk of:
L dk
max ( RX - RK , 0) [1]
1 + RK d k
This can be rewritten as:
Ê ( R - RK ) L d k ˆ
max Á X , 0˜
Ë 1 + RK d k ¯
Ê ( R L d k - RK L d k + L - L ) ˆ
= max Á X , 0˜
Ë 1 + RK d k ¯
Ê ( L + LRX d k - LRK d k - L ) ˆ
= max Á , 0˜
Ë 1 + RK d k ¯
Ê L (1 + RX d k ) ˆ
= max Á - L, 0˜ [1½]
Ë 1 + RK d k ¯
L (1 + RX d k )
is the value at time tk of a zero-coupon bond that pays L (1 + RX d k ) at
1 + RK d k
time tk +1 . [½]

Thus, the above expression is equal to the value of the payoff from a call option with an
exercise date and price of tk and L respectively, on a zero-coupon bond with a principal
of L (1 + RX d k ) payable at time tk +1 . [1]
[Total 5]
Solution 3.4
(i) Effective annual interest rate
If the quoted price of an interest rate future is Z, then the implied interest rate
convertible quarterly is equal to i (4) = 100 - Z . Thus, here:
i (4) = 100 - 95.02 = 4.98% [1]
So the annual effective interest rate must be:
4 4
Ê i (4) ˆ Ê 0.0498 ˆ
i = Á1 + - 1 = ÁË 1 + ˜ - 1 = 5.074% pa [1]
Ë 4 ˜¯ 4 ¯
[Total 2]
(ii) Profit or loss to bank
In order to speculate on a view that interest rates will fall, and hence that the price of the
interest rate future will rise, the bank must have taken a long position in interest rate
futures. Hence, in this instance, the bank has entered into a long position on 12 interest
rate futures contracts. [1]
The contract price when the bank entered into the contracts is equal to:
10, 000 ÈÎ100 - ¼ (100 - 95.02) ˘˚ = 987,550 [1]
The contract price when the bank closed out the contracts is equal to:
10, 000 ÈÎ100 - ¼ (100 - 95.29) ˘˚ = 988, 225 [1]
Thus, the total profit to the bank from taking out long positions on 12 contracts is given
by:
12 ¥ (988, 225 - 987,550) = +8,100 [1]

[Total 4]

(iii) How and why the forward rate would differ from the futures rate
The forward rate would be lower than the futures interest rate due to impact of the
margining requirements associated with the futures contracts, but which would not have
applied under equivalent forward contracts (ie forward rate agreements). [1]
For interest rate futures, the contract price is inversely related to short-term interest
rates. Hence, when interest rates fall and the contract price increases, then an investor
with a long futures position makes an immediate gain because of the daily margining
procedure of marking to market. As such gains happen when interest rates are low,
however, this gain will tend to be invested at lower than average interest rates.
Likewise, interest rate rises that produce falls in the contract price, will lead to an
immediate loss to an investor with a long futures position, which will tend to be
financed at higher than average interest rates. [2]
interest rate movements. [½]
Thus, all else being equal, a long futures contract will be less attractive than the
equivalent long forward contract. Futures prices will therefore tend to be lower than
forward prices … [1]
… and by implication, the corresponding forward interest rates will tend to be lower
than the equivalent futures interest rates. [½]
[Total 5]
Solution 3.5
(i) 1-year and 2-year Government bond prices
Assuming that the bonds have an exact term of 1 year and 2 years respectively, their
prices can be calculated by discounting the future payments using the spot rates
provided.
So, the price of the 1-year Government bond is:
P1 = 106 e -1¥ s1 = 106 e -1¥0.0422 = 101.62% [1]
And the price of the 2-year Government bond is:
P2 = 8 e -1¥ s1 + 108 e -2¥ s2 = 8 e -1¥0.0422 + 108 e -2¥0.0438 = 106.61% [1]

[Total 2]

(ii) 3-year and 4-year spot rates
The 3-year spot rate is estimated from the equation of value for the 3-year Government
bond:
P3 = 6 e -1¥0.0422 + 6 e -2¥0.0438 + 106 e -3¥ s3 = 103.83 [½]
Solving this gives:
s3 = 4.51% pa [1]
In the absence of any other information, it is usual to assume that the spot rate curve is
flat beyond the longest known term. Hence, our best estimate of the 4-year spot rate is
also 4.51% pa. [½]
[Total 2]
(iii) Broad pattern of forward rates over first three years
Spot rates are essentially averages of the forward rates over the same future term. [½]
Thus, if spot rates are increasing with outstanding term over the first three years, this
can only be because the forward rates are above the spot rates and “pulling up” the spot
rates. [½]
So the current forward rate curve must be upward-sloping over the first three years. [½]
And it must be sloping upwards more steeply than the spot rate curve. [½]
[Total 2]
(iv) 3-year par yield
The 3-year par yield C is found from the equation of value:
( )
100 = C ¥ e - s1 + e -2 s2 + e -3s3 + 100 e -3s3
Substituting in the spot rates gives:
( )
100 = C ¥ e -0.0422 + e -2¥0.0438 + e -3¥0.0451 + 100 e -3¥0.0451 [1]
This is then solved to give:
C = 4.605% pa [1]
[Total 2]

(v) Instantaneous forward rate at term 2 years
The instantaneous forward rate at term 2 years is the rate of interest implied by spot
rates that applies to an instant of time 2 years into the future. [½]
In an arbitrage-free market, it represents the rate at which you can agree now to borrow
or lend over an instant of time (overnight?) 2 years from now. [½]
The instantaneous forward rate RF is related to the spot rate R by the formula:
∂R
RF = R + T . [½]
∂T
∂R
Here we have insufficient information to evaluate exactly, however we can
∂T
estimate it by considering the change in the spot rate over the discrete time interval from
T = 1 to T = 3 . [½]
Hence:
RF ª s2 + 2.
( s3 - s1 ) = 4.38 + 2 (4.51 - 4.22) = 4.67% pa [1]
3 -1 3 -1
[Total 3]
Solution 3.6
(i) Agreed forward rate of interest
The agreed rate of interest will be such that the value of the FRA to both parties is zero
at outset. This will be the case if the agreed rate is set equal to the 1-year forward rate
from 1 September 2018 to 1 September 2019 applicable on 1 September 2014. [½]
This can be found from:
(
e5¥ s5 = e 4¥ s4 ¥ 1 + f 4,1 ) [½]
 (
e5¥0.0507 = e4¥ 0.0509 ¥ 1 + f 4,1 )
ie f 4,1 = 5.117% pa (to three decimal places) [1]
[Total 2]

(ii) Value of the FRA to SBR on 1 September 2015
Under the FRA, SBR has notionally agreed to lend $10m for a 1-year period starting on
1 September 2018. The notional cashflows exchanged will therefore be:
 –10m on 1 September 2018
 +10m  1.05117 on 1 September 2019. [1]
Remember that in practice, these cashflows will normally not be exchanged.
By 1 September 2015, the pattern of spot rates has changed to the following.
Maturity date Spot rate, %

The net present value of the cashflows that will notionally be exchanged according to
the FRA is therefore:
= -10m ¥ e -3¥0.0519 + 10m ¥ 1.05117 ¥ e -4¥ 0.0517
= –$10,231 [1]
As at 1 September 2015, the value of the FRA to SBR Bank is negative, ie the bank is
looking at a loss. This is because under the terms of the FRA it effectively agreed to
lend over the 1-year forward period at an annual effective rate of 5.117% pa. However,
interest rates have since increased. [1]
In particular, by 1 September 2015, the forward applying over the year beginning
1 September 2018 has increased to:
e4¥0.0517
1 + f3,1 =
e3¥0.0519
ie an annual effective forward rate of f3,1 = 5.243% pa [1]

[Total 4]

Solution 3.7
(i) Process used to determine price range (fundamental share analysis)
To help predict the future earnings of the company a financial model of its cashflows
and earnings must be developed. [½]
Forecasts of future sales and costs (allowing for price and wage inflation) will be used
to build up expected future income statements (profit and loss accounts). Estimates of
rates of interest on overdrafts and loans will also be required. Forecasts of sales and
costs will need to take into account view of management ability, product quality,
prospects for market growth, changes in the company’s competitive environment and
company, sector and market history. [1]
The forecast P&L accounts will provide estimates of earnings to which expected payout
ratios can be applied to derive estimates of future dividend streams to shareholders. The
payout ratios would take account of previous distributions to private shareholders,
payouts of similar but listed companies and any estimates made by the company itself.
[1]
The dividend streams would be valued using either:
V = Â Dt v(t ) [½]
t
or, using a simplified approach of
D1
V= [½]
i-g
where:
 Dt = dividend payment at time t
 v(t ) = t-year discount factor for period 0 to t
 i = required rate of return (derived from market valuations of similar

companies)
 g = continuous rate of growth of dividends (derived from the financial model
of the company). [1]
The price range would be obtained by considering the lower and upper estimates of
earnings, payout ratio, i and g. This may be done by using a set of scenarios each with a
mutually consistent set of estimates. [1]

Alternatively, next year’s earnings could be estimated using the above analysis and a
price derived by applying a market PE ratio. [½]
[Maximum 5]
(ii) Information required to value company
 historical financial accounts

 historical and current accounting ratios
 dividend cover (of the existing private company)
 level and structure of borrowing
 levels of liquidity
 market values of assets
 comparative values of the above for similar companies
Trends would be of greater interest rather than the absolute values of the above.
 details of goods and services produced

 details of the management – character, ability, qualifications and experience, etc
 details of available business plans and strategies
 public statements, press information and listing details
 opinions of management, analysis, competitors & customers
[¼ each, maximum 3]
(iii) Reasons why price recommended lower than fair market value
 To ensure that the share offer is fully subscribed and to avoid the costs of
mitigating the risk of under-subscription. Positive investor sentiment would be
created by the price rising upon listing. [1]
 To counter any problems caused by negative economic or market conditions
during the period of subscription, which might reduce the fair value from its
current level. [1]
 To provide an incentive for investors to disinvest from similar shares in order to
subscribe (by in effect creating a price anomaly). [1]
[Maximum 2]

Solution 3.8
(i) Flat and spot volatilities
In the context of an interest rate cap (or floor), “volatility” refers to the annualised
standard deviation of the change in the short-term interest rate on which the possible cap
payments are based over the lifetime of the particular caplet. [½]
More specifically, Black’s model assumes that the log of the short-term interest rate at
the start of any caplet (ie at time tk ) has a variance given by s k2tk . [½]
If a different volatility is used to value all of the caplets in any particular cap, then each
volatility is referred to as a spot volatility for the term tk . [½]
If the same volatility is used to value all of the caplets in any particular cap, then this is
referred to as a flat volatility, and it represents an average of the spot volatilities over the
entire term of the cap. [½]
[Total 2]
(ii)(a) Value of the caplet in the final year
The Black’s model formula for valuing a caplet as a call option on the variable interest
rate is:
caplet = L d k P (0, tk +1 ) [ FK F(d1 ) - RX F(d 2 )]
where:
Ê ln ( FK RX ) + s k2tk 2 ˆ
 d1 = Á ˜
Ë s k tk ¯
 d 2 = d1 - s k tk [1]
Here:
 the principal is L = 50m
 the tenor is d k = 1
1
 the discount factor is P (0,5) = = 0.740248
1.0625
 the forward rate is FK = 0.062 , as the spot rate is 6.2% pa at all terms
 the fixed rate is RX = 0.060

 the volatility is s k = 0.18
 the term of the caplet is tk = 4 [1]
So:
caplet = 50m ¥ 1¥ 0.740248 [0.062 ¥ F(d1 ) - 0.060 ¥ F(d 2 )]
where:
Ê ln (0.062 0.060) + 0.182 ¥ 4 2 ˆ
 d1 = Á ˜ = 0.27108 [½]
Ë 0.18 4 ¯
 d 2 = d1 - 0.18 4 = -0.08892 [½]
So:
 F (d1 ) = 0.60683 [½]
 F (d 2 ) = 0.46457 [½]
Thus:
caplet = 50m ¥ 1 ¥ 0.740248 [0.062 ¥ 0.60683 - 0.060 ¥ 0.46457] = 360,844 [1]

[Total 5]
(ii)(b) Value of caplet in the third year
Here all of the parameters are the same as before except that tk = 2 and the discount
1
factor is P (0,3) = = 0.834885 . Thus:
1.0623
Ê ln (0.062 0.060) + 0.182 ¥ 2 2 ˆ

 d1 = Á ˜ = 0.25609 [½]
Ë 0.18 2 ¯
 d 2 = d1 - 0.18 2 = 0.00153 [½]
So:
 F (d1 ) = 0.60106 [½]
 F (d 2 ) = 0.50061 [½]

Thus:
caplet = 50m ¥ 1¥ 0.834885 [0.062 ¥ 0.60106 - 0.060 ¥ 0.50061] = 301, 772 [1]
The value of this caplet is less than that in the final year.
This is because this caplet has a shorter term and so there is less opportunity for the
short-term variable interest rate to increase above the current forward rate of 6.2% pa,
thereby increasing the amount of the (possible) caplet payoff. [½]
This extra time value is offset a little by the fact that the (possible) payoff from the third
year caplet is two years nearer and so each dollar of possible payoff will have a greater
present value. [½]
[Total 4]
(iii) Value of FRA and floorlet
We can value the FRA by considering the cashflows that would notionally change
hands under the agreement. As Bank A is earning 6% pa fixed under the FRA, this is
equivalent to lending at 6% pa fixed over Year 5. Thus, the present value of the
notional cashflows is given by:
-50m 50m ¥ 1.06

+ = -74, 025
1.0624 1.0625
ie the value of the FRA to Bank A is –$74, 025. [2]
This is a loss because the current forward rate over Year 5 is 6.2% pa, which is greater
than the rate fixed within the FRA. [½]
To value the floorlet using the caplet and FRA values already calculated, we can use the
put-call parity relationship between a cap, a floor and a swap:
cap = floor + pay fixed for floating swap [1]
This applies equally to single payments and so:
caplet = floorlet + ( pay fixed & receive floating )
 caplet = floorlet + ( FRA borrowing at the fixed rate)
 floorlet = caplet + ( FRA lending at the fixed rate) [1]

So, the value of the floorlet is given by:
floorlet = 360,844 - 74, 025 = 286,819
ie the floorlet has a positive value of $286,819. [1]
This is less than the value of the corresponding caplet because the forward rate over the
fifth year is currently 6.2% pa, which is greater than the fixed cap/floor rate of 6% pa.
Hence the caplet is more valuable than the floorlet. [½]
[Total 6]
Solution 3.9
If the economy is moderately buoyant and profits are fairly stable, both defensive and
cyclical companies might be similarly rated, ie have similar PERs. The range of PERs
might be quite narrow. [1]
As the economy starts to move into recession, PERs for cyclical companies are likely to
fall as the market starts to anticipate a drop in profits, while those of defensive
companies will remain stable or may even rise slightly. [1]
At the bottom of the cycle, the PERs of cyclical companies will probably have risen
from their low point as earnings have fallen, but defensive stocks will still be more
highly rated (ie higher PERs). A company that has made exceptionally low profits
might have a very high PER. No PER is given for companies that make losses. [1]
As the economy starts to recover, the PERs of cyclical companies will rise as the price
increases in anticipation of future earnings growth. PERs of defensive companies may
be below those of cyclicals. [1]
As growth continues, the earnings of cyclical companies will catch up with the share
price and PERs will fall back, so that both types of company may again be similarly
rated. [1]
[Total 5]

Solution 3.10
(i) State and justify formula for forward price
The formula for the price of a forward contract based on an underlying share that pays
continuous dividends is:
F0 = S0 e( )
r -q T
[½]
where:
 F0 is the price of the forward contract
 S0 is the current price of the underlying share
 r is the continuously-compounded risk-free rate of interest

 q is the continuously-compounded rate of income payment
 T is the term of the forward contract. [1]

This formula can be justified as follows.
Suppose that F0 > S0 e( ) , then it would be possible to make risk-free arbitrage

r -q T
profits by:
 borrowing S0 e - qT cash at the risk-free rate
 using it to buy e - qT shares

 selling a forward at F0 . [1]
If the dividends received on the shares held are continuously reinvested to buy
additional shares, then at time T, you would hold exactly one share. This share could
then be handed over to the purchaser of the forward contract in return for the sum F0 .
This sum could then be used to repay the cash borrowed, which by then would have
accumulated up to S0 e( ) . This would leave a risk-free arbitrage profit equal to:
r -q T
F0 - S0 e( ) > 0
r -q T
[1]
Likewise if at outset, F0 < S0 e( ) , then it would be possible to make a risk-free

r -q T
profit by taking opposite positions to those described above. [½]

Thus:
 if markets are arbitrage-free [½]
 shares are infinitely divisible and short selling is permitted [½]
 there are no taxes or transactions costs [½]
then it must be the case that neither of the above possibilities arises, which is possible
only if:
F0 = S0 e( )
r -q T
[½]
[Total 6]
(ii)(a) Price of an 18-month forward contract
Here:
 S0 = 4, 400
 q = 0.032
 r = 0.0375
 T = 1.5 .
Thus, the forward price is given by:
F0 = 4, 400 e(
0.0375- 0.032)¥1.5
= 4436.45 [2]
(b) Total return on the forward
Three months later, we have:

 S0 = 4,800
 q = 0.0295
 r = 0.040
 T = 1.25 .
Thus, the forward price is given by:
F0 = 4,800 e(
0.040- 0.0295)¥1.25
= 4,863.42 [2]
So the total return on the forward contract is:
Ê 4,863.42 ˆ
ÁË 4, 436.45 - 1˜¯ ¥ 100% = 9.62% [1]

This compares to an increase in the value of the index of:
Ê 4,800 ˆ
ÁË 4, 400 - 1˜¯ ¥ 100% = 9.09% [1]
The forward price has increased more rapidly over the three-month period because:
 the risk-free rate has increased, making the forward a more valuable way of
delaying the purchase of the underlying equities in order to earn more interest on
the money saved by not purchasing the shares now [1]
 the dividend yield has fallen, meaning that the value of the future dividends to be
received over the term to maturity of the forward has reduced (as a proportion of
the value of the shares themselves). [1]
However, this comparison ignores:
 the dividends that would have been received had the index equities actually been
held over the last three months. These would have been approximately equal in
value to:
(
4, 400 e¼¥0.032 - 1 = 35.3)
or: 4,800 (e ¼ ¥ 0.0295
- 1) = 35.5 [1]
Adding this to the increase in the capital value of the index would then give a
total return of about:
Ê 4,800 + 35 ˆ
ÁË 4, 400 - 1˜¯ ¥ 100%  9.9% [1]
 the interest earned on the money saved by buying the forward and not the shares.
This could be estimated as being at least:
( )
4, 400 e¼¥0.0375 - 1 = 41.4 [1]
Adding this to the increase in the capital value of the forward would then give a
total return of about:
Ê 4,863.42 + 41.4 ˆ
ÁË - 1˜ ¥ 100% = 9.95% [1]
4, 436.45 ¯
This is slightly higher than the total return from the index due to the rise in the risk-free
rate. [½]
[Maximum 12]

Solution 3.11
(i) Modified duration of the 4-year zero-coupon bond
By definition, the duration of a 4-year zero-coupon bond must be 4 years. [½]
In addition, the annual effective spot rate offered by the zero-coupon bond is equal to:
i = e0.0562 - 1 = 0.05781 [½]
The modified duration of the bond is therefore:
Duration 4
D= = = 3.7814 years [1]
1+ i 1.05781
[Total 2]
(ii) Forward price volatility and price of put option
The current price of the bond is given by:
B0 = 100 e -4 s4 = 100 e -4¥0.0562 = 79.868% [1]
So, the forward price of the bond at the strike date of the option is given by:
F0 = B0 e s1 = 79.868 e0.0511 = 84.055% [1]
The initial forward yield of the bond y0 can therefore be found from:
100 = F0 (1 + y0 ) = 84.055 (1 + y0 )
3 3
ie y0 = 0.05961 [1]
Note that we require that this yield be compounded annually in order to use it in the
relationship between the price and yield volatilities below.
And the modified duration of the forward bond is then found as:
Duration 3
D= = = 2.8312 years [1]
1 + y0 1.05961

We can now find the forward price volatility s of the bond from:
s = D y0 s y [½]
where s y is the current forward yield volatility of the bond. Thus:
s = 2.8312 ¥ 0.05961 ¥ 0.16 = 0.02700 [½]
So, the price of the 1-year European put option on the zero-coupon bond is found from:
put = P (0, 1) [ X F( - d 2 ) - F0 F( - d1 )]
with:
(
Ê ln (84.055 / 85) + 0.027002 ¥ 1/ 2
d1 = Á
) ˆ˜ = - 0.40057 [½]
ÁË 0.02700 1 ˜¯
d 2 = d1 - s T = - 0.40057 - 0.02700 1 = -0.42757 [½]
So:
F ( - d1 ) = 0.65563 [½]
F ( - d 2 ) = 0.66552 [½]
The put option price is therefore given by:
put = P (0, 1) [ X F( - d 2 ) - F0 F( - d1 )]
= e -0.0511 ¥ [85 ¥ 0.66552 - 84.055 ¥ 0.65563]
= 1.39 [1]
[Total 8]

Solution 3.12
(i) 1-year and 2-year forward rates from 1 January 2017 at 1 January 2015
The 1-year forward rate, f 2,1 , is found from the spot rates using the relationship:
1  s2 2 1  f 2,1   1  s3 3
 1.0402 2 1  f 2,1   1.0410 3
ie f 2,1  0.042602 or 4.2602% pa effective [1]
Similarly:
1  s2 2 1  f 2,2 
2
 1  s4 
4
1.0402 2 1  f 2,2 
2
 1.0418 
4

ie f 2,2  0.043402 or 4.3402% pa effective [1]

[Total 2]
(ii)(a) Swap rate and forward swap rate
The swap rate for a particular term at a particular time is the fixed interest rate that
would be exchanged for LIBOR in a new swap with the same principal and term. In
other words, if we consider an interest rate swap in terms of swapping a fixed rate bond
for a floating rate bond, then the swap rate is the fixed rate such that the two bonds have
the same present value at the start of the swap. [1]
The forward swap rate is just the swap rate that would apply for a swap beginning at a
forward date (rather than now) based on the current term structure of interest rates. [1]

(ii)(b) Show that forward swap rate is 4.3385%
Applying the definition in (ii)(a), the required forward swap rate is the fixed rate that
makes the present value of a 2-year fixed rate bond starting on 1 January 2017 equal to
the present value of a 2-year floating rate bond also starting on 1 January 2017.
Recall that the present value of a floating rate bond at the outset is always equal to the
principal. So the forward swap rate is the fixed rate such the present value at the outset
of a 2-year fixed rate bond starting on 1 January 2017 is equal to its principal. [1]
Thus, if we denote the forward swap rate by F0 , then we can find it from:
 
F0 1  F0 
1   [1]
 1  f 2,1 1  f
 2,2  
2

Substituting in the values for the forward rates from part (i) and solving then gives:
F0  0.043385
ie 4.3385% pa [1]
[Total 5]
(iii)(a) Value of the swaption
As the swaption is based on a “pay fixed and receive floating” interest rate swap, we
can value it using the formula (this formula effectively values the swaption as a call
option on the swap rate):
LA  F0  d1   RX   d 2   [1]
where:
Ê ln ( F0 RX ) + s 2T 2 ˆ
 d1 = Á ˜ and d 2 = d1 - s T
Ë s T ¯
 F0 = 0.043385 is the forward swap rate
 RX = 0.04 is the fixed rate
 s = 0.20 is the volatility of the swap rate
 L  20m is the principal amount

 T  2 is the term of the swaption
1 1
 A  is an annuity factor used to discount the swap payments
1  s3 3
1  s4 4
back to the valuation date of 1 January 2015. [1]
Here:
Ê ln (0.043385 0.04) + 0.202 ¥ 2 2 ˆ

d1 = Á ˜ = 0.42863 [½]
Ë 0.20 2 ¯
d 2 = 0.42863 - 0.20 2 = 0.14579 [½]
1 1
A 3
  1.73535 [½]
1.0410 1.04184
So:
  d1   0.66590 [½]
  d 2   0.55795 [½]
And the value of the swaption is given by:
= LA  F0  d1   RX   d 2  
= 20m  1.73535  0.043385  0.66590  0.040  0.55795
 228,097
ie about €228k [1]
(iii)(b) Volatility of 30% pa
The value of the swaption would be higher ... [½]
… because a higher volatility would mean a higher probability that the swap rate
increases further between now and the strike date leading to a greater profit on exercise.
[½]
Although there would also be a higher probability of the swap rate falling by the strike
date, which acts to make the swaption less valuable, this downside risk is limited by the
choice that the swaption confers. [½]
[Total 7]

Solution 3.13
(i) Formula for magnitude of default
If VT , the value of the company at time T , exceeds F , the face value of the bonds, then
(theoretically at least) the company will choose to repay the bonds in full, and the
default will be zero. [1]
If on the other hand, VT is less than F , then the company will only be able to afford to
repay VT , and there will be a shortfall (default) of F - VT . [1]
These two possibilities are captured in the equation DT = max( F - VT , 0) . [1]

[Total 3]
(ii) Formula for Δt
The formula for DT from part (i) exactly matches the payoff from a put option on the
stochastic quantity VT with a strike price F . [1]
Since we are told that Vt follows geometric Brownian motion, this fits in with the
Black-Scholes model, and we can apply the Black-Scholes formula for the value of a
put option, namely:
Dt = Fe - r (T -t ) F( - d 2 ) - Vt F( - d1 )
log(Vt / F ) + (r + 12 s 2 )(T - t )
where d1 = and d 2 = d1 - s T - t . [1]
s T -t
(iii) Value of bond allowing for default
Ignoring the possibility of default, the value of the bond at time t would be Fe - r (T -t ) .
[½]
If we allow for the possibility of default, the value would be reduced to Fe - r (T -t ) - Dt

[½].

Using the formula derived in (ii), this gives:
Fe - r (T -t ) - Dt = Fe - r (T -t ) - {Fe - r (T -t ) F( - d 2 ) - Vt F( - d1 )}
= Fe - r (T -t ) {1 - F( - d 2 )} + Vt F( - d1 ) [1]
Using the fact that the normal distribution is symmetrical, this simplifies to:
Fe - r (T -t ) - Dt = Fe - r (T -t ) F(d 2 ) + Vt F( - d1 ) [1]
[Total 3]
(iv) Interpretation of Φ(d 2 )
As we have already noted, Fe - r (T -t ) is the value of the bond ignoring the possibility of
default. In the formula, we are multiplying (or “discounting”) this by the factor F(d 2 ) ,
which is a probability – effectively the probability of “survival” or not defaulting. So,
this would be consistent with 1 - F(d 2 ) = F( - d 2 ) representing the “probability of
default”. [1]
In fact in this situation default isn’t a “digital” (= all or nothing) event. “Partial”
default is possible. So the “probability” referred to is actually a weighted probability
that also reflects the amount of the default.
In Subject CT8, we saw that one of the ways of deriving the Black-Scholes formulae was
to carry out calculations in a “risk-neutral” world. In fact the probability here is the
probability in a risk-neutral world, which would not normally match the real-life
probability.
(v) Calculation for A2Z Ltd
This is a direct application of the formula in (iii). We have (working in £ million):
V = 25 , F = 10 , r = 0.05 , s = 0.25 , T - t = 5
log(25 /10) + (0.05 + 12 ¥ 0.252 )(5)

So: d1 = = 2.3658 [½]
0.25 5
and d 2 = 2.366 - 0.25 5 = 1.8068 [½]

So the value of the bond is:
10e -0.05¥5F(1.8068) + 25F( -2.3658) = 7.788 ¥ 0.96460 + 25 ¥ 0.00885 = 7.734
ie approximately £7.734 million. [2]

[Total 3]
(vi) What if the value of the company changed?
The value of the bond ( Bt , say) is Fe - r (T -t ) F(d 2 ) + Vt F( - d1 ) . The change in this

∂Bt
value when the underlying asset changes by a small amount dVt is given by dVt .
∂Vt
[½]
∂Bt
Here is the “delta” for the bond when viewed as a derivative instrument. [½]
∂Vt
As with other Black-Scholes formulae, this delta can be calculated by differentiating the
formula ignoring the fact that d1 and d 2 are actually functions of Vt as well. So we
get:
∂Bt
= F( - d1 ) == F( -0.23658) = 0.00885 [½]
∂Vt
This tells us that the bond value would fall by 0.00885 dVt . [½]
[Total 2]

Question 4.1
(i) List ten possible uses for fixed interest yield indices based on government bonds.
List four other possible uses for fixed interest price indices. [7]
(ii) Outline the particular issues that need to be addressed when constructing property
indices. [2]
(iii) At the start of the year, the values of a capital value index and the corresponding
total return index are 1,222, the corresponding dividend yield is 3.5% pa and the
total return index has a value of 1,428.
Use the information given in the table below to calculate values for the total
return index series at the end of each subsequent quarter and hence estimate the
total return on the index over the year.
End of Quarter Capital index value Dividend yield, pa
1 1,346 3.19%
2 1,521 2.88%
3 1,299 3.33%
4 1,423 3.10%
[7]
[Total 16]
Question 4.2
(i) Suggest reasons why a life insurance company may prefer to compare its
investment performance with a benchmark portfolio rather than with other life
insurance companies’ investment performance. [3]
(ii) An actuarial student calculates the rate of return for the investments of the
financial institution for which he works and gets an answer of 16.5% pa. Suggest
reasons why this answer may be unsuitable as a basis for assessing the
performance of the institution’s fund managers. [5]
[Total 8]

Question 4.3
(i) Give eight general forms of “exposure” (eg economic or other factors) that may
adversely affect the profits of a manufacturing/trading company. [4]
(ii) Major food retailers are normally fairly immune to downturns in the economy.
Under what circumstances might a supermarket chain suffer a sharp fall in share
price when the economy goes into recession? [3]
(iii) You are an analyst in a stock broking firm responsible for the UK services
sector. For some time the opinion of the directors of the company has been that
the UK economy is growing strongly and will continue to do so, supported by
strong consumer demand. However, following a recent meeting of the
investment director and the economic analyst, the view has changed. The view
(or “house view”) is now that UK consumers will begin to spend less and that
economic growth will reduce over the coming year or two, although
international growth will continue to be strong.
List the types of companies in the services sector and explain how your preferred
stocks within the sector might change as a result of the new house view. [8]
[Total 15]
Question 4.4
(i) State the formula that you would use to calculate a capital value index series
allowing for chain linking. Define all of the terms that you use. [2]
(ii) Suppose that an index is to be calculated to measure the level of capital values in
an emerging market in which there are currently only two shares, X and Y. At
the base date of the index, there are 200 X shares each priced at 5.12 and 100 Y
shares each priced at 3.06.
(a) What value is required for the index divisor if the base value of the index
is to be 1,000?
(b) At the close of play on the final trading day at the end of the first month,
the prices of X and Y have changed to 4.68 and 3.22 respectively. What
is the value of the index at that date?
(c) After the close of play on that date, Company Z’s shares are introduced
to the stock market. 50 Z shares are issued at a price of 2.00 each. At the
end of the second month, the prices of the three shares have moved to
4.88, 3.52 and 2.19 respectively. Calculate the value of the capital value
index at the end of the second month. [6]
[Total 8]

Question 4.5
An actuary suggests that a fund’s performance be assessed by calculating the following

statistic:
Ï Ê n ˆ ¸
0.5
Á Â (max(( R p - xi ), 0)) ˜
Ô 2 Ô
Ô ˜ Ô˝
R p - R f + Ì( R f - Rm ) Á in=1
Ô Á ˜
Á Â (max(( Rm - yi ), 0))2 ˜ Ô
Ô Ë i =1 ¯ ÔÔ
ÓÔ ˛
where:
 R p = average monthly return on fund over the last five years
 Rm = average monthly return on the FTSE 100 over the last five years
 R f = average monthly risk free rate of return over the last five years
 xi = return on the fund in month i (i = 1, 2, ..., 60) of the last 60
 yi = return on the FTSE 100 in month i.
Comment on the suitability of using this statistic to assess investment performance. [8]
Question 4.6
(i) Describe the main features of the following UK equity indices:

(a) FTSE 100 Index
(b) FTSE All-Share Index. [6]
(ii) Explain how these indices are used by investors. [5]

[Total 11]
Question 4.7
Discuss the methods you would use to assess the performance of a pension fund
investment manager. Your answer should consider several alternative approaches, and
should highlight the difficulties you may face, including how to allow for risk. [22]

Question 4.8
You are the actuary advising a fund that invests in investment trusts. You have been
given the following information on the performance of the two investment trusts and the
FTSE All-Share index over the last five years:
Trust A Trust B Index

Average return: 16% pa 17% pa 15%
Standard deviation 24% pa 60% pa 22%
Correlation coefficient with FTSE All-Share 0.81 0.4 1.0
The risk-free rate of return over the period was 10%.
(i) Calculate four different risk-adjusted performance measures for each fund. [5]
(ii) Discuss briefly which of the two investment trusts the fund should choose to
invest in on the basis of your calculations in (i) mentioning any limitations of
your analysis. [7]
[Total 12]
Question 4.9
The following information is available in respect of the accumulation units of a mutual

Worldwide Equities Growth fund and an index of world equity prices.
Unit Net units Gross investment % change in Gross

Date income in prior index in prior dividend
price created
6 months 6 months yield on index
1.1.14 1.00 120 18 –5.0% 6.0%
1.7.14 1.05 –47 20 –2.6% 6.3%
1.1.15 1.25 100 21 +20.3% 5.4%
(1) Number of units on 31.12.13 = 1,000

(2) The fund uses single pricing, ie there is no bid-offer spread
(3) Assume that the fund is liable to taxation of one quarter of its investment
income, payable at the same time that the investment income is received
(4) Cashflows occurred only on the dates shown
(5) Assume that all dividends are paid at the end of each 6-month period

(6) Unit prices shown apply after receipt of net income for the preceding 6 months
(7) All figures are in sterling.
Ignoring expenses and stating any additional assumptions you make:
(i) Calculate the time-weighted return, the internal rate of return and the linked
internal rate of return (using 6 monthly sub-intervals) for the fund in 2014 based
on the information given above. Explain the differences. [9]
(ii) Compare the performance of the fund against a notional fund invested in the
index. You should take account of differences between actual income and
income on the index as well as capital appreciation. [9]
[Total 18]
Question 4.10
(i) Discuss the use of the net asset value and the net present value as indicators of
equity investment performance. [4]
(ii) You are a non-executive director on the remuneration committee of Cleanup plc.
Cleanup started out providing cleaning services but has recently expanded
rapidly and now offers a wide range of different services to its predominantly
corporate clients.
Currently, the executives’ earnings include a substantial performance-related

element, which takes the form of an annual issue of new five-year share options
(ie each issue can only be exercised five years after it has been issued). One of
the executives has approached you and suggested that this element of earnings
be scrapped and replaced with bonuses based on the company’s risk-adjusted
return on capital (using accounting values), whereas another has suggested that
profit-related bonuses would be more appropriate.
Explain why the current performance-related element may take the form that it
does and also why you might be reluctant to replace this arrangement with either
of the two suggested alternatives. [8]
[Total 12]

Question 4.11
The benchmark for a fund is 60% invested in equities tracking an All-Share Index and
40% in bonds tracking an “All-Bonds” Index, with rebalancing of asset classes at the
end of each quarter.
During 2014 the manager believes that economic growth will accelerate so that equities
will outperform and long-dated bond yields will rise. Therefore, at 1 January 2014 he
places $800m of the $1,000m fund into equities. The remaining $200m is placed into
short dated bonds.
The manager reinvests the dividends and coupons in the respective sectors of the fund
immediately they are received. New money is invested in the 80:20 proportion and the
fund is rebalanced at the end of each quarter. You have the following data:
Fund value Premium income less

claims in quarter
Equities Short bonds starting on:
1 January 2014 800 200 +200
31 March 2014 885 230 +180
30 June 2014 1,030 245 –100
30 September 2014 1,000 230 +150
1 January 2015 1,150 275
Returns (income
Benchmark Returns (% per quarter)
reinvested)
Equities: Bonds: Bonds:
All-Share All-Bonds < 5 years
Quarter 1 10.0 –9.0 –5.0
Quarter 2 –2.0 –15.0 –8.0
Quarter 3 5.7 –3.0 +2.0
Quarter 4 3.5 20.0 +6.0
You should assume that new money is received at the mid-point of the quarter and that
there are no transaction expenses. Ignore taxation.
(i) Calculate the money-weighted rate of return for the fund in 2014. [3]

(ii) Estimate the time-weighted rate of return for the fund in 2014 by calculating the
linked internal rate of return, using quarterly sub-intervals. [3]
(iii) Allocate the difference between the fund’s rate of return and the return on the
benchmark between that which is attributable to stock selection, that which is
attributable to sector (bond v equity) selection, and that which is attributable to
bond duration selection (short v all stocks). You should show the attribution
split for each quarter. [14]
(iv) Comment on the manager’s performance. [8]

[Total 28]
Question 4.12
(i) Describe the distinctive characteristics of the following industry groupings:

(a) industrials
(b) consumer goods
(c) financials. [6]
(ii) For each group in (i), state, with reasons, how you would expect the profits of
companies in the relevant FTSE All-Share subsector index to perform during the
first 12 months of an economic recovery. [9]
[Total 15]
Question 4.13
A financial services group is thinking of offering a “guaranteed” oil and gas sector unit
trust. The trust will pay investors 95% of the investment return generated by the
median unit trust specialising in the oil and gas industry group of the FTSE UK index
over a 5-year period. In addition, it will offer a guarantee that investors will receive all
of the original investment back at the end of five years, should the median unit trust
return be less than zero.
(i) Describe the key features of companies that operate in the oil and gas group. [3]
(ii) Explain why this particular unit trust might appeal to investors. [2]
(iii) Describe two different investment strategies that might be appropriate for this
unit trust and the practical difficulties associated with their adoption. [6]
[Total 11]

Question 4.14
The benchmark for an investment fund is 80% invested in UK equities, as measured by

the FTSE Actuaries All-Share Index, and 20% in cash deposits. The manager of the fund
is allowed to deviate from the benchmark if she believes that it will add to the fund’s
return.
During 2004 the manager believes that equities will outperform. Therefore, at the start
of each quarter (including the first), the fund manager rebalances the fund in the
proportions 90% equities and 10% cash.
The manager reinvests the dividends and interest payments in the respective sectors of
the fund as soon as they are received. The values of the fund at the end of each quarter
before the manager rebalances the portfolio and the new money she receives from the
Trustees each quarter are:
Total fund Fund invested in New money

Equities Cash
1 January 2014 1,000 900 100 100
31 March 2014 1,244 1,130 114 100
30 June 2014 1,337 1,199 138 (100)
30 September 2014 1,360 1,233 127 (100)
1 January 2015 1,197 1,067 130
The performance of the benchmarks (allowing for the reinvestment of income) over the
year are:
Benchmark Returns
UK Equities % Cash % Fund %
Quarter 1 16.7 3.2 14.0
Quarter 2 (1.2) 3.0 (0.4)
Quarter 3 10.7 2.8 9.1
Quarter 4 (5.4) 2.7 (3.8)
Full year 20.7 12.2 19.2

You should assume that:

 new money is received at the mid-point of the quarter
 there are no transaction expenses and that taxation can be ignored
 equity income performance is neutral for 2014.
(i) Calculate the money-weighted rate of return for 2014. [2]
(ii) Calculate the linked internal rate of return for 2014. [4]
(iii) Allocate the difference between the fund’s performance and the benchmark
performance between that attributable to stock selection and that attributable to
sector selection. [4]
(iv) Assess the manager’s performance in the UK equity portion of the fund and
hence comment on the manager. [4]
[Total 14]
Question 4.15
(i) Over a six-month period the Dow Jones Industrial Average has significantly
under-performed the Standard & Poor’s 500 Index. List the main features of
these indices and give possible reasons for the difference in performance. [5]
(ii) Write down a formula for the relationship at time t between the FTSE World
Index (US) denominated in Euro and the FTSE World Index (US) denominated
in US Dollars, in terms of the base levels of the indices at time 0 and the
exchange rate. [3]
[Total 8]
Question 4.16
(i) Define the VIX, in the context of derivatives trading. [2]
(ii) Traditionally, very low values of the VIX have been interpreted as indicating
that the US stock market is over-valued. Many investors believe that very high
values of the VIX indicate that the US stock market is undervalued. Suggest
why this might be the case. [3]
[Total 5]

Question 4.17
(i) Discuss the advantages and disadvantages of measuring investment performance

using market values. [4]
(ii) A European-based investment fund aims to outperform a benchmark fund

allocated equally between the US and UK stock markets. At the start of the
year, the fund’s investment manager was bullish about the prospects for the US
market and so allocated 60% of the total fund value of €1,000 million to that
market, the rest being allocated to the UK market. At the end of the year, the US
element of the fund was worth $777 million, whilst the UK element was valued
at £299 million.
Ignoring tax and expenses, and assuming that there were no net cashflows into
or out of the fund during the year, use the information in the table below to
analyse fully the performance of the investment manager.
UK total return index US total return index

Start-year index value 6,120 11,222
End-year index value 6,328 11,928
Start-year exchange rate £0.70/€1 $1.31/€1
End-year exchange rate £0.68/€1 $1.25/€1
[12]
[Total 16]

Solution 4.1
(i) Ten possible uses for fixed interest yield indices
Ten possible uses for fixed interest yield indices include:

1. to give a description of the average level of yields at the current time
2. to give a description of the shape of the yield curve at the current time (only
possible if average yields for several terms are available)
3. to give a historical record of the average level of yields
4. to give a historical record of the shape of the yield curve
5. to give a record of how the level and shape change over time
6. to give a record of how the yield relationship between stocks of different coupon
levels varies over time (only possible if average yields for different coupons are
available)
7. to measure the yield gap with equities, and thus consider their relative
attractiveness as investments
8. to use as the benchmark interest rate in actuarial calculations (eg valuations and
premium setting)
9. to use as the benchmark with which non-government bond fixed interest yields
can be compared
10. to help set the terms for a new issue of government bonds.
Four possible uses for fixed interest price indices not included above:
1. to use as a benchmark for performance measurement
2. for “asset share” type calculations (eg for an internal fund)
3. to use as a means of approximately valuing assets
4. to compare against historic returns on other assets.
[½ each]

(ii) Issues when constructing property indices
Individual properties are unique and so it is harder to represent the property market. [½]
A lot of data needs to be gathered from different sources. [½]
As trading is rather infrequent, independent valuations need to be used rather than

transaction data. [½]
This leads to greater subjectivity. [½]

[Total 2]
(iii) Calculate total return index and estimate total return
The dividends received during quarter t, div(t), can be estimated using the following
formula:
y (t )
div(t ) = I (t ) ¥
4
where:
 I (t ) = capital index value at end of quarter t
 y (t ) = dividend yield at end of quarter t. [1]
The total return index series can then be calculated using the formula:
È I (t + 1) + div(t + 1) ˘
TRI (t + 1) = TRI (t ) ¥ Í ˙ [1]
Î I (t ) ˚

End of Quarter I (t ) y (t ) , pa div(t ) TRI (t )

1 1,346 3.19% 10.734 1,585.45
2 1,521 2.88% 10.951 1,804.48
3 1,299 3.33% 10.814 1,553.93
4 1,423 3.10% 11.028 1,715.46
[½ for each correct figure in the last two columns]

In the above table, the total return index value at the end of the first quarter is estimated
as:
Ê 1,346 + 10.734 ˆ
1, 428 ¥ Á ˜¯ = 1585.45
Ë 1, 222
The total return over the year can thus be estimated as:
TRI (4) 1, 715.46

-1 = - 1 = + 20.1% [1]
TRI (0) 1, 428
[Total 7]
Solution 4.2
(i) Life insurance company investment performance
Note that similar issues will apply when comparing the investment performance of other
financial institutions.
A life insurance company may be operating under certain constraints because of a

significantly different liability profile compared with other companies. [½]
This could arise because of differing mixes of business between with-profit and non-
profit policies. [½]
In addition, the level of free reserves will influence the investment strategy. [½]
So comparing the performance with other life companies could be misleading. [½]

Comparing the performance of a mutual office and a proprietary office may also give
misleading information. Comparisons with its competitors may lead to an over-
emphasis on short-term performance at the expense of the office’s long-term needs. [½]
Finally, performance data on other insurance companies may be difficult to obtain. [½]
[Total 3]
(ii) Why 16.5% may not be suitable as the basis for assessing fund managers.
If the figure is an internal rate of return, it could be distorted by the timing and amounts
of cash flows, which are typically beyond the control of the fund managers. We
therefore want a time-weighted rate of return. [½]
It is unclear whether the rate has been calculated net or gross of tax. The allowance (if
any) made in the calculation for the taxation of both income and capital gains may not
accurately reflect the actual tax position of the fund. [½]
The fund’s tax position is not necessarily within the control of the fund managers, eg if
it depends upon the mix of business or the tax treatment of expenses. [½]
We need to take account of the objectives of the fund and the constraints on the
investments, eg is there a benchmark portfolio against which performance is to be
measured? [1]
The time period may be too short to assess the manager. [½]
Valuations of certain assets (eg property) may be open to doubt. [½]
Different managers are responsible for different asset categories. Their separate
performances should be considered. [½]
It might be sensible to adjust the figure to allow for the degree of risk taken. [½]
The student might have made a calculation error. [½]

[Total 5]

Solution 4.3
(i) Eight general forms of “exposure”
Forms of “exposure” adversely affecting the profits of a manufacturing or trading

company:
 interest rate increases, which increase the cost of the company’s (variable-interest)
capital
 inflation, which increases input costs
 exchange rate increases, which make exports less competitive and so harder to sell
 exchange rate decreases, which makes imported raw materials more expensive,
thereby increasing productions costs
 technological developments, which make established processes obsolete
 economic recession, which reduces consumer spending and hence demand for the
company’s products
 squeeze on public expenditure, which will reduce sales if the company relies
heavily on sales to the public sector
 the company’s products go out of fashion, again leading to fewer sales
 supply of raw materials or stocks is restricted (various possible reasons).
[½ for each point, including valid alternatives, maximum 4]
(ii) Supermarket chain suffers sharp fall in share price
Possible reasons why a supermarket chain suffers sharp fall in share price when the
economy goes into recession might include:
 relying on higher margin items (ie luxury foods) which are cut back as consumers
feel the pinch [1]
 the company is very highly geared, and so the high fixed interest costs increase the
exposure of the share price to economic turbulence [1]
 if the share price was underpinned by property values (where the company owns
its shops) and property values come down. [1]
 where the company financed expansion through variable interest rate borrowings
and interest rate increases are the cause of recession. [1]
[Maximum 3]
Give 1 for any alternative valid reason.

(iii) List the companies in the services sector
The companies in the services sector are divided into two groups:
1. cyclical
2. non-cyclical. [½]
Those within the cyclical group include:

 general retailers
 transport
 hotel and media companies
 distributors
 restaurants and pubs
 support services. [½ for each, total 3]
Those classified as “non-cyclical include:

 food and drug retailers
 telecommunication services. [½ each, total 1]
Consequences of change of view
If growth is likely to slow, this will favour the less cyclical stocks such as food retailers
(eg Tesco), where demand is relatively stable in all economic conditions. [1]
Companies that are heavily exposed to economic growth such as hotel chains,
restaurants and distributors will perform badly in the new environment. [1]
The caveat is that some of the more defensive companies are likely to have adopted
high levels of financial gearing. This can exaggerate the sensitivity of the company’s
earnings to changes in economic conditions and consequently it may have a high beta.
[½]
Most companies in the services sector are more exposed to the domestic economy,
therefore the international events will have less impact. It is the UK economy that
matters. [1]
Most companies in the services sector are labour-intensive and will be influenced by
levels of salary inflation in the UK. Depending on the reasons for the slowing growth
this may lead to lower salary inflation, which would be good for the sector. [½]
[Maximum 8]

Solution 4.4
(i) State the formula for a capital value index
Â Ni,t Pi,t
i
I (t ) = [1]
B(t )
where:
 Ni ,t is the number of shares issued for the ith constituent at time t,
 Pi ,t is the price of share i at time t, and
 B (t ) is the base value, or divisor, at time t, which is obtained from B(t - 1)

through the chain-linking process. [1]
(ii)(a) Value for index divisor
Applying the formula above at time 0, we have:
Â Ni ,0 Pi ,0
i = X ,Y 200 ¥ 5.12 + 100 ¥ 3.06
I (0) = = = 1, 000
B (0) B(0)
from which B(0) = 1.33 . [1]
(ii)(b) Value of the capital value index at time 1
Again using the formula from (i), but at time 1, gives:
Â Ni ,1Pi ,1
i = X ,Y 200 ¥ 4.68 + 100 ¥ 3.22
I (1) = = = 945.86 [1]
B(0) 1.33
Note that the divisor is unchanged as there have not yet been any changes to the
constituents of the index.

(ii)(c) Value of the capital value index at time 2
The introduction of new Z shares into the market will increase the market capitalisation,
but should not affect the index value, as this should change only in response to
investment performance. Chain linking – to suitably alter the value of the divisor – is
therefore required to accommodate the introduction of the Z shares at time 1. [1]
The divisor must be altered so as to maintain the index value at 945.86 at time 1. Thus,
the new divisor B (1) can be found from (where the summation is over all three
companies):
Â Ni ,1Pi ,1
i = X ,Y , Z
I (1) = 945.86 = [1]
B (1)
Substituting in the relevant numbers thus gives:
200 ¥ 4.68 + 100 ¥ 3.22 + 50 ¥ 2.00 1,358

I (1) = 945.86 = =
B(1) B(1)
ie B (1) = 1.4357 [1]
The index value at the end of the second month (time 2) is therefore:
Â Ni ,2 Pi ,2
i = X ,Y , Z 200 ¥ 4.88 + 100 ¥ 3.52 + 50 ¥ 2.19
I (2) = = = 1, 001.24 [1]
B(1) 1.4357
[Total 6]

Solution 4.5
Suitability of investment performance statistic
It is similar in form to the “pre-specified standard deviation” statistic described in the

notes. It may be suitable if the level of risk has been pre-specified. [1]
The definition of risk includes systematic and specific risk. Therefore it may be a
suitable measure if the fund represents substantially all of the investor’s wealth. It
would not be suitable if it were only a small part of the investor’s wealth because the
specific risk could be diversified away. [1]
Unlike the “pre-specified standard deviation” it uses the (square root of) the semi-
variance of return rather than the standard deviation. This may or may not be
appropriate, depending upon the investor’s utility function. [1]
A downside risk measure such as a the downside semi-variance (or downside semi-
standard deviation) is a better measure if the investor is particularly concerned with
downside risk. [½]
However, the statistic ignores the pattern of returns above the mean. [½]
The time period of 5 years is questionable. It could be too short to distinguish luck
from skill and/or too long if there has been any significant change to the fund (eg a new
manager appointed) during the period. [1]
The choice of the FTSE 100 is questionable as a benchmark. A more diversified index
(eg the FTSE All-Share could be more suitable). [1]
The emphasis on returns relative to any single index is also questionable. It may be
more appropriate to compare the fund against a benchmark that more closely matches
the investor’s liabilities. [1]
The actions of the fund manager may be bound by constraints (eg with regard to
liabilities) that are not allowed for or captured by the use of this summary statistic. [1]
The fund’s returns are likely to be measured net of tax and costs, whereas the index
returns will not be. [½]
[Maximum 8]

Solution 4.6
(i) Main features of indices
(a) FTSE 100 Share Index
Started on 31 December 1983 and based on 100 of the largest companies (by market
capitalisation). Quarterly reviews of composition, but attempts to avoid too frequent
changes. Company dropped if below 110th, and added if 90th or above. [½]
Weighted average arithmetic index, weighted by market capitalisations. [½]
Calculated in real time – ie every minute. [½]
Gives a good guide to the whole market (it accounts for about 80% of the total UK
market by value). Quick to calculate so useful for quick decisions. [1]
Related information given is average net dividend cover, dividend yield, price earnings
ratio, ex-dividend adjustment and total return index. [½]
(b) FTSE All-Share Index
Started in 1962 to monitor market sectors as well as providing a long-term basis for
monitoring (virtually) the whole market. [½]
Index based on a weighted arithmetic average … [½]
… where the weights are adjusted to reflect changes in market capitalisation. [½]
Index calculated daily, along with total return index, dividend yield, ex-dividend
adjustment, net dividend cover and P/E ratio. Figures also given for each of the
individual sectors. [1]
Most appropriate for long-term comparisons and performance measurement, and

analysis of different sectors. [½]
[Total 6]

(ii) Possible uses of indices by investors
The possible uses of indices by investors include:
 as a yardstick for comparing returns from investment managers, and hence as a

basis for assessing good/bad managers (FTSE All-Share in particular)
 to monitor the level of the stock market in the short term (FTSE 100 especially)
 to provide long-term monitoring of the stock market (FTSE All-Share)
 to provide a benchmark for financial futures and options (FTSE 100 and
FTSE 250 only)
 to advertise good performance by fund managers (whichever index puts the

results in the best light)
 to assess the methods of equity investment – for example, to test validity of

efficient market hypotheses
 for use in notional fund calculations (FTSE All-Share especially)
 by fund managers when assessing the components of index tracking funds

(FTSE 100 or FTSE All-Share), and market portfolios (FTSE All-Share
especially)
 by chartists to spot trends by looking for levels of support and resistance, head
and shoulders, triangles
 to calculate asset shares, eg life office work
 analysing sub-sectors of the market (particularly FTSE All-Share) .

[½ for each, maximum 5]

Solution 4.7
Comment
Your solution to this type of open question is greatly enhanced by spending sufficient
time at the planning stage. For example, 12-15 minutes planning and 25-30 minutes
writing might be appropriate. Your approach in planning should be:
(1) note all of the things that you know about performance measurement,
(2) decide which bits are relevant,
(3) put them in a sensible order.
Key points:
 methods you would use to assess the investment performance
– rates of return: internal (money), time-weighted, linked
– comparison methods (notional funds, fund comparisons etc)
 problems (short-term view, property values, other factors)
 the level of risk undertaken by the investor.
Methods used to assess the investment performance
There are several different methods that could be used to “assess the investment
performance”.
For example:
(a) calculate the rate of return achieved [½]
(b) compare with other investment managers [½]
(c) compare with a benchmark index [½]
(d) compare with movements in liabilities (eg salary rises) [½]
(e) calculate risk-adjusted performance figures. [½]
The approach used must depend on the purpose of the assessment. [½]
The most common interpretation is probably (b) above.

The rate of return
There are several alternative approaches:
1. the money-weighted rate of return: gives the rate of return earned by the fund.
By itself, it answers (a) above. Not perfect as a basis for comparison as the
result may be distorted by the incidence of cashflows into and out of the fund,
which is largely beyond the control of the investment manager. [2]
2. the time-weighted return: removes the cashflow distortions above, and therefore
better as the basis of comparison. In practice, unusable as it requires a valuation
each time money enters or leaves the fund. The linked internal rate of return,
based on the compounding of monthly or quarterly internal rates, is a practical
compromise, requiring monthly or quarterly valuations as appropriate. [2]
Comparisons
Again there are several alternative approaches for comparing the performance:
1. Notional funds
The pension fund’s assets are notionally invested in a base portfolio (eg the FTSE All-
Share Index in the UK), and the actual flows of new money into and out of the fund are
mirrored by the notional fund. The use of a notional fund shows the benefit (hopefully)
of paying for an investment manager, rather than passive investment in an index-
tracking fund. The downsides are:
 doesn’t give comparison with other managers’ performance
 special arrangements must be made for expenses and any rebalancing from a
differently performing fund. [3]
2. Pension fund performance measurement services
Investment returns from many different pension funds are compared. For the reasons
given in (1) and (2) above, the rate to be used should be the linked internal rate of
return. This system is dependent on sufficient funds participating, and supplying
appropriate information. The advantage of this is that we will see how well the
investment manager has used the assets compared with other fund managers. This is the
method that is most sensibly used, but there are a number of difficulties, as listed below.
[2]

Difficulties
1. Pension fund investment should be aimed at long-term returns. This type of

performance measurement makes managers focus on short-term results. [1]
2. Some assets (eg property) are difficult to value, thus making performance
measurement and comparison between funds difficult. Short-term measurement
is particularly inappropriate since buying/selling opportunities are rare. [1]
3. Different pension funds have different circumstances, and these may affect the
investment policy and/or returns produced. [½]
Examples of these are:
 incidence of cashflows (which shouldn’t disturb the linked internal rate
of return so much) [½]
 some companies may need to hold more liquid assets (eg declining fund,
company taking contribution holiday, bulk transfers, etc) [½]
 size of fund [½]
 level of surplus or deficit [½]
 nature of liabilities (fixed/real, term, etc) [½]
 level of risk accepted by and constraints imposed by trustees. [½]
Risk
The level of risk adopted is difficult to quantify, but it could be assessed by:
 the volatility of performance [½]
 the beta of the portfolio [½]
 the amount of specific risk (using the CAPM) [½]
 subjective assessment of:
– the degree of diversification [½]
– the extent to which the assets match the liabilities. [½]
The following risk-adjusted figures could be calculated depending upon whether or not
the level of risk was pre-specified.

The Sharpe measure
This is a measure of reward per unit total risk defined as:
Rp - r
T =
sp
where:
 R p is the return on the portfolio;
 r is the risk-free rate of return over the period;

 s p is the standard deviation of return over the period. [2]
Pre-specified standard deviation
If the standard deviation of the portfolio return is pre-specified the return on the
benchmark portfolio is given by:
Rm - r
Rb = r + sp (m subscripts refer to the market)
sm
and the differential return measure is R p - Rb . [2]
Measures based on systematic risk
Similar risk-adjusted measures to the two given above based on beta rather than
standard deviation of return are possible. These might be appropriate if the pension
fund’s assets were managed by a number of managers. [1]
[Maximum 22]

Solution 4.8
(i) Calculations
We first need to calculate the b ’s of the two investment trusts using:
Cov ( Ri , Rm )
bi =
Vm
0.81 ¥ 0.24 ¥ 0.22

bA = = 0.88 [½]
0.222
0.4 ¥ 0.6 ¥ 0.22

bB = = 1.09 [½]
0.222
Investment Trust A
0.16 - 0.1
Treynor measure = 0.07 [½]
0.88
0.16 - 0.1
Sharpe measure = 0.25 [½]
0.24
Jensen measure 0.16 – (0.1 + 0.88 ¥ (0.15 - 0.1)) = 0.016 [½]
Ê 0.15 - 0.1 ˆ
Pre-specified SD 0.16 – Á 0.1 + ¥ 0.24˜ = 0.005 [½]
Ë 0.22 ¯
Investment Trust B
0.17 - 0.1
Treynor measure = 0.06 [½]
1.09
0.17 - 0.1
Sharpe measure = 0.12 [½]
0.6
Jensen measure 0.17 - (0.1 + 1.09 ¥ (0.15 - 0.1)) = 0.016 [½]
Ê 0.15 - 0.1 ˆ
Pre-specified SD 0.17 - Á 0.1 + ¥ 0.6˜ = -0.066 [½]
Ë 0.22 ¯
[Total 5]

(ii) Which Investment Trust?
Investment Trust A outperforms on both measures based on the standard deviation of

return (ie Sharpe and Pre-specified SD). The two measures based on systematic risk
(ie Treynor and Jensen) give very similar results. [1]
If the investment trust(s) are held as the sole asset of the pension fund then it is
appropriate to consider the total risk. Investment Trust A is then preferred because it is
much less risky than Investment Trust B in standard deviation terms. [1]
If the investment trust(s) are held as a small part of the pension fund’s investments the
high specific risk of Investment Trust B will be diversified away. In this case it is
appropriate to focus on systematic risk only. It is then not clear that Investment Trust A
would be preferred because the Treynor and Jensen measures are both so close for the
two investment trusts. More information would be needed to reach a firm conclusion.
[1]
Limitations
The data is based on the last five years. There is no guarantee that the same
relationships will hold in the future. For example, there may be changes in the way in
which the investment trusts are run. (It may be that the only reliable information that
this data gives us is that Investment Trust B has been riskier than Investment Trust A.)
[1]
We are not told how the returns have been calculated (eg what allowance has been made
for expenses, tax paid by the trusts, etc). [1]
We have not considered the suitability of the trust for the fund’s liabilities. [1]
The Treynor and Jensen measures rest on the validity of the capital asset pricing Model.
[1]
[Total 7]

Solution 4.9
Comment
Perhaps the hardest part of this question was trying to establish what was going on.
With any notional fund calculation question it is critical that you clarify what the
cashflows are, and which cashflows are included in the fund value. Once you have
worked out what is going on, it should be easy to get most of the 18 marks available.
(i) Calculate rates of return
Value of fund on 1.1.14 before additional units:
= 1,0001.00 = 1,000.00 [½]
Money raised by additional units created 1.1.14:
= 1201.00 = 120.00 [½]
Money paid out in respect of units destroyed 1.7.14:
= 471.05 = 49.35 [½]
Value of fund on 1.1.15 before additional units:
= (1,000 + 120 – 47)  1.25 = 1,341.25 [½]
Time-weighted rate of return
For a unitised fund (with no tax complications) this is just the growth in unit price
(because the unit price is unaffected by cashflows): 25% [1]
Internal rate of return (or money-weighted rate of return)
This is the solution, i, to the equation of value:
1,000(1+i) + 120(1+i) – 49.35(1+i)½ = 1,341.25 [1]
Using the approximation (1 + i ) ª (1 + it ) gives:

t
1,095.3i = 270.6  i = 24.7% [1]

Reasonableness check
Based on the capital gain provided by the index and the average dividend yield across
the year of about 6%, we would expect the answer to be about:
0.974  1.203  1.06 = 1.24 (ie 24%) [1]
Linked internal rate of return
Since no cashflows occurred during the six-monthly sub-intervals of time, the linked
internal rate of return (using six-monthly sub-intervals) will be the same as the time-
weighted rate of return. [1]
Explanation of differences
The fund’s best performance came in the second six-month period when there were
fewer units. The internal rate of return is affected by the timing of net cashflows into
the fund (unlike the time-weighted return).
Since money was disinvested after 6 months the internal rate of return was more
influenced by the first six months than the second. Consequently the internal rate of
return was lower than the time-weighted return. The difference was small since the
cashflow on 1 July 2014 was reasonably small relative to the size of the fund. [2]
[Total 9]
(ii) Comparison against a notional fund
We want to calculate: [½]
Performance based on Performance based on

actual income and – notional income and
actual capital notional capital
appreciation appreciation
The first term was calculated in part (i) (ie 1,341.25). [½]
The second term is calculated as:
Value of notional fund on 1.1.14: = 1,120.00 [½]
Value of notional fund on 1.7.14 prior to cashflows:
= (1 - 0.026) ¥ 1,120 = 1, 090.88 [1]

Estimated value of notional income received 1.7.14:
0.063
1, 090.88 ¥ ¥ 0.75 = 25.77 [1]
2
Here the investment income received during the first half year has been estimated from
the gross dividend yield, allowing for the 25% tax rate.
Value of net new money received 1.7.14: = –49.35 [½]
Value of notional fund on 1.7.14 after cashflows: = 1,067.30 [1]
Value of notional fund on 31.12.14 prior to cashflow:

= 1.203  1,067.30 = 1,283.96 [1]
Estimated value of notional income received 31.12.14:
0.054
1, 283.96 ¥ ¥ 0.75 = 26.00 [1]
2
This has been estimated in the same way as for the first half year.
Value of notional fund on 1.1.15 after income (before new units) = 1,309.96 [½]
So the actual fund outperformed the notional fund by:
1341.25 – 1,309.96 = 31.29 [1]
This can be expressed as a % of the market value at the beginning of the year plus
weighted new money invested:
31.29  (1,000 + 120 – ½  49.35) = 2.9% [½]

[Total 9]

Solution 4.10
(i) Net asset value
The net asset value per share may have the advantage from a performance measurement
viewpoint of being less volatile than the share price and so the results obtained may be
less dependent on the time period considered. [½]
The net asset value of a company may also be a useful measure of performance for
those companies whose shares are unquoted and so do not have a market price. [½]
Net asset value suffers from the fact that it is based on accounting data. The asset
values recorded in the balance sheet may not reflect the true values of the assets owned
by the company. [½]
In addition, much of the value of a company is not reflected in the asset values that
appear in the accounts as items such as human capital and internally generated goodwill
are not recorded on the balance sheet. [½]
The net asset value may, however, be a useful indicator of performance for investment
and property company shares, most of whose value is based on tangible underlying
investments and so the above issues are likely to be less problematic. [½]
Net present value
As a measure of performance, the net present value of a share has the disadvantage that
it depends upon many assumptions regarding future cashflows and the risk discount rate
used to calculate it. It is therefore extremely subjective. [½]
Also, changes in the net present value over time may largely reflect changes in the
underlying assumptions rather than changes in the true value of the asset. [½]
The net present value will also generally differ from the market price (where there is
one), in which case it is important to consider exactly why this is the case. Also, the
market price will ultimately need to be used for investment performance calculations if
the shares are sold. [½]
Changes in the net present value may, however, be a useful indicator of performance for
shares that do not have a market price. [½]
[Maximum 4]

(ii) Current performance-related element
Providing a substantial performance-related element to earnings is intended to provide

the executives with a significant incentive to ensure that the company performs well. [½]
More specifically, providing this performance-related element in the form of share

options helps to align the interests of the executives with those of the shareholders, who
will want the executives to maximise the market price of the company’s shares on their
behalf, which will in turn increase the value of the share options. [1]
Providing new five-year options each year will focus the executives’ attention on the
longer term and so avoid the pursuit of too short-term a management strategy [½]
In addition, if the options have to be surrendered on leaving, then they can help retain
successful executives, by providing an incentive not to leave before the options have
been exercised. [½]
Reluctance to replace current arrangement with RAROC-based approach
You might be reluctant to replace the current scheme with one based on the risk-
adjusted return on capital (RAROC) because you are aware that in practice RAROC is
likely to be extremely difficult to calculate with any degree of confidence. [½]
In particular, the determination of the capital employed within this company would be
very difficult, as the majority of the company’s assets are likely to be intangible
(eg contracts with clients). Even if intangible assets (goodwill) are covered by
accounting standards, there will be still be a fair degree of subjectivity required to
implement those standards. [½]
In addition, the executives are likely to be better placed to assess and potentially
influence any such asset valuations than non-executive directors, who may have
insufficient insight to verify their reasonableness. [½]
Furthermore, the riskiness of the company (as indicated by the beta of it shares) could
be difficult to estimate accurately, particularly as the company has recently expanded
rapidly and now provides a wider range of services than previously and so its beta is
likely to have changed. [½]
This in contrast to the share price itself, which is objectively determined by the
marketplace and difficult for the executives to legally manipulate. [½]

Reluctance to replace current arrangement with profit-based approach
Likewise, profits could possibly be manipulated upwards by the executives, at least in

the short term, to maximise their short-term gains in a way that is inconsistent with the
long-term interests of the shareholders. [½]
For example, assets could be sold and/or cutbacks made that boost short-term profits,
but which could make further long-term growth more difficult and/or expensive, eg if
they need to be reversed in order to enable subsequent expansion. [½]
Alternatively, less conservative accounting policies could be adopted, whilst keeping

within the letter of accounting standards and/or the law, that lead to higher apparent
profits. [½]
Over the longer term, the desire for higher profits might lead the executive to an over-
aggressive expansion of the company so as to increase total profits, without allowing for
the opportunity costs to the shareholders of doing so, ie without considering the amount
of capital that shareholders have had to invest to achieve the profits. [½]
A further possible drawback is that using profits as the measure of performance ignores
the level of risk taken to generate those profits. It may therefore encourage the
executives to adopt a more risky management approach than the shareholders would
like in order to boost profits. [½]
Finally, you may also be suspicious of the executive’s motives for changing the bonus
scheme. Presumably, they wish to do so because they think it in their interests to do so,
so as to increase their earnings. However, as a non-executive director, one of your key
roles is to represent the interest of shareholders on the board and thereby minimise the
agency costs of employing managers. [1]
[Maximum 8]

Solution 4.11
This question requires a lot of calculations. However if you:

 know what to do, and
 set out your answer in a systematic way
it is possible to do the number crunching quite quickly.
A question very similar to this appeared on the April 2004 Subject 301 Exam paper.
(i) Money-weighted return
1000(1 + i ) + 200(1 + i )0.875 + 180(1 + i )0.625 - 100(1 + i )0.375 + 150(1 + i )0.125 = 1,425 [1]
Using the approximation (1 + i ) ª (1 + it ) :

t
 1,430 + 1,268¾i = 1,425 [1]
 i = –0.39% pa [1]
[Total 3]
(ii) Linked internal rate of return
MWRR over each quarter:
Q1 1,000(1+i1) + 200(1+i1)½ = 1,115  i1 = –0.07727 [½]

Q2 1,115(1+i2) + 180(1+i2)½ = 1,275  i2 = –0.01660 [½]
Q3 1,275(1+i3) – 100(1+i3)½ = 1,230  i3 = +0.04490 [½]
Q4 1,230(1+i4) + 150(1+i4)½ = 1,425  i4 = +0.03448 [½]
LIRR = (1+i1)(1+i2)(1+i3)(1+i4) – 1
= 0.980848 – 1 ie –1.92% pa [1]

[Total 3]

(iii) Attribution analysis
(1) Notional sector, notional duration (ie all bonds), notional individual stocks
Q1 0.6  10 + 0.4  –9 = +2.4% [1]

Q2 0.6  –2 + 0.4  –15 = –7.2% [1]
Q3 0.6  5.7 + 0.4  –3 = +2.22% [1]
Q4 0.6  3.5 + 0.4  20 = +10.1% [1]
Total for year [from (1+r1)(1+r2)(1+r3)(1+r4) – 1 ] = +6.9%
(2) Actual sectors, notional duration (ie all bonds), notional individual stocks
Q1 0.8  10 + 0.2  –9 = +6.2% [1]

Q2 0.8  –2 + 0.2  –15 = –4.6% [1]
Q3 0.8  5.7 + 0.2  –3 = +3.96% [1]
Q4 0.8  3.5 + 0.2  20 = +6.8% [1]
Total for year = +12.5%
(3) Actual sectors, notional short bonds (< 5 years index), notional individual stocks
Q1 0.8  10 + 0.2  –5 = +7% [1]

Q2 0.8  -2 + 0.2  –8 = –3.2% [1]
Q3 0.8  5.7 + 0.2  2 = +4.96% [1]
Q4 0.8  3.5 + 0.2  6 = +4% [1]
Total for year = +13.1%
(4) Actual sectors, actual short bonds (< 5 years), actual individual stocks
These have already been calculated in part (ii):
Q1 –7.7% Q2 –1.7% Q3 +4.5% Q4 +3.4%
Total for year = –1.9%

Returns
Excess over benchmark (% per quarter)
(income reinvested)
Sector Bond duration Stock Total for
(bond v (all stock v selection period
equity) 5 year)
Quarter 1 +3.8 +0.8 –14.7 –10.1
Quarter 2 +2.6 +1.4 +1.6 +5.5
Quarter 3 +1.7 +1 –0.5 +2.3
Quarter 4 –3.3 –2.8 –0.6 –6.7
Total for year +5.6 +0.6 –15 –8.9
[2 for figures in table]
Sector selection profit due to bond equity mix is: (2) – (1)
Profit due to selection of short-dated (instead of all) bonds is: (3) – (2)
Stock selection profit is: (4) – (3)
(due to choice of actual equities and short-dated bonds)
Total out-performance profit is: (4) – (1)
[Total 14]
(iv) Comment
The manger was sensible to go over-weight in equities. [1]
The decision to go (relatively) overweight in short-dated bonds compared with a

mixture of short-dated and long-dated bonds was also profitable, but only by a small
amount. [1]
However, the manager’s individual stock selection was very poor in Quarter 1. So,
despite the good sector allocation decisions the result was an overall under-performance
against the benchmark. [1]
Overall, the manager has under-performed significantly despite mismatching the

benchmark and being overweight in the best-performing asset category. [1]
Also, the performance was fairly irregular over the year. The overall performance was
very largely attributable to poor stock selection in the first quarter (and, to a lesser
extent, poor sector choice in the last quarter). [1]

Given the large stock selection loss it would have been better if the manager had:
 simply tracked the equity index, or:
 kept more in bonds (to avoid equity stock selection losses)
 employed someone else to choose stocks [1]
To some extent the sector profit for being overweight in equities is expected as
compensation for the extra risks involved. (Although this is not true of his decision to
invest in short-dated, rather than long-dated, bonds.) [1]
It is difficult to draw definitive conclusions from one year’s data. However, the large
degree of stock selection loss in the first quarter suggests a worryingly large deviation
from the All-Share index. It may also indicate a lack of skill and/or risk control
procedures. [1]
[Total 8]
Solution 4.12
(i) Distinctive characteristics
(a) Industrials
This group includes companies in industries such as construction, engineering and

industry support services. [½]
Such industries are often very cyclical. They are heavily dependent upon economic
investment which itself is very volatile. [½]
These companies’ profits may move ahead of the trade cycle. [½]
As profits are volatile anyway, gearing levels are usually very low. [½]
Industrials can require a lot of costly machinery, ie they are often capital intensive. [½]
Some industries are more labour intensive (eg aircraft production). [½]

Other common features are:

 large unit size of contracts (which are often sponsored by the government) [½]
 long term of the contracts means that accounting bases will affect the emergence
of profit [½]
 profit margins can be high. [½]
(b) Consumer goods
This sector includes manufacturers of consumer durables (eg furniture and electrical
goods) and non-durables (eg food and drink). [½]
Business (particularly in durables) can be sensitive to consumer expenditure. Interest

rates and employment prospects are therefore important. [½]
Less volatile than general industrials and smaller unit size. [½]
Profit margins can be low so efficiency and capacity utilisation is important. [½]
Moderate to high gearing. [½]
Brand names important. [½]
Increasingly international. [½]
(c) Financial group
Includes banks, life and general insurance companies. [½]
Often very highly-geared (eg banks) so profits for shareholders can be very volatile (the
profits from banks in the 1980s and 1990s illustrate this well). [½]
They are generally capital intensive and sensitive to (real) interest rates – a key factor is
often the difference between lending and borrowing rates. [½]
Other than the cost of capital, staff costs will be the main component of the costs. [½]
[Maximum 6]

(ii) How the profits will perform in first 12 months of economic recovery
(a) Industrials
Investment demand is likely to pick up quickly in the early stages of recovery. Firms will
purchase capital goods (machinery, etc) to meet the new level of demand and anticipated
higher future demand. [1]
The “multiplier” and “accelerator” effects should gear up the increase in demand for
capital goods. This could generate a big increase in profits. However, 12 months may
not be long enough to see all of these effects. [1]
For companies with high fixed costs, increased demand could have a big impact on
profits. [1]
(b) Consumer goods
As consumer confidence returns, there should be an increase in the demand for consumer
goods. [1]
Profits should therefore improve … [½]
… although the increase will probably be less marked than for general industrials. [½]
International factors (eg the extent to which increased imports meet the higher demand)
will have a bearing on the recovery of this group. [1]
(c) Financial groups
This is more difficult to predict as there may be compensating factors. [½]
Reduced bad debts and increased demand for investment funds should help banks’ profits.
[1]
Changes in the propensity to save may push profits one way or the other. Greater
consumption could lead to lower saving which would not help profits of banks or life
offices. However, there might also be more willingness to start long-term savings plans.
[1]
Higher interest rates (possible if the government worries about inflation) might give banks
an opportunity to widen margins. [1]
But the recovery might have been triggered by lower rates! [½]
[Maximum 9]

Solution 4.13
(i) Key features of companies in the oil and gas industry
Companies that operate in the oil and gas industry are involved in the extraction and
supply of oil and gas products used throughout industry. [1]
Their key characteristics include:

 They are typically large companies, often operating in more than one country,
although smaller and more specialist firms do exist. [½]
 They are often global, in the sense that they supply their products in many
different countries and so are exposed to the fortunes of the world economy as a
whole. [½]
 They are often risky, as their profitability is heavily dependent on the
unpredictable discovery of new deposits of resources and the demand for their
products, which may be reduced by the discovery of new alternative energy
sources. [½]
 Their profitability is linked closely to the level of commodity prices, which can
often fluctuate quite markedly. [½]
[Total 3]
(ii) Why this unit trust might appeal to investors
This unit trust might appeal to investors who wish to gain exposure to the resources
sector, but with as little downside risk as possible, given the inherently risky nature of
the sector, ie it might appeal to risk-averse investors who desire exposure to this sector.
[1]
This fund will offer low-risk exposure to the sector because:

 of the guarantee, which means that, at the very least, investors are certain to get
their initial investment back after five years (assuming the financial services
group does not go bust!) [½]
 by essentially tracking the median of resource sector unit trusts, the fund should
offer a widely-diversified exposure to the sector, thereby minimising as far as
possible specific risk and reducing the volatility of investment returns. [½]
[Total 2]

(iii) Investment strategies
One investment strategy might involve investing the money subscribed into a suitable
combination of five-year zero-coupon bonds and over-the-counter call options based on
a resources sector unit trust index. The zero-coupon bonds guarantee the return of no
less than 95% of the initial investment, whilst the call options offer the required upside
exposure should the index end higher in five years’ time. [1]
Alternatively, if zero-coupon bonds are unavailable then cash deposits and/or money
market securities could be used instead. [½]
A second approach could involve buying units in resources sector unit trusts and also
five-year over-the-counter put options, based on suitable unit trust index. If the units
increase in value then the puts would expire worthless, whereas if the units fell in value
over the five-year period, the puts could be exercised to sell them at a fixed price,
thereby returning 95% of the initial investment. [1]
Practical difficulties
The practical difficulties associated with the adoption of one of these strategies include:
 The over-the-counter options required would need to be privately negotiated

with an investment bank, which would lead to a (small) counterparty risk. [½]
However, the unusual nature of the underlying assets combined with the five-
year term means that investment banks may be unwilling to offer them. [½]
For example, there may not be a suitable unit trust index on which to base the
options. [½]
In addition, if such options are available, their somewhat unusual nature means
that they are likely to prove relatively expensive. [½]
 If five-year options are unavailable then shorter-term options would need to be

used. These would need to be rolled over, leading to higher expenses. [½]
 If money market instruments are used, they will not offer a guaranteed return
over the five-year period. Instead they will involve some re-investment risk. [½]
 The rankings of the unit trusts may change frequently. In addition, the
underlying assets held by the median unit trust will not be known at all times.
Therefore it would prove impossible to track the performance of the median unit
trust exactly. [1]
The information that is available is likely to be both infrequent and out-of-date
by the time it is made available. [½]

 The fees obtained by deducting 5% of the total return from investors may be
insufficient to cover both the cost of the options and the up-front capital
investment required when the fund is first set up. [½]
[Maximum 6]
Solution 4.14
(i) Money-weighted rate of return
1000(1 + i ) + 100(1 + i )0.875 + 100(1 + i )0.625 - 100(1 + i )0.375 - 100(1 + i )0.125 = 1,197
Using (1 + i )t ª (1 + it ) :
1,000 + 1,100i = 1,197
ie i = 17.91%
[2 for correct answer & method]
[1 for correct method, but incorrect answer]
(ii) Linked internal rate of return
1000(1 + i1 ) + 100(1 + i1 )0.5 = 1, 244  i1 = 0.13714
1244(1 + i2 ) + 100(1 + i2 )0.5 = 1,337  i2 = –0.00541
1337(1 + i3 ) - 100(1 + i3 )0.5 = 1,360  i3 = 0.09557
1360(1 + i4 ) - 100(1 + i4 )0.5 = 1,197  i4 = –0.04809
Note that these figures have also been calculated using the approximation used in (i).
So:
LIRR = (1 + i1 )(1 + i2 )(1 + i3 )(1 + i4 ) – 1 = 17.95%
[4 for correct answer & method]

[2 for correct method, but incorrect answer]

(iii) Stock and sector selection
The benchmark performance is given in the question as 19.2%. We need to calculate

the time-weighted return on a notional fund using the actual sector split (ie 90/10).
Rebalance at the end of each quarter in line with actual re-balancing decision.
0.9  1.167 + 0.1  1.032 = 1.1535

0.9  0.988 + 0.1  1.030 = 0.9922
0.9  1.107 + 0.1  1.028 = 1.0991
0.9  0.946 + 0.1  1.027 = 0.9541
Giving:
1.1535  0.9922  1.0991  0.9541 – 1 = 20.02%
[1 for method, 1 for numbers (deduct ½ for each mistake)]
Sector selection = 20.02 – 19.20  0.8% profit [1]

Stock selection = 17.95 – 20.02  2.1% loss [1]
Alternative answer using notional funds, has fully notional fund of 1,208.1 (or 1,209.5
using overall figures given in question). The notional fund with actual sectors is
1,218.7 (which builds up as follows: Q1 1,260.9, Q2 1,350.7, Q3 1,379.7).
[Total 4]
(iv) Equity assessment
Calculation of linked internal rate of return on equity portion (assuming new money
invested in 90:10 split and again using the approximation from (i) above).
900(1 + i1 ) + 90(1 + i1 )0.5 = 1,130  i1 = 0.14815
(0.9 ¥ 1, 224)(1 + i2 ) + 90(1 + i2 )0.5 = 1,199  i2 = –0.00910
(0.9 ¥ 1,337)(1 + i3 ) - 90(1 + i3 )0.5 = 1,233  i3 = 0.10334
(0.9 ¥ 1,360)(1 + i4 ) - 90(1 + i4 )0.5 = 1,067  i4 = –0.05683
LIRR(equities) = (1 + i1 )(1 + i2 )(1 + i3 )(1 + i4 ) – 1  18.4%
[1 for method, 1 for numbers (deduct ½ for each mistake)]

Comment
 Her choice of individual equities was poor (18.4% v 20.7%).
 Equity stock selection under-performance is capital under-performance (we are

told that income performance was neutral for equities)
 She did particularly badly when share prices increased a lot (Q1 and Q3).
 Sector selection seems good (0.8% profit).
 But, you might expect an overweight equity position to generate higher returns.
So, the sector selection profit may be “fair return for risk”, rather than skill.
[½ for each point, maximum 2]

[Total 4]
Solution 4.15
(i) Main features of Dow Jones
 It is an unweighted arithmetic index. [½]

 It includes just 30 shares [½]
 It consists largely of stocks in the industrial sector and is not representative of
the US equity market as a whole. [½]
Main features of S&P 500
 It is a market capitalisation weighted arithmetic index. [½]

 It is made up of 500 shares. [½]
 The 500 are the leading companies in the USA representing a broad cross-
section of all sectors of the market (for which sub-indices are produced). [½]

Reasons for difference in performance
The difference in the constituents may partly explain some of the divergence. For
example, the best performing stocks may have been:
 mid-size companies that are too small for the Dow but appear in the S&P 500
 from non-industrial sectors, and so are not included in the Dow. [1]
The difference in the calculation method may also be relevant. The Dow gives most
weight to the companies with the highest prices whereas the S&P 500 gives more
weight to those companies with larger market capitalisation. It is possible that within
the stocks in both indices the larger market capitalisation stocks performed best. [1]
[Total 5]
(ii) Formula for the relationship between the indices
The formula is as follows:
($ per € )0 I ( € )0
I ( € )t = I ($)t ¥ ¥
($ per € )t I ($)0
where:
 I ( X )s = index at time s in Currency X
 t = current time
 0 = base date for indices [3]

Solution 4.16
(i) Define the VIX
The full name of the VIX is the Chicago Board Options Exchange Volatility Index. [½]
It is essentially a weighted average of prices for a range of 30-day expiry put and call
options on the S&P 500 index. [½]
Intuitively, the level of the index, which is quoted in annualised percentage terms, is the
risk-neutral expectation of the volatility on the S&P index over a 30-day period. [½]
It is typically used as an indication of the market perception of risk. [½]

[Total 2]
(ii) Suggest why this might be the case
A high value for the VIX indicates a high level of market volatility and that investors
are relatively concerned about market risk. [½]
The US stock market typically tends to rise slowly for long periods of time, which are
punctuated by shorter but more rapid falls in value. [½]
The volatility of the stock market therefore tends to be greater in times of stock market
decline (ie in a bear market) than when it is rising (ie in a bull market). [½]
Consequently, the value of the VIX tends to be lower when the market is following a
rising trend and higher when stock prices are falling. [½]
Hence, a lower value of the VIX may indicate that the US stock market has risen too
high (as investors are relatively unconcerned about risk) and hence is over-valued. [½]
Conversely, a very high value for the VIX may indicate that the stock market has fallen
too rapidly (because investors are over-worried about risk) and hence that the US stock
market is under-valued. [½]
[Total 3]

Solution 4.17
(i) Advantages of measuring investment performance using market values
 Market values are objective. [½]
 Market values are easily and cheaply obtainable for quoted securities. [½]
 The use of market values is easy to justify and explain to non-experts. [½]
 Market values reflect the realisable values of investments and so are of particular
relevance if the investments may be sold. [½]
Disadvantages of measuring investment performance using market values
 The market value represents the market’s best estimate of the value of future
cashflows to the average investor. However, this may not be a reflection of the
true value of the investment to the particular investor. [1]
 Market values can be very volatile and so the results obtained will be very
sensitive to the exact time period considered. [½]
 Market values are not available for unquoted investments and will therefore
need to be estimated subjectively. [½]
[Total 4]
(ii) Analyse fully the performance of the investment manager
The actual weights allocated to the UK and US stock markets were:

wUKA = 0.4
wUSA = 0.6
The notional weights allocated to the UK and US stock markets were:

wUKN = 0.5
wUSN = 0.5
Working in Euro, the actual return achieved on the UK element of the fund was:
rUKA =
(299 / 0.68) - 1 = 0.09926 ie +9.926% [1]
400

Similarly (and again working in Euro), the actual return achieved on the US element of
the fund was:
rUKA =
(777 /1.25) - 1 = 0.03600 ie +3.600% [1]
600
During the year, Sterling appreciated by:
0.70
rUKC = - 1 = 0.0294 ie by 2.94%
0.68
During the year, the US Dollar appreciated by:
1.31
rUSC = - 1 = 0.0480 ie by 4.80%
1.25
The notional return due to currency appreciation was therefore:
rCN = wUKN ¥ rUKC + wUSN ¥ rUSC = 0.5 ¥ 2.94 + 0.5 ¥ 4.80 = 3.87% [1]
Allowing for both the increase in the value of the UK stock market index and the
appreciation of Sterling against the Euro, the notional return on investment in UK
equities (in Euro terms) was:
6,328 0.70
rUKN = ¥ - 1 = 0.06440 ie +6.440% [1]
6,120 0.68
Likewise, allowing for both the increase in the value of the US stock market index and
the appreciation of the US Dollar against the Euro, the notional return on investment in
US equities (in Euro terms) was:
11,928 1.31
rUSN = ¥ - 1 = 0.11393 ie +11.393% [1]
11, 222 1.25
The overall return on the actual investment fund (with actual sectors and actual stocks)
was:
rAA = wUKA ¥ rUKA + wUSA ¥ rUSA
= 0.4 ¥ 9.926 + 0.6 ¥ 3.600
= +6.13% [1]

The overall return on the benchmark investment fund (with notional sectors and
notional stocks) was:
rNN = wUKN ¥ rUKN + wUSN ¥ rUSN
= 0.5 ¥ 6.440 + 0.5 ¥ 11.393
= +8.92% [1]
The return on a notional fund with actual sectors and notional stocks was:
rNN = wUKA ¥ rUKN + wUSA ¥ rUSN
= 0.4 ¥ 6.440 + 0.6 ¥ 11.393
= +9.41% [1]
So:
 the overall profit was: rAA - rNN = 6.13 - 8.92 = -2.79% [½]
 the overall stock selection profit was: rAA - rAN = 6.13 - 9.41 = -3.28% [½]
 the overall sector selection profit was: rAN - rNN = 9.41 - 8.92 = +0.49% [½]
The contribution of the UK stock market to the overall stock selection profit (including
the effect of the currency appreciation) was:
wUKA ¥ (rUKA - rUKN ) = 0.4 ¥ (9.926 - 6.440) = +1.39% [½]
The contribution of the US stock market to the overall stock selection profit (including
the effect of the currency appreciation) was:
wUSA ¥ (rUSA - rUSN ) = 0.6 ¥ (3.600 - 11.393) = -4.68% [½]
The contribution of the UK stock market to the overall sector selection profit was:
( wUKA - wUKN ) ¥ (rUKN - rNN ) = (0.4 - 0.5) ¥ (6.440 - 8.92) = +0.25% [½]
The contribution of the US stock market to the overall sector selection profit was:
( wUSA - wUSN ) ¥ (rUSN - rNN ) = (0.6 - 0.5) ¥ (11.393 - 8.92) = +0.25% [½]

The contribution of the appreciation of Sterling to the overall sector selection profit
was:
( wUKA - wUKN ) ¥ (rUKC - rCN ) = (0.4 - 0.5) ¥ (2.94 - 3.87) = +0.09% [½]
The contribution of the appreciation of the US Dollar to the overall sector selection
profit was:
( wUSA - wUSN ) ¥ (rUSC - rCN ) = (0.6 - 0.5) ¥ (4.80 - 3.87) = +0.09% [½]
[Maximum 12]

Question 5.1
Explain in detail what is meant by asset pricing, what asset pricing models are used for
and the main categories of asset pricing models in existence. [9]
Question 5.2
An investment fund invests entirely in equities. The trustees of the fund, want to
analyse the likelihood of the market value of the assets being insufficient to meet the
value of the liabilities on discontinuance at any time in the next ten years, and on the
assumption that they maintain their 100% equities policy. You have been asked to help
the trustees with this investigation.
Suggest how you might project the market value of the assets in order to compare
against the projected liability valuation. [6]
Question 5.3
An insurance company with an undistinguished investment record has appointed you to

develop a structured approach to the investment process.
(i) Discuss briefly the features of the liabilities that need to be taken into account
when determining an appropriate investment strategy. [4]
(ii) Outline the five main financial risks the institution faces and suggest suitable
guidelines for controlling these risks. [16]
[Total 20]
Question 5.4
(i) Define market risk and explain how value at risk may be used to help control it.
[4]
(ii) Discuss the use of dynamic liability benchmarks. [3]

[Total 16]

Question 5.5
(i) List five active fund management styles and briefly describe what differentiates
each style from another. [6]
(ii) A UK equity unit trust manages its investments as follows:

 approximately 75% of the fund by value is invested passively to track the
FTSE 100 index
 the remainder of the fund is actively invested in a range of non-FTSE 100
UK equities.
Give possible reasons why the unit trust’s managers may have chosen to
structure its investment portfolio in this way. [6]
[Total 12]
Question 5.6
Describe how a stochastic model can be used in asset liability modelling to assess the
long-term solvency position of a pension fund. [4]
Question 5.7
(i) A bond investor is considering switching between the following two bonds:
 Treasury 3% Sept 2025, clean price 115.10, Gross Redemption Yield
(GRY) = 1.42%
 Treasury 2.5% Apr 2025, clean price 109.23, GRY = 1.51%
Describe the type of switch the investor is undertaking and the investigations
that the investor may make before undertaking this switch. [5]
(ii) A second investor is considering the following switch:

 switch from Treasury 3% Sept 2025, clean price 115.10, GRY = 1.42%
 into Treasury 2.25% Nov 2045, clean price 98.11, GRY = 2.30%
Describe the type of switch the investor is undertaking and the reasons why this
investor may be considering the switch [5]

(iii) An investment manager has inherited a fixed interest portfolio that is invested
entirely in long-dated conventional government bonds. He believes that the
market’s expectation on inflation is far too low.
List four actions that he might take to alter the portfolio to be more consistent
with his views. [4]
[Total 14]
Question 5.8
The pension scheme trustees of ABC plc wish to hedge the mortality risk associated
with the scheme’s pensions in payment. The scheme’s investment consultant has
therefore suggested that it invests in a mortality bond that offers coupons linked to
survival according to a life table for pensions annuitants. The bond would be issued by
DEF investment bank solely to the pension scheme.
Outline the disadvantages of this approach to hedging the mortality risk. [6]





the course.

Solution 5.1
Asset pricing
Asset pricing relates to the systematic determination of the value of risky securities such
as equities, bonds and derivatives. Modern asset pricing models all derive from the
notion that price equals the expected discounted payoffs from an asset. [1]
Approaches used include:

 consumption-based models [½]
 the capital asset pricing model [½]
 multifactor models [½]
as well as term structure models and option pricing models. [½]
All these models are attempts to handle the effects of delay and risk in evaluating a
sequence of anticipated payments. [½]
Uses and categories of asset pricing models
Asset pricing models have two uses:

1. to determine whether an observed asset price is “wrong”, ie whether an asset is
mispriced (and represents a trading opportunity for the shrewd investor) [½]
2. to determine what the price of an asset should be (where it cannot be observed).
[½]
Absolute pricing prices assets by reference to exposure to fundamental sources of

macroeconomic risk – ie unpredictable macroeconomic variables such as inflation,
economic growth and interest rates. [1]
The consumption-based and general equilibrium models (such as CAPM) are examples
of this approach, which can be used to predict how prices might change if policy or
economic structures change. [½]
Relative pricing, as exemplified by Black-Scholes option pricing and Arbitrage Pricing

Theory, considers the value of an asset given the price of some other assets. Here we
use as little information about fundamental risk factors as possible, and we do not ask
where the prices of the other assets came from. [1]

(1) pt = E (mt +1 xt +1 )
(2) mt +1 = f ( data, parameters )

where:
 mt +1 = stochastic discount factor (or state-price deflator). [2]
In this way, the specification of the economic assumptions of the model as captured in
(2) can be separated from the step of deciding which kind of empirical representation to
pursue in (1). [½]
The first equation can lead to predictions stated in terms of returns, price-dividend
ratios, expected return (beta) representations, moment conditions and so on. [½]
[Maximum 9]
Solution 5.2
 The method should be to carry out many simulations using a stochastic time
series investment model, such as the Wilkie model. [½]
 The assumptions used in the projections should be consistent with the

assumptions underlying the liability valuation, ie there should be appropriate
dynamic links between the asset and liability projections, perhaps via an
inflation variable. [1]
 First derive a random variable for the year-on-year growth in dividends. This
variable may be linked to inflation, which will be one of the variables used in the
liability valuation. [1]
 If we assume that the equity portfolio is invested across the whole of the
domestic equity market, the random variable might have quite low variance
because dividends are smoothed. [1]
 The market value at future dates is found by dividing the projected dividend
income by the assumed dividend yield at that time. (Note that this combination
produces a “pseudo market value” that will reflect the volatility of true market
values.) [1]

 The dividend yield will itself also be a random variable, probably related to past
values. (It is often modelled as an autoregressive and mean-reverting process in
practice.) The mean and variance could be chosen by reference to the history of
dividend yields over the last few decades. [1]
 Future net cash flows will need to be incorporated within the projections, and
with reference to the projected market values at the date of cashflow. [½]
[Total 6]
Solution 5.3
(i) Features of the liabilities to consider in investment strategy
Nature
This will depend upon the mix of business between non-profit (almost always a fixed
liability), unit-linked (unit related liability that should be matched exactly) and with-
profit (a fixed guaranteed liability with policyholders' reasonable expectations of
bonuses on top). [1]
Term
This is likely to be mostly medium-term to long-term (eg 10 to 15 years on average). [1]
Currency
This is likely to be mostly in domestic currency. [1]
Certainty
The main source of uncertainty will come from surrenders, but these are not problematic
unless guaranteed surrender values are offered. Otherwise, the timing and amounts of
the future cashflows should be reasonably predictable [1]
[Total 4]

(ii) Overall investment risks and risk control guidelines
Market risk
The insurance company will face market risk. [½]
This is the risk of unpredictable falls in the value of its surplus due to unpredictable
changes in the market values of the assets in which it is invested. [½]
An overall market risk control guideline for the main fund could be based on a Value at
Risk (VaR) measure, eg “a reduction in the statutory free assets of 10% over a one-year
period must have a probability of less than 95%”. [1]
For unit linked funds the VaR might be with reference to an index or a median fund. [½]
To ensure that the VaR limit is not breached fund managers might be given a
benchmark asset distribution reflecting the liabilities for traditional business (or the
median fund for unit-linked). [½]
Permitted ranges would then be established within which managers have freedom to
depart from the benchmark. These could be set either as a load difference (eg limiting
UK equities to between 30% and 50% of the total portfolio) or a load ratio
(eg equivalently limiting domestic equities to 40% ± 25%{of the 40%}). [1]
Liquidity risk
The insurance company also faces liquidity risk. [½]
This is the risk of not having sufficient cash to meet operational needs at all times. [½]
It is related to market risk in as much as the liquidity of the overall portfolio needs to be
taken into account in portfolio selection. [½]
Techniques that can be used for identifying and measuring liquidity risk include the
cash budgeting / short-term financial planning techniques. [½]
Liquidity gap analysis may also be carried out. [½]
A simple “balance sheet” model of liquidity is useful for establishing liquidity policies
and operating limits. [½]
All assets are allocated to one of two categories − liquid or illiquid. [½]
All liabilities are classified as either stable or volatile. [½]

Liquidity gap or net liquid assets are defined as the difference between the level of
liquid assets and volatile liabilities. [½]
A more rigorous approach is duration analysis. [½]
This involves the concept of liquidity duration or liquidity risk elasticity (LRE), where
the impact of changes in market conditions is considered. [½]
The process consists of two steps:
1. Calculate the present value of assets and liabilities using the “cost of funds” rate
as the discount rate. [½]
2. Measure the change in the market value of the institution’s equity (LRE) from a
change in the cost of funds. [½]
If the LRE is zero, the institution has zero liquidity risk (by this measure). [½]
If the LRE is sharply negative, it will pay the institution to shorten the maturity of its
assets and lengthen the maturity of its liabilities, thereby increasing liquidity. [½]
Credit risk
The company faces credit risk. [½]
This is the risk that a counterparty to whom the insurance company has loaned money
(eg a bond issuer or a swap counterparty) may default on their legal obligations to make
capital and interest payments. [½]
The creditworthiness of counterparties can be controlled by placing limits on the credit

ratings (as published by the major rating agencies) with which the insurance company
may deal, eg no cash deposits with banks with a “BBB” rating or lower. [1]
It can also be controlled in derivatives transactions by dealing on a recognised exchange

with a central clearing house which stands as counterparty to all deals, rather than over-
the-counter. [½]
Limits should be placed on the credit exposure to any single counterparty, eg no more
than £10m deposited with any single “A”-rated bank. In applying this type of guideline
the insurance company will need to allow for the particular relationships between
different companies within the same group. [1]
Credit derivatives such as credit default swaps could also be used to limit the credit
exposure to particular borrowers. [½]

Operational risk
The insurance company also faces operational risk. [½]
This is the risk of losses due to fraud and mismanagement within its own internal
organisation. [½]
The guidelines needed to control operational risk will typically relate to:
 the separation of “front office” (dealing and recording) and “back office”
(accounting and settlement) functions [½]
 ensuring that all individuals have the appropriate experience and qualifications
required to properly perform their roles [½]
 ensuring that the roles and responsibilities of all individuals and department are
clearly divided and known [½]
 monitoring closely the actions of derivative traders and the resulting derivative
exposures. [½]
Relative performance risk
Finally, the insurance company also faces relative performance risk. [½]
This is the risk that its investments under-perform relative to those of its competitors, in
which case it might lose new and/or existing business to those competitors. [½]
This risk can be controlled in a similar way to market risk, except that the asset
selection guidelines (loss ratios, etc) will relate to competitors’ portfolios (eg the
median fund) rather than to a benchmark portfolio. [½]
[Maximum 16]

Solution 5.4
(i) Market risk and Value at Risk
Market risk is defined as the risk relating to changes in the value of the portfolio arising
from movements in the market value of the assets held. It is sometimes determined with
reference to the overall solvency position of the organisation concerned. [1]
Market risk can be measured using Value at Risk (VaR). VaR is an estimate, with a
given degree of confidence, of how much the market value of the portfolio can decrease
over a specified time horizon. [½]
Thus, if the VaR with a 95% confidence level over the next year is $100m, this means
that there is estimated to be a 5% probability that the market value of the portfolio will
fall by more than $100m over the next year. [½]
Calculation of the VaR for a portfolio requires estimates of the current prices, expected
returns, volatilities and correlations of returns between all of the constituent assets of the
portfolio. [½]
The time period involved is usually chosen by reference to the term and liquidity of the
assets held. Thus, a clearing bank would normally consider a shorter time period than a
pension scheme. [½]
In practice, the VaR at any time might be calculated at more than one confidence level
and over a series of different time horizons. [½]
If the resulting value for the VaR, and hence the market risk, is thought to be too high,
then the investment strategy may be changed so as to reduce the market risk. [½]
Consequently, the VaR calculation may well be:

 repeated for several different investment strategies, as well as that currently
being pursued
 and calculated at regular intervals …
… in order to help identify the optimal investment strategy on a continuing basis. [½]
[Maximum 4]

(ii) Use of dynamic liability benchmarks
Dynamic liability benchmarks are benchmarks given to an investment manager that vary
continually with the nature of the liabilities. [½]
Unlike static liability benchmarks they are closely linked to the liability portfolio at all
times. [½]
As such they represent an intermediate position between conventional “static”

benchmarks and full liability hedging. [½]
They are usually used in situations where the nature of the liabilities (and market
conditions) can change rapidly and are unpredictable, eg in the context of currencies.
[½]
Here historical benchmarks would rapidly become inappropriate and would need to be
modified continually as the nature of the liabilities altered. [½]
Where dynamic liability benchmarks are seen to be necessary, this will influence the
choice of assets – in particular, the liquidity of the chosen assets. [½]
[Total 3]
Solution 5.5
(i) Five active fund management styles
Growth style
A “growth” manager chooses stocks that are expected to have high potential future
earnings growth. [½]
These are typically identified as stocks having:

 high actual sales and earnings growth
 high forecast earnings growth
 high return on equity
 upwards earnings revisions. [1]

Value style
A “value” manager chooses stocks that offer good fundamental value using certain
traditional measures. [½]
These measures are typically:
 a high book value to market price ratio
 high dividend, earnings and cashflow yields
 a high sales to market price ratio. [1]
Momentum style
Such managers do not try to identify cheap stocks based on fundamentals about the
company. Stocks are instead picked that appear to have risen in the recent past and look
likely to continue to outperform. Stocks are sold that appear to be doing the reverse. [1]
Contrarian style
A contrarian manager does the opposite of a momentum manager, ie he chooses stocks

that have fallen in price and seem “out of favour” on the basis that the market tends to
overreact to news. He likewise sells stocks that have outperformed recently and so may
now be expensive. [1]
Rotational style
A rotational manager alternates between the growth style and the value style depending
on how he reads the market. In times when the market is rising and “bullish” he would
normally look for “growth” stocks. [1]
Answers including “large capitalisation” and “small capitalisation” managers are also
acceptable.
[Total 6]
(ii) Possible reasons to adopt a “core/satellite” investment structure
This approach to structuring an investment portfolio is known as the “core/satellite”

approach. [½]
The unit trust mangers may believe that the large UK shares are all efficiently priced.
[½]
Consequently, it will not be possible to consistently select out-performing stocks from

amongst the FTSE 100 constituents to produce excess risk-adjusted returns. [½]

In addition, adopting a passive approach to the management of the “core” majority of

the fund will help to minimise fund management and dealing costs ... [½]
… particularly if they choose to track the index synthetically using FTSE 100 index
futures and Treasury bills, rather than aiming to replicate it by holding actual shares. [½]
As the FTSE 100 index represents about 80% of the UK equity market, investing the
majority of their funds to passively track this index:
 will help to reduce the relative performance risk compared to other UK equity
unit trust managers ... [½]
especially if the trust’s peer group of investment managers choose to adopt a
broadly similar management approach. [½]
 will ensure a wide degree of diversification within the unit trust fund, so
eliminating much specific risk and helping to reduce the overall volatility of
investment performance. [½]
It may be that the fund’s stated investment objective as set out in the marketing
literature is to invest and manage the UK equities held in this way. [½]
Even if this approach is not an explicit requirement of the investment objective, it may
be adopted if it is currently fashionable amongst the actual and potential investors in the
unit trust and so will a help to attract and retain customers. [½]
They may nevertheless choose to adopt a more active investment approach to the
remainder of the fund, if they believe:
 the market for smaller UK equities to be less than fully efficient, and also [½]
 that they have the investment management skills to exploit any inefficiencies to
produce higher returns even after allowing for the additional costs associated
with an active approach. [½]
However, this might prove difficult in practice, due to the higher dealing costs and
lower marketability of smaller shares. [½]
[Maximum 6]

Solution 5.6
The starting point will be to model the key features of the pension fund’s asset proceeds
and liability outgo that have to be projected into the future. [½]
Realistic values will be chosen for all the parameters. These include the mean return,
variance of return and correlations between the returns on the main asset categories
(eg domestic equities and government bonds) and also price and salary inflation. [1]
A large number of simulations are then carried out, based on the pension fund’s current
asset distribution. [½]
The results may be presented/analysed in a number of ways. For example, the number of
times (eg out of 1,000) in which the fund becomes “insolvent” over a given period (eg 50
years) could be calculated. Alternatively, the value of the fund at the end of the period
may be considered on its own. [1]
“Insolvency” may be defined in a number of ways (eg insolvency on a statutory basis, or

in terms of an actuarial valuation showing a value of assets of less than 100% of the value
of liabilities). [½]
Asset liability modelling is likely to include an analysis of how changes to the investment
strategy would change the long-term solvency position of the fund. [½]
[Total 4]

Solution 5.7
(i) Investigations for bonds switch
This is an example of an anomaly switch. [1]
The investor may investigate the price ratio ... [½]
115.10
... which is the ratio of the two bond prices = 1.05374 [½]
109.23
This ratio would be expected to stable over time as the two bonds are very similar in
characteristics (such as duration). [1]
If the ratio has moved from the long term average, then this may present an anomaly
which might reverse itself later, allowing the investor to switch back to the original
bond. [½]
A similar investigation can be carried out using the historical trends of the yield ratio
1.42%
= 0.09404 [1]
1.51%
Alternatively the investor could build a model of bond yields, or of bond prices, using
factors such as term, marketability, size of issue, special features, ... [½]
... and compare the prices of the two bonds to the model prices, to look for anomalies.
[½]
[Maximum 5]
(ii) Reasons for undertaking the switch
This is an example of a policy switch. [1]
The investor is switching into a longer, more volatile bond. [½]
It may be that the investor expects yields in the market generally to fall, and prices to
rise. If this happens, then all bonds will rise in price, but the longer bond will rise
further giving the investor a profit. [1]
Similarly if the investor expects the yield curve to flatten in shape, then the long bond
yield will fall (and prices rise) and the shorter bond yield will rise (and prices fall),
delivering a profit on the switch. [1]

Both the above strategies may be due to the investor’s views on spot and forward rates,
and how they compare to the market’s estimates. [1]
The investor may have evaluated the rate at which the shorter bond would have to be
reinvested on maturity in 2025 in order to achieve the same overall return to 2045 as the
longer bond offers. If this rate is higher than the investor believes is possible, then
he/she may switch into the longer bond to lock in the yield. [1]
It may also be due to a change in liability profile. [½]

[Maximum 5]
(iii) Four actions consistent with views on inflation
Move at least some of the portfolio into shorter-dated government bonds. Then if
inflation and yields rise any capital loss will be smaller. [1]
Move into cash to avoid any capital loss. [1]
Sell government bond futures or buy put options on a government bond future. Then if
inflation and yields rise the profit on the derivatives will compensate for the loss on the
government bonds. [1]
Buy real assets such as index-linked government bonds or equities. [1]

[Total 4]

Solution 5.8
Disadvantages of hedging mortality risk with mortality bond
Buying the bond exposes the scheme to the credit risk that DEF may default on the
coupons and/or redemption payment. Although this is unlikely to be a problem under
normal economic conditions, it could become material in the event of another big event
such as “credit crunch”. [1]
Being issued solely to ABC pension scheme the bond would be highly illiquid. This
could cause problems if the scheme needed to sell the bond, eg if it needed additional
cashflow or if it was concerned about the risk of DEF defaulting on the coupons. [1]
It may be costly and time-consuming to invest in the bond … [½]
… as the scheme may need to:

 undertake or pay for a credit rating of the bond [½]
 negotiate the exact terms of the bond [½]
 obtain the necessary ISDA documentation. [½]
The price paid for the bond will need to cover the profit margin required by DEF for
designing and issuing the bond and then taking on board the mortality risk of the
pension scheme. It may therefore be relatively expensive. [1]
The survival experience of ABC’s pension scheme is unlikely to exactly mirror that of
the life table underlying the bond. The resulting basis risk will render the hedge less
than exact. [1]
[Total 6]

Question 6.1
(i) Explain how the tax system in a country can influence the dividend policy of a
company and describe the three main corporate tax systems. [7]
(ii) Outline the tax-related factors the investor should allow for when selecting
investments so as to maximise net of tax investment returns. [4]
[Total 11]
Question 6.2
(i) Define speculation and explain why an investor might choose to speculate using
derivatives as opposed to the underlying asset itself. [4]
(ii) A strip is an option strategy that involves going long in one call and long in two
puts, all on the same share and with the same strike price and expiry date. Draw
a diagram showing the overall profit or loss from undertaking such a strategy
and explain the circumstances in which the investor might choose to use it. [5]
[Total 9]
Question 6.3
(i) Explain how an investment manager might use Government bond futures
contracts to manage a diversified bond portfolio. [5]
(ii) You expect the level of the FTSE 100 index to soar over the next six months.
Explain how do you profit from this by using futures and why this may be better
than buying in the cash market. [4]
(iii) Describe two ways in which an investor could use derivatives to protect a
portfolio against a fall in the equity market. [2]
(iv) Identify the two main types of risk when:

(a) using futures to hedge
(b) speculating using swaps. [4]
[Total 15]

Question 6.4
(i) An investor decides to speculate on the price movement of a share using call
options. She does so by taking a short position in a call with a strike price of 88
and a long position in one with a strike price of 95. The two options are priced
at 10 and 6.5 respectively and the current share price is 92.
Draw a payoff diagram showing the net profit or loss from undertaking this
strategy and explain the circumstances under which the strategy would make
sense. [5]
(ii) A second investor decides to go long in a call option on a short-term interest rate
future, whilst at the same time going short in a put option (with a lower strike
price) on the same short-term interest rate future. Describe fully how this
strategy affects the rate at which the investor is able to lend money and hence
why the investor might wish to undertake this strategy. [6]
(iii) A third investor believes that XYZ shares, which are currently priced at $1.20,
are about to rise in price. She therefore decides to buy calls with a strike price of
$1.30 for a premium of $0.10 each. Suppose that the share price at the strike
date turns out to be $1.60, calculate her percentage return and compare it with
that obtained from simply buying the share directly. [3]
[Total 14]
Question 6.5
(i) Explain briefly the problems involved in estimating the prospective standard
deviation or volatility of investment returns for a share using observed market
data. [3]
(ii) Discuss the merits of the standard deviation as a measure of investment risk. [3]
(iii) You have been asked to design a suitable portfolio for a charitable fund that
awards bursaries each year to promising young actuarial students.
Describe the process of risk budgeting and explain how it could help you
achieve this task. [8]
[Total 14]

Question 6.6
(i) Describe how an institutional investor could use equity index futures in
protecting her UK equity portfolio. [5]
(ii) Explain why the types of hedge in (ii) may not completely eliminate market risk.
[3]
[Total 8]
Question 6.7
(i) Describe how you would calculate the backward-looking tracking error and the
forward-looking tracking error of a US equity fund. [2]
(ii) Two US equity funds that are of a similar fund size have given you the
following information:
number of positive total value of

3-year
“active money” positive active
information
positions greater than money positions
ratio
$1m in value greater than $1m
Fund A 1.5 50 $80m
Fund B 0.7 10 $20m
Describe in detail what the above information means and the conclusions you
would draw. [6]
(iii) Discuss the limitations of an analysis based on the above data. [3]
[Total 11]
Question 6.8
The trustees of a pension fund that you act as advisor to have indicated that they believe
the equity market has risen too far and that they would like to change the benchmark for
their fund. They would like to invest more heavily in bonds and invest in “value”
equities.
(i) Explain briefly how you could use risk budgeting to help analyse the effect of
such a change. [3]
(ii) Explain the meaning of “value” and how you would determine an appropriate
fund to comply with your clients’ wishes. [5]
[Total 8]

Question 6.9
The trustees of a large pension fund are in the process of deciding on how they would
like their fund to be managed. The choice is between:
● a single fund manager given a “multi-asset” (or balanced) mandate, or

● investing the bulk of the portfolio in a passive fund and selecting a number of
managers in particular fields and awarding them “specialist” mandates.
Under the second option the idea would be to change the line-up of specialist managers
from time to time depending on market conditions and in order to have the best asset
weighting and the most suitable style of manager for the particular economic
circumstances.
Discuss the advantages and disadvantages of each of these two approaches. [6]
Question 6.10
A British company, UPX, wishes to borrow in € at a fixed rate of interest and an Irish
company, EPQ, wishes to borrow the equivalent amount in UK £ at a variable rate of
interest. Both companies want to borrow for the same time period and face the
following interest rates in the international capital markets:
Interest rate / Company EPQ UPX

£ variable rate LIBOR + 0.7% pa LIBOR + 0.1% pa
€ fixed rate 4% pa 3.7% pa
A large investment bank is to arrange a swap for the two companies, and requires a
margin of 10 basis points for its services. The remaining gains from the swap are to be
divided equally between the two companies so as to ensure that they face no foreign
exchange risk on the interest payments under the swap.
(i) Explain in detail how the swap would be constructed and draw a diagram
showing the interest rates (and the interest rate currency) paid and received by
the various parties. [8]
(ii) Describe the market risk faced by the bank. [1]

[Total 9]

Question 6.11
(i) Value at Risk and stress testing are two methods of assessing downside risk.
Discuss how the two measures differ and the advantages and disadvantages of
each. [7]
(ii) Define the information ratio. [2]
(iii) The following table shows the quarterly investment returns achieved by
Portfolios A and B and also the benchmark market index return over each of the
last 12 quarters.
Quarter Portfolio A, % Portfolio B, % Market index, %

1 –6 3 5
2 7 –2 2
3 0 3 –3
4 4 –1 –5
5 13 5 11
6 0 4 2
7 –7 10 3
8 1 –2 –4
9 5 0 6
10 9 2 2
11 –8 –5 –7
12 10 5 6
Calculate the information ratio for both portfolios and comment on your
analysis. [6]
[Total 15]

Question 6.12
You are a consultant to a large UK investment fund that currently has $200 million
invested in US equities. As a result of a recent asset allocation meeting, the decision
has been taken to invest a further $600 million in US equities by selling the
corresponding amount of UK equities. The asset allocation team has emphasised the
need for the switch to go ahead as soon as possible.
(i) Describe the practical problems of carrying out such a switch without the use of
derivatives. [4]
(ii) Explain how this switching process can be made easier by the use of derivatives.
[4]
You decide to buy US equity exposure by buying the S&P 500 June futures contract.
You know that you have sufficient cash to cover the margin position. The unit of
trading is $500 per index point and the current value of the S&P 500 index is 1,200.
(iii) Calculate the number of contracts you would need to buy to gain the required
US equity exposure. [1]
Prior to this new US equity investment, the fund had no holdings in the technology
sector. Technology stocks constitute 12% of the S&P 500 index.
(iv) Calculate the exposure of the fund to technology after the purchase of the
futures. [1]
(v) Discuss briefly methods by which you might attempt to eliminate the technology
weighting. [4]
The asset allocators of the fund are bullish on US stocks, but they are worried about the
level of the dollar, which they think may depreciate in the short-term against sterling.
As a result they would like only one half of the fund exposed to the dollar.
(vi) Explain how you might achieve this reduced exposure, including in your
answers details of the problems that would have to be overcome. [3]
[Total 17]

Question 6.13
(i) Explain why investments with a high running yield, might offer a lower gross
redemption yield. [2]
(ii) An investor spends $5,000 on Company A shares on 1 January in each of the

years 2010 to 2012 inclusive and sells the shares on 1 January 2014.
Calculate both the amount of her liability to capital gains tax and the net yield that she
obtained on her investment (to the nearest 1% pa). Assume that:
 the share prices on 1 January 2010, 2011, 2012, 2013 and 2014 were $1.00,
$1.25, $1.10, $1.50 and $2.00 respectively
 all capital gains are taxed at the moment at which they are realised
 she enjoys an annual capital gains tax allowance of $10,000 (which is not
cumulative − ie she cannot carry forward allowances that are unused)
 the tax rate on capital gains is 18%
 Company A paid no dividends throughout the period in question. [5]
[Total 7]
Question 6.14
Suppose that the current level of the FTSE 100 capital value index is 4,500, with a
dividend yield of 4% pa and that the 3-month interest rate is 5% pa. Both rates are
quoted convertible quarterly rates.
(i) (a) Calculate the theoretical price of a 3-month FTSE 100 future.
(b) Define the basis of a future. Calculate the value of the basis for the
FTSE 100 future above and explain what is meant by basis risk. [4]
(ii) Describe in detail how you would expect the market’s estimate of the value of
the future level of the FTSE 100 in 3 months’ time to compare with the value of
the futures price you calculated in (i) above. [3]
A fund manager manages a share portfolio. She is worried that the market is currently
overvalued and so wishes to reduce her exposure to a potential fall in the market.
(iii) Explain in general terms how she could use stock index futures to achieve her
aim and explain why exact hedging will not be possible in practice. [5]
[Total 12]

Question 6.15
The table below shows the capital value index and the rental yield for a general property
index series in 2006.
Date Capital value index Rental yield, pa

1 January 2014 100.0 5.82%
31 March 2014 100.7 5.91%
30 June 2014 101.9 5.88%
30 September 2014 102.4 5.82%
31 December 2014 103.6 5.77%
(i) Use the information in the table to construct a quarterly total return on property
index series for the year 2014. (You may ignore tax.) [4]
(ii) A specialist property investment manager whose benchmark is the above index
achieved an actual return on his portfolio of 8% in 2014. Explain why, by itself,
this figure tells us little about the investment skill of the property manger. [4]
(iii) Based on the last three years’ performance, the property investment manager has
actually achieved an information ratio of +0.15, compared to the value of +0.22
achieved by an equity investment manager colleague over the corresponding
time period. Comment on the assertion that the equity manager has out-
performed the property manager. [5]
[Total 13]

Question 6.16
ABC pension fund has $100 million of assets, which are currently invested entirely in a
broad mix of equities and government bonds. The fund is considering whether to also
invest in corporate bonds.
(i) Outline the main possible reasons for investing in corporate bonds and list the
different types of corporate bonds in which the fund may invest. [6]
ABC pension fund also wishes to invest some 10% of its portfolio so as to gain
exposure to property returns as a way of matching its pensions in payments. However,
its investment consultant has suggested that rather than investing in property directly,
the fund could instead enter into a swap with DEF plc. Under this arrangement it would
receive payments linked to the rental incomes received on a portfolio of commercial
properties owned by DEF plc.
(ii) Outline how the swap would work. [2]
(iii) Describe the advantages of the swap arrangement for ABC pension fund and
also the main risks involved. [8]
[Total 16]





the course.

Solution 6.1
(i) Influence on dividend policy
Company profits (usually after interest charges) can either be distributed to shareholders
as dividends or share buy-backs or retained within the company. The way in which
retained profits and distributions are taxed will influence investors’ preferences between
dividends and the increase in share values that should follow from retained profits. [1]
For example, a system that makes dividends attractive from a tax point of view to a
significant number of investors can lead to pressure on companies to pay a high rate of
dividend. [1]
Governments may attempt to make the corporation tax system as neutral as possible or
may take a view on the desirability or otherwise of dividends and manipulate the system
accordingly. [½]
Three corporate tax systems
Classical system
In the classical system of corporation tax, company profits are taxed independently in
the hands of the company and in the hands of the investor. In other words, the company
pays tax on its profits, dividends are then paid out of post-tax profits and the investor is
taxed on those dividends. [1]
Investors are typically subject to income tax on distributions and capital gains tax
arising from increases in the share price. This tax system tends to discourage the
payment of dividends. [½]
Split-rate system
The split-rate system is similar to the classical system except that different rates of
corporation tax are levied on distributed profits and retained profits. [½]
This system is often used when income and capital gains are taxed at different rates in
the hands of investors. Thus, a higher level of income tax than capital gains tax would
be coupled with a higher tax rate on retained profits than on distributed profits. This
may remove the incentive to pay dividends. [1]

Imputation system
In the imputation system the company has to deduct some of the tax payable by
investors on distributions and pay it directly to the government. This amount can then
be set off against the total corporation tax bill of the company. [1]
The tax deducted by the company is “imputed” to the shareholder who may be able to
reclaim it if they are not liable to tax. If the rate at which they are liable to tax is greater
than the rate imputed they may have to pay some more tax on their dividend. Investor’s
should be ambivalent to dividends or capital gains. [1]
[Maximum 7]
(ii) Tax-related factors to allow for
The total rate of tax on an investment and how the tax is split between different
components of the investment return … [½]
… in particular the split between income and capital gains if the investor has different
rates or allowances on these. [½]
The timing of tax payments – by deferring tax it will be possible to reduce the present
value of the tax payments and so increase the net of tax investment return. [1]
Whether the tax is deducted at source or whether it has to be paid subsequently, which
is clearly related to the extent to which tax deducted at source can be reclaimed by the
investor. [1]
The extent to which losses or gains can be aggregated between different investments or
over different time periods for tax purposes. [1]
[Total 4]

Solution 6.2
(i) Speculation
Speculation involves taking short-term, high-risk positions with the aim of making large
profits should an expectation about the short-term direction and/or extent of movement
of the price of an asset be fulfilled. [1]
An investor might choose to speculate using derivatives as opposed to the underlying

asset itself because:
 it is quicker, cheaper and easier to carry out the required transaction(s) using
exchange-traded derivatives, eg futures and traded options, than by trading the
asset itself [1]
 using a particular combination of derivatives will enable the investor to obtain a
pattern of potential returns that is not possible simply by trading in the
underlying asset. [½]
In particular:
– using derivatives may enable the investor to speculate on the volatility of
the asset in a way that is not possible by trading only in the underlying
asset [½]
– the investor may believe that the market price of the asset is about to fall,
but is unable to short sell the asset due to internal restrictions or
regulation [½]
– using options introduces the possibility of asymmetric returns and
enables losses to be capped. [½]
 the investor wishes to take advantage of the possibility of a geared investment
offered by a derivative such as a future or option, so as to maximise potential
trading profits for a given initial investment. [½]
[Total 4]
(ii) Profit/loss diagram for a strip
Allowing for the option premium (c) paid at outset, the profit from the long call given a
share price at expiry of ST and an exercise price of K is:
max [ ST - K , 0] - c
Allowing for the option premium ( p) paid at outset, the total profit from the two long
put options is:
2 ¥ max [ K - ST , 0] - 2 p

So, if ST > K , the overall profit is:
ST - K - c - 2 p [½]
If ST = K , the overall profit is:
-c - 2 p [½]
And if ST < K , the overall profit is:
2 ¥ ( K - ST ) - c - 2 p [½]
The diagram therefore looks like this:
profit/loss
strip
call
each put
K
0 ST
-2p - c K + c + 2p
½(2K - c - 2p)
[1½ for correct diagram]
This strategy makes sense if the investor:

 believes that the price of the underlying asset is likely to change significantly in
the near future, perhaps due to an earnings announcement … [½]
 … and is unsure which way the price is likely to move … [½]
 … but thinks that it is more likely to fall than to rise and/or that it is likely to fall
further than it is likely to rise. [1]
[Total 5]

Solution 6.3
(i) Using government bond futures
Bond futures may be used to hedge the existing portfolio against market movements,
thereby reducing market risk. [½]
For example, in a short hedge to protect the value of a long position in bonds futures
contracts would be sold. If bond prices subsequently fall the profit on the futures
position should offset the loss on the underlying portfolio. (This is similar to a policy
switch into shorter-dated bonds.) [½]
Care is needed to allow for the relative durations of the notional bond underlying the
future and the fixed interest portfolio, and also for the degree of correlation between the
“diversified” portfolio and the bond futures used, so as to minimise cross hedging. [½]
Futures could also be used to (long) hedge future cash in-flows. Here futures are
purchased, so if bond prices subsequently rise the profit on the futures compensates for
the higher cost of investing in fixed interest stocks. [½]
Futures can be used to speculate, in an attempt to benefit from anticipated movements in

bond prices. [½]
For example, if prices are expected to rise in a particular segment of the bond market,
the fund could buy bond futures of an appropriate duration to profit from the anticipated
price rise. (This is similar to a policy switch into actual bonds of the appropriate
duration.) [½]
Occasionally the fund may be able to make arbitrage (or near arbitrage) profits by
exploiting mispricing between the bond futures and fixed interest stocks. [½]
Using futures to increase/decrease the duration of the portfolio may be seen as a way of
maintaining the desired degree of matching between the assets and the duration of the
liabilities. [½]
Adjusting the composition of the bond portfolio using futures will be particularly
attractive when the “diversified” portfolio would otherwise be trading unmarketable
corporate debt, with high dealing costs. [½]
Some of the “diversified” portfolio may be in non-sterling debt. The bond futures (in
conjunction with derivatives on overseas bonds and currency derivatives) could be used
to adjust the portfolio’s international exposure. [½]

The future could be used as part of a strategy to synthetically track a bond index,
perhaps as part of a passively managed “core”, combined with an actively managed
“satellite” portfolio of bonds. [½]
[Maximum 5]
(ii) How to profit from a rise in the market using futures
Buy a 6-month futures contract. [1]
It may be better than dealing in the cash market because:
 you can deal on margin (ie your initial capital outlay is initial margin only), and
you can therefore heavily gear up your investment (but risky: losses can be many
times the initial outlay) [1]
 it is administratively easier and expenses will be lower as a proportion of the

total effective exposure [1]
 there is no need to worry about stock selection. [1]

[Total 4]
(iii) Two ways to protect an equity portfolio against a market fall
Buy put options on an underlying asset (eg an appropriate equity index) that is closely
correlated with the portfolio. A loss on the portfolio will be offset by a gain on the put
option. For dynamic hedging the investor may want to purchase –1/D options for each
unit of the underlying asset in the portfolio, where D is the delta of the options. [1]
Sell futures on a closely correlated underlying asset. A loss on the portfolio will be
offset by a gain on the futures. Unlike the option strategy this will also remove the
beneficial effects of a rise in the value of the portfolio (but does not require the payment
of a premium). [1]
Selling equity index calls will yield a premium now, but will otherwise not protect the
fund against a fall in the market. In addition, it will remove the possibility of profits
should the market instead rise.
[Total 2]
(iv)(a) Main types of risk when using futures to hedge
Cross-hedging risk: the risk that the future and hedged asset’s prices diverge due to
price divergence between the asset being hedged and the (different) asset underlying the
future. [1]

Basis risk: the risk of adverse changes in the market price of the future relative to that of
the asset underlying the future, either because future interest rates and dividends cannot
be predicted with certainty or because the future moves away from its “fair” or
theoretical value. [1]
(iv)(b) Main types of risk when speculating using swaps
Market risk: the risk of the market moving the wrong way, adversely affecting the value
of the swap – ie the present value of payments required increases relative to that of
receipts due. [1]
Credit risk: the risk of default by the counterparty when the swap has a positive present
value to the speculator, ie when the present value of receipts exceeds the present value
of payments due. [1]
[Total 4]
Solution 6.4
(i) Payoff diagram and explain the circumstances
The payoff diagram is as follows. The overall profit/loss is shown by the thick line.
Profit/loss
10.0 101.5 long call at 95
3.5
95 Share price
at expiry
-3.5 88
-6.5
short call at 88
[Up to 3 for correct diagram]

If ST < 88 , then both calls expire worthless and the investor makes a net profit of:
+10 – 6.5 = 3.5
If 88 £ ST £ 95 , then the short call is exercised and the long call isn’t. The resulting net
profit is equal to:
- ( ST - 88 - 10) - 6.5 = 91½ - ST
If ST > 95 , then both calls are exercised and the investor makes a profit of:
+10 - ( ST - 88) - 6.5 + ( ST - 95) = -3.5
ie a loss of –3.5.
The investor might use such a strategy (a bear spread) if it thought that the share price
was likely to decrease, but was not very certain that it would do so. [1]
If the investor is correct, then it will make a small profit, which is limited to a maximum
of 3.5. Conversely, if the investor is proved wrong, then it will make a loss. However,
the loss is limited to a maximum of 3.5. [1]
[Total 5]
(ii) Long call and short put on short-term interest rate futures
A long position in a call option on a short-term interest rate future effectively fixes a
minimum rate at which the investor is able to lend over the future term of the short-term
interest rate underlying the future. [1]
This is because by going long, the investor has an option to go long in an interest rate
future and so effectively lend over the future period based on a fixed contract price. [½]
Suppose that the actual contract price at the strike date turns out to be higher than the
strike price, ie the short-term future interest rate turns out to be lower than that
corresponding to the strike price. In this instance, the investor will exercise its option to
lend at a strike rate that exceeds the current future interest rate, in order to make a profit.
[1]
Conversely, suppose instead that the actual contract price at the strike date is lower than
the strike price, ie the short-term future interest rate turns out to be higher than that
corresponding to the strike price. In this case, the investor will not exercise its option to
lend at a strike rate that is less than the current future interest rate. [1]

The downside of this strategy is that money has to be found to fund the option premium.
[½]
One way of funding this is by selling a put option on a short-term interest rate future.
[½]
This will generate the put option premium for the investor, but at the cost of fixing a
maximum interest rate at which they are able to lend over the future time period. [½]
This is for the following reason. Suppose that the actual contract price at the strike date
turns out to be higher than the strike price, ie the short-term interest rate turns out to be
lower than that corresponding to the strike price. Then the put holder will let their
option to sell the interest rate contract (ie borrow) at a strike rate that exceeds the
current future interest rate expire worthless. [1]
Conversely, suppose that instead the actual contract price at the strike date is lower than
the strike price, ie the short-term future interest rate turns out to be higher than that
corresponding to the strike price. In this case, the put holder will exercise their option
to lend at a fixed strike rate that is less than the current future interest rate. [1]
[Maximum 6]
(iii) Percentage return from buying puts on XYZ shares
The percentage return on capital invested from buying the shares themselves is equal to:
1.60 - 1.20
= +33% [1]
1.20
The profit at expiry from buying the call is equal to:
1.60 - 1.30 = 0.30
After allowing for the premium paid at outset, the percentage return from buying the
call is therefore equal to:
0.30 - 0.10
= +200% [1½]
0.10
The call option gives a much higher percentage return because it provides exposure to
most of the absolute profit on the share but for a much smaller initial investment (of just
$0.10 compared to $1.30 for the share). [½]
[Total 3]
Note that the investor has actually made a smaller absolute profit by buying the calls.

Solution 6.5
(i) Difficulties involved in estimating the prospective standard deviation
Observed market data can only ever be used to estimate the standard deviation or
volatility of investment returns for a particular share. [½]
This is because estimates based on historical data are subject to random variation and
depend on the data set used. [½]
In addition, the volatility of both individual shares and the market as a whole may
change through time. [½]
Estimates of implied volatility from option prices are likewise only estimates that rely
on the applicability of the Black-Scholes formula. [½]
In practice the implied volatilities obtained tend to differ for different options on the
same share. [½]
Likewise implied volatilities and estimates of volatilities based on historical data tend to
differ. [½]
[Total 3]
(ii) Merits of standard deviation as a measure of investment risk
+ It is mathematically tractable. In particular, its use is consistent with mean-

variance portfolio theory. [1]
+ It is more likely to be familiar to non-experts than other measures of investment

risk, such as downside semi-standard deviation. [½]
– Standard deviation measures risk symmetrically about the mean, whereas in

practice investors are likely to be more concerned with downside risk. A
downside risk measure may therefore be more suitable. [½]
– Its symmetry also means that it does not adequately capture the risk when
returns are negatively skewed. [½]
– Standard deviation measures risk in relation to the mean investment return,

whereas the investor may be more concerned with risk relative to some other
benchmark rate of return, eg zero absolute return or the median fund return. [½]
[Total 3]

(iii) Risk budgeting
Risk budgeting is concerned with determining both the total amount of investment risk
an investor is prepared to take and also where it is most efficient to take that risk in
order to maximise investment return. It therefore enables the investor to maximise total
expected investment returns for a given level of investment risk. [1]
Initially it would be necessary to define a “feasible set” of asset classes that could be
included in the portfolio. [½]
It is necessary to obtain expected returns, volatility and covariance data on each feasible
investment category. [½]
Next an asset-liability modelling process is used to determine a suitable asset allocation

to meet the liabilities with an acceptable degree of certainty (“matching portfolio”). [½]
The next step is then to use Value at Risk techniques to determine the overall
investment risk (the “risk budget”) that the fund is prepared to take in order to achieve
higher returns. This will depend on the risk attitude of the sponsors. [1]
Having determined this, it is next necessary to:

1. decide how to allocate the risk between strategic risk (ie the risk taken relative to
the liabilities) and active risk (the extent to which individual managers are
allowed to deviate from their benchmark portfolios) [1]
2. allocate the available active risk across the component portfolios and between
the individual managers. [1]
These risk allocations will need to allow for

 the extent to which the sponsors believe that active management is able to add
value [½]
 the assumed correlations between strategic and active risk [½]
 the assumed correlations between the active risks of the individual fund
managers employed. [½]
Having determined and implemented the optimal asset allocation, exposures will need
to be monitored subsequently both in terms of increases and decreases in the exposures
and in terms of changes in the volatility and correlation data. [1]
Rebalancing should be carried out in response to short-term changes in the volatility and
correlation of assets in order to keep the total risk within the tolerable limits of the
investor or sponsor. [1]
[Maximum 8]

Solution 6.6
(i) How to use equity index futures to protect an equity portfolio
Hedging
A process known as hedging can be used to protect the portfolio. It involves taking a
position in the equity index futures (ie long or short) which is opposite to the position
held in the UK equity market. The idea is that a loss or profit made in the UK equity
market will be counterbalanced by a profit or loss on the futures. [1]
For UK equities the main futures contract is one on the FTSE 100 index, although there
is also a less liquid contract on the FTSE 250. The use of each will depend upon the
structure of portfolio being hedged. [½]
Short hedge
The investor can protect against a market fall by selling index futures with a contract
value equal to the size of the portfolio. Any fall in the value of the equities will then be
offset by profits on the futures and vice versa. [1]
Alternatively, only part of the portfolio may be hedged. [½]
By hedging, the equities have effectively been sold in the future at a fixed price. This
type of hedging is particularly useful when a fund is going to disinvest a large sum of
money in a few months and wants to avoid any future risk. It can also be used when a
manager feels that the market is looking over-priced and vulnerable to a fall. [1]
Long hedge
If the UK equity portfolio is expecting a large cash inflow in the future the investor may
wish to protect against a rise in the market by buying futures. [1]
[Total 5]
(ii) Why the hedge may not completely eliminate market risk
There are two types of risk that remain:
Basis risk: although the price of a future follows the cash price very closely, the basis
may not move exactly as expected. [1]
This occurs because it is impossible to predict exactly what the future levels of interest
rates and equity dividends will be over the term of the future. [½]

In addition, the existence of transaction costs mean that the futures price can move
within a “no-arbitrage channel” about the theoretical fair value. [½]
Cross hedging: unless the portfolio consists of a mixture of FTSE 100 (and/or
FTSE 250) stocks in the same proportions as the index, the change in value of the
portfolio will not match the change in the theoretical fair value of the future. [1]
[Total 3]
Solution 6.7
(i) Tracking errors
Tracking error is normally defined as the annualised standard deviation of the difference
between the portfolio returns (over a specified period) and the benchmark returns. [½]
The backward-looking tracking error is calculated using historical data, typically for
monthly or quarterly investment returns. [½]
The resulting monthly (say) tracking error is then annualised by scaling it up using a
factor of 12 . [½]
A forward-looking tracking error uses estimates of likely future volatilities and

correlations of different stocks and markets to estimate what the likely scope for
tracking error will be in the future (based on the holdings of the fund at the present time
and those of the benchmark). [½]
[Total 2]
(ii) Two US equity funds
relative return
relative risk
where:
 relative return is the mean difference between the return generated by the fund
and the return of the benchmark
 relative risk is the standard deviation of the relative return. [1]
A positive information ratio indicates that the fund has achieved out-performance
compared to their respective benchmarks. Both funds have managed this. [1]

A higher ratio indicates that the fund has achieved greater out-performance in terms of
risk-adjusted returns, which is generally considered to be a good thing. Fund A seems
to have performed better by this measure. [1]
The active money position is equal to the amount that a fund has invested in a particular
stock less the amount that an index-tracker has invested in that stock (if it is targeting
the same benchmark). It represents the “bet” that the fund is placing on a stock and can
be both positive (for stocks that the fund believes will out-perform) or negative. [1]
Fund A looks as if it is taking much greater risks relative to the benchmark, both in
terms of the number of active positions and in terms of the amount of mismatch
involved in the active positions. It therefore seems to be taking a higher-risk position,
which the information ratio suggests has paid off even after allowing for the additional
risk. [2]
[Total 6]
(iii) Limitations involved in this analysis
 3 years may not be a long enough time period to make inferences about
investment performance. [½]
 Past performance is not necessarily a good guide to the future. [½]
 The managers may have had other constraints placed on them, or different
objectives. [½]
 Fund B may have a large number of smaller active money positions rather than
many larger (greater than £1m) active money positions. [½]
 The results may be very different over other periods (both longer and shorter).
[½]
 An active money position in a stock with a high beta is more risky than the
equivalent active money position in a low-beta stock, hence the figures may be
misleading in terms of the risk undertaken. [½]
[Total 3]

Solution 6.8
(i) Risk budgeting
The process of risk budgeting allows risk to be taken where it is considered most
efficient – ie it has a higher chance of producing a higher return. In this case the
trustees appear keen to take strategic risk relative to the liabilities by being heavier in
bonds, and to take active risk by being more heavily invested in value stocks. [1]
The risk budgeting process will allow the strategic risk and manager risk to be
quantified and compared. The proposed new asset allocation can be investigated using
asset liability modelling projections and a suitable risk/return optimisation process, and
using a VaR assessment to determine the risk tolerance. [1]
This will quantify the amount of strategic risk the trustees are taking and the potential
effect on future funding and solvency levels. This could be compared against the risk
taken by investing in growth equities (rather than the equity index included in the
strategic benchmark and in the current allocation). [1]
[Total 3]
(ii) Meaning of “value”
Value stocks are stocks that appear relatively cheap in terms of certain key accounting
and investment ratios. [1]
In particular, a value stock will have a higher than average ratio for either all or for the
majority of the following ratios:
 book to price ratio
 dividend yield
 earnings yield
 cashflow yield
 sales to price. [1]
Identifying a “value” fund
The most common way is to perform a regression analysis based on recent performance
data between the fund being investigated and an index that has been specially designed
to represent “value” stocks. The regression will show whether the fund in question is
genuinely behaving as a value fund would be expected to behave. [1]

Alternatively, it would be possible to look at the current constituents of the fund in

terms of sector weights and the averages of each of the above accounting and
investment ratios (the average ratio should be higher in the fund than for the market as a
whole). [1]
Or the constituents could be ranked in terms of each of the above ratios, then the
quartile averages compared against the quartile averages for the index of the market. [½]
It might also be useful to discuss with the manager about how he chooses stocks for the
portfolio – this might also indicate whether he has a value bias. [1]
The fund literature might also give some indication of its objectives. [½]
[Maximum 5]
Solution 6.9
Multi-asset (or balanced) mandate
+ The main advantage of this route would be its ease of administration. The
decision regarding the most suitable style to employ at any given time is out-
sourced to the manager who is assumed to have the expertise to make such
decisions. [½]
+ By employing a single fund manager for the entire fund the pension fund might
be able to negotiate a reduction in investment management fees. [½]
+ In addition, the fund will avoid the potentially prohibitive costs associated with
changing the line up of investment managers from time to time, eg costs of
hiring investment advisers to help choose the new managers, negotiation of new
contracts, changing the asset allocation, etc. [½]
+ The manager may be large enough to have exposure to such categories as

property through unitised in-house funds. [½]
+ Although the manager will have some discretion over the weightings in the
different asset categories, this could be largely controlled by the trustees to suit
their fund requirements. [½]
– Arguably a large part of a sizeable balanced portfolio is actually passive anyway,

but the trustees would be paying higher fees on this section. This can be
considered a waste of money. [½]

Specialist managers
+ The core passive portfolio would be low-cost because it is an index-tracking

fund, so helping to reduce the overall cost of fund management. [½]
– It may not be possible to get passive funds in certain areas like property, and the
fund may be too small to get exposure to property through a specialist manager
(ie the portfolio is too small to achieve an acceptable level of diversification). [½]
+ The specialist expertise and high risk tolerance of the specialist funds may give
the potential for significant out-performance. [½]
– It would be hard to determine when to change the type and the style of the
specialist managers. If experienced portfolio managers cannot do it
successfully, then the trustees will struggle. [½]
+ As the fund is large it would be possible to employ a number of competing

specialist managers in each category to add a competitive incentive to achieve
good performance. [½]
+ It would be possible to include private equity and hedge funds as part of the
specialist mandates. [½]
– There is a lot more monitoring required to assess the performance of each

individual manager. [½]
+ Employing a number of different specialists with different investment

approaches would lead to a greater diversification of active risk, which could
enable the fund to achieve a higher level of expected returns for the same level
of overall investment risk. [½]
[Maximum 6]

Solution 6.10
(i) Explain in detail how the swap would be constructed and draw a diagram
EPQ enjoys a comparative advantage in borrowing Euro in the fixed-rate currency

market. [½]
This is because it only has to pay 0.3% pa more than UPX to borrow Euro at a fixed
rate, whereas it has to pay 0.6% pa more than UPX to borrow sterling at a variable rate.
[1]
Conversely, UPX enjoys a comparative advantage in borrowing Sterling in the variable

rate currency market. This is because it can borrow variable rate Sterling for 0.6% pa
less than EPQ, whereas it can only borrow fixed rate Euro for 0.3% pa less than EPQ.[1]
So, EPQ will initially borrow Euro at the fixed rate of 4% pa and UPX will borrow
Sterling at the variable rate of LIBOR + 0.1% pa. [½]
The total savings arising if each company borrows where it enjoys a comparative
advantage (rather than in the currency it actually wishes to borrow) are given by:
( LIBOR + 0.7 + 3.7) - ( LIBOR + 0.1 + 4.0) = 0.3% pa [1]
Of these savings, the bank gains 0.1% pa, whilst the remainder is split equally between
the two companies giving them a saving of 0.1% pa each. [1]
UPX lends to the bank arranging the swap at LIBOR+0.1% pa in Sterling because it
wishes to face no foreign exchange risk with regard to the value of Sterling. It borrows
Euro at a fixed rate of 3.6% pa, so that it enjoys a saving of 0.1% pa.
EPQ lends to the bank arranging the swap at a fixed rate of 4% pa in Euro because it
wishes to face no foreign exchange risk with regard to the value of Euro. It borrows
Sterling at a variable rate of LIBOR+0.6% pa, so that it enjoys a saving of 0.1% pa.

So the swap diagram is as follows:
£, LIBOR+0.6% Bank £, LIBOR+0.1%
€, 4% Fixed
€, 3.6% Fixed
£, LIBOR+0.1%
EPQ UPX
€, 4% Fixed
The bank makes a profit in Sterling of:
LIBOR + 0.6% - LIBOR + 0.1% = + 0.5% pa
It makes a loss in Euro of:
+3.6% - 4.0% = - 0.4% pa
Its overall profit is therefore:
+0.5 - 0.4 = + 0.1% pa
as required. [1]
[Total 8]
(ii) Bank’s market risk
As the bank makes a profit in Sterling and a loss in Euro, it is therefore exposed to the
market risk that Sterling falls in value relative to the Euro, in which case the value of
this apparent 0.1% pa would be reduced. [1]

Solution 6.11
(i) Value at Risk and stress testing
Value at Risk (VaR) is an estimate of the maximum loss that may occur with a given
probability over a specified time period. [½]
It is calculated either on a forward-looking basis or a backward-looking basis:
 forward-looking – historical data is gathered on the volatility and correlations

between the individual components of the fund. This is then used to estimate the
future using a suitable modelling technique (often Monte Carlo simulation). [1]
 backward-looking – historical performance data is fitted to an appropriate

distribution and the maximum loss is estimated by looking at the lower tail of
the distribution for the specified probability. [1]
Stress testing involves modelling the fund under specified scenarios and estimating how
the portfolio would perform. [½]
Advantages and disadvantages of each method
The disadvantage of VaR is that it does not allow the user to investigate specific
situations or combinations of situations that may result in a loss – ie VaR only looks at
past events or future events based on data from past events. [1]
Stress testing allows the user to model specific scenarios, which may either be to gauge
the effect of market turmoil (an abnormal event that would not be captured in the VaR
historical data) or to identify weak areas in the portfolio (or fund vs liabilities). [1]
In this respect a stress test can focus on the risk factors that the portfolio is most
exposed to and it should be tailored to reveal weaknesses in the portfolio structure. [½]
The disadvantage of stress testing is that the user must select scenarios to be modelled
which adds a large element of subjectivity. Whereas VaR models the likely scenarios
based on what has actually happened in the past. It is therefore less subjective, though
parameter estimates and choice of model may be. [1]
Stress testing allows for the changes in both volatilities and correlations that may occur
in extreme market conditions, eg a market crash. [½]
[Total 7]

(ii) Information ratio
mean of relative return

IR = [1]
standard deviation of relative return
where:
relative return = return on actual fund – return on benchmark fund [1]
The standard deviation of relative return is also known as the tracking error.
(iii) Calculate information ratio and comment
The calculations are as follows:
Quarter RA - RM RB - RM ( RA - RM )2 ( RB - RM )2
1 –11 –2 121 4
2 5 –4 25 16
3 3 6 9 36
4 9 4 81 16
5 2 –6 4 36
6 –2 2 4 4
7 –10 7 100 49
8 5 2 25 4
9 –1 –6 1 36
10 7 0 49 0
11 –1 2 1 4
12 4 –1 16 1
Total 10 4 436 206
So:
 Portfolio A’s relative return = 10/12 = +0.83% [½]
2
Ê 10 ˆ
 Portfolio A’s tracking error = 436 /12 - Á ˜ = 5.97% [½]
Ë 12 ¯
 Portfolio A’s information ratio = 0.83/5.97 = +0.14 [½]

 Portfolio B’s relative return = 4/12 = +0.33% [½]

2
Ê 4ˆ
 Portfolio B’s tracking error = 206 /12 - Á ˜ = 4.13% [½]
Ë 12 ¯
 Portfolio B’s information ratio = 0.33/4.13 = +0.08 [½]
Comment
Both portfolios generated a positive relative return – ie they both out-performed the
market. [½]
A’s higher relative return indicates that it out-performed B in terms of investment return
alone. [½]
A’s higher tracking error suggests that it adopted a riskier approach than B did in order
to generate the higher investment returns. [½]
However, A’s higher information ratio suggests that it out-performed B over the last 3
years even after allowing for the additional risk – ie it out-performed in risk-adjusted
terms. [½]
We should also note however that the above results relate only to a particular 3-year
period and so:
 similar strategies may not produce similar results in the future [½]
 the period concerned may be too short a period on which to judge the investment
managers, as the observed difference in performance may be due more to luck
than skill. [½]
Also, there may be other factors influencing or constraining the actions of the
investment managers of which we are unaware. [½]
[Maximum 6]
Solution 6.12
(i) Problems of making a large UK to US equity switch in a short time period
The possibility of shifting market prices (on sale of the existing UK equity portfolio, on
the purchase of US equities and possibly on the currency trade). [1]
The time needed to effect the change and the difficulty of making sure that the timing of
deals is advantageous. [1]

The dealing costs involved, including equity and currency market bid-offer spreads,
broker commissions, stamp duty, settlement and accounting costs. [1]
The possibility of the crystallisation of capital gains on the UK equities sold, leading to
a potentially large tax liability if the investor has achieved large gains and the
investment fund is subject to tax. [1]
[Total 4]
(ii) How derivatives can make the switching process easier
The fund could:

 sell FTSE 100 futures
 buy S&P 500 futures. [1]
If the switch is short-term and “tactical”, there will be a saving in the round-trip dealing
costs (because dealing costs are typically much lower on traded derivatives in particular
than in the underlying securities). [1]
If the switch is long-term and “strategic”, then the fund will benefit from having greater
time to make the individual stock selection decisions. The derivatives position would
be unwound as US equities are purchased in the cash market. [1]
In either case, there should be less of a market impact problem because the traded
derivatives and forward currency markets are very liquid. [1]
[Total 4]
(iii) Calculation of number of contracts
600,000,000  (1,200  500) = 1,000 contracts [1]
(iv) Exposure to technology
600  0.12 = $72m
ie 9% of the US equity portfolio after the switch [1]
(v) Discussion of methods to eliminate technology weighting
Short sell Technology stocks with a value equivalent to $72m. [½]
This may not be permitted by the investment fund’s own constitution. [½]

Buy traded put options on Technology stocks – this will cost some money, but will only
remove the down-side exposure, leaving up-side exposure to the sector. [1]
Write traded call options on Technology stocks – this will generate some income, but
will only remove the up-side exposure, leaving the downside exposure to the sector. [1]
Arrange an OTC deal (eg a forward sale) of a sub-index representing Technology

stocks. This may result in some cross-hedging and basis risk. [1]
[Total 4]
(vi) How to reduce dollar exposure (& problems)
The dollar exposure could be reduced by selling dollars forward using currency
forwards and/or a currency swap. [1]
Care will be needed to allow for dividend payments and the fact that margin accounts
will probably be maintained in dollars. [1]
The hedge is unlikely to be precise. For example, without knowing the future value of
the S&P index it is not possible to hedge 50% of the future currency exposure. [1]
[Total 3]
Solution 6.13
(i) Why a lower gross redemption yield?
Investors will aim to maximise their investment return net of tax (and subject to
acceptable level of risk). [½]
Thus, investors subject to a high rate of tax on income will prefer investments with a
low running yield (and vice versa), so as to minimise their income tax liability. [½]
Consequently, if most investors are taxed more heavily on income than capital gains,
then the prices of low income investments are bid up, resulting in lower gross
redemption yields. [½]
Conversely the demand for investments offering a high running yield is low. Thus, they
enjoy a relatively lower price and offer a higher gross redemption yield. [½]
[Total 2]

(ii) Calculation of CGT liability and net yield
The total value of shares on 1 January 2014 is found from the equation:
Ê 1 1 1 ˆ
5, 000 ¥ 2 ¥ Á + + = 27, 091
Ë 1.00 1.25 1.10 ˜¯
The real value of the capital gain up to that date is therefore:
27, 091 - 5, 000 ¥ 3 = 12, 091
Hence, the investor’s liability to capital gains tax is found from:
0.18 ¥ (12, 091 - 10, 000) = 376
ie $376. [2]
The equation of value to find her net yield is then:
5, 000a3| - (27, 091 - 376) v 4 = 0 [1]
Solving this by iteration gives a yield of about 20.75% pa (approximate answers by

interpolation are fine). [2]
[Total 5]
Solution 6.14
(i)(a) Price of the 3-month FTSE 100 future
The theoretical futures price for an asset paying income continuously is:
F0 = S0 e(
r - q )T
Given that the dividend yield (q) and a 3-month interest rate (r ) are both convertible
quarterly, the futures prices here is equal to:
F0 = S0 + S0 (r - q ) ¥ ¼ [½]
ie F0 = 4,500 + 4,500 ¥ (0.05 - 0.04) ¥ ¼ = 4,511.25 [½]

(i)(b) Basis and basis risk
The basis is defined as the difference between the current price of the underlying asset
(here the FTSE 100 index) and the corresponding (3-month) futures price. [½]
The basis here is therefore equal to:
F0 - S0 = 11.25 [½]
This assumes that the theoretical and market prices of the future are equal, which may
not always be the case. Strictly speaking, the basis is the difference between the market
prices of the asset and the future.
Basis risk arises because the future value of the basis cannot be predicted with certainty,
except at the settlement date of the future. [½]
This is because:
 The future values of the dividend yield and the risk-free rate over the
outstanding term of the future cannot be predicted with certainty. [½]
 The actual futures price in the market can diverge slightly from the theoretical
(no-arbitrage) price predicted by the arbitrage pricing formula, due to differing
supply and demand conditions in the spot and futures markets. [½]
In practice, arbitrage will occur only once the arbitrage profits exceed the cost of
the taxes and transactions costs incurred in taking advantage of any arbitrage
opportunities. [½]
[Total 4]
(ii) Market’s estimate of the index compared to the futures price
The total expected return on the FTSE 100 is made up of the expected capital gain and
the expected income, ie i = d + g . [½]
The expected capital gain on the FTSE 100 over the next 3 months is therefore equal to
the total return expected on the index less the expected income, as indicated by the
dividend yield, both applied over the next 3-month period ie ¼ g = ¼ ¥ (i - d ) . [½]
The futures price calculated in (i) was found by increasing the current value by the risk-
free rate less the expected dividend yield over the 3-month term to settlement,
ie ¼ ¥ ( r - d ) . [½]

As investors are risk-averse, the total expected return on the FTSE 100 should exceed
the risk-free rate of return by a suitable risk premium. [½]
Hence, the market’s estimate of the value of the FTSE 100 index in 3 months’ time
should be greater than the current futures price by approximately one quarter of the
annual risk margin/premium required by investors to compensate them for their
exposure to the risks of the equity market. [1]
[Total 3]
(iii) How she could use stock index futures to reduce exposure
The fund manager could go short in (or sell) FTSE 100 futures. [½]
If the market then fell, the fall in value of her equity portfolio would be offset by a rise
in the value of her short futures position. [½]
By choosing the appropriate number of futures, reflecting both the total value of her
fund and the weighted average beta of her stock portfolio, she could aim to hedge all of
the exposure of her portfolio to market movements. [½]
This would involve shorting sufficient futures (with negative beta), so that the overall
beta of the hedged portfolio is equal to zero. [½]
Equivalently, the number of futures would be equal to the ratio of the portfolio value to
the value of the individual futures used, multiplied by the optimal hedge ratio. [½]
Alternatively she might choose to hedge only part of the exposure by using fewer
futures, so leaving the overall combined portfolio beta greater than zero. [½]
Exact hedging will not be possible in practice because:

 even if she sets the overall portfolio beta equal to zero, there will still be some
specific risk remaining in the portfolio, ie there will be an element of cross
hedging [½]
 the beta of the hedged portfolio is likely to change, away from zero, through
time [½]
 there will be basis risk, if she needs/chooses to close out the futures position
prior to the settlement date of the futures [½]
 the uncertain income yielded by the share portfolio cannot be hedged exactly [½]
 of the impact of the transactions costs incurred in setting up the hedged position.
[½]
[Total 5]

Solution 6.15
(i) Total return on property index series
The total return on property index series can be constructed using the following
formula:
È CV + Rt ˘
TRI t = TRI t -1 ¥ Í t ˙
Î CVt -1 ˚
where:
 CVt is the capital value index at time t
 Rt is an estimate of the rent received over the sub-period from t - 1 to t ,
estimated as ¼ ¥ RYt ¥ CVt , where RYt is the index rental yield at time t
Using the first formula above, the total return index values are as follows:
È 100.7 + ¼ ¥ 100.7 ¥ 0.0591 ˘

TRI 31/ 3 = 100.0 ¥ Í ˙ = 102.19 [1]
Î 100.0 ˚
È 101.9 + ¼ ¥ 101.9 ¥ 0.0588 ˘

TRI 30 / 6 = 102.19 ¥ Í ˙˚ = 104.93 [1]
Î 100.7
È 102.4 + ¼ ¥ 102.4 ¥ 0.0582 ˘

TRI 30 / 9 = 104.93 ¥ Í ˙ = 106.97 [1]
Î 101.9 ˚
È 103.6 + ¼ ¥ 103.6 ¥ 0.0577 ˘

TRI 31/12 = 106.97 ¥ Í ˙˚ = 109.79 [1]
Î 102.4
[Total 4]

(ii) What this suggests about the skill of the property manger
The actual return figure of 8% achieved by the manager was lower than the benchmark
index return by almost 2%. By itself, this suggests that the manager has not performed
well over the year. [½]
However, there are a number of factors that must be considered together with this
figure. These mean that, by itself, the figure tells us little about the investment skill of
the property manger.
 Both the index return and the manager’s return are likely to be somewhat
subjective, as they will necessarily be reliant to some extent on subjective and
approximate property valuations. [½]
 The property index may be a barometer index, with a rental yield based on
current rack rents rather than rents paid, in which case it would not be an entirely
suitable benchmark. [½]
 If the manager is constrained in his choice of properties, then a “general

property” index might not be an entirely appropriate benchmark. [½]
For example, it may be that his portfolio is relatively small and so size
constraints mean that he is unable to invest in the full range of properties
covered by the index, eg large shops and offices, shopping centres etc. [½]
 The manager’s performance over a short period such as a single year will be
heavily influenced by factors outside of his immediate control of the manager,
such as rent reviews and void experience. [½]
Likewise, the manager’s ability to make profits by actively trading property is
limited by the flow of properties that actually come onto the market. It may be
that those properties that did come up for sale were “worse” than his existing
properties. [½]
 At various points of the year, part of the actual property portfolio will have been
invested in cash, eg rental income waiting to be reinvested, which is likely to
have reduced the overall return on the property fund compared to the fully
invested portfolio underlying the index. [½]
 In addition, and unlike the index, the property portfolio is likely to have incurred
tax and expenses, which will have further reduced its overall return. [½]
[Maximum 4]
Give (up to full) marks for appropriate comments here, even if the calculation in part (i)
is incorrect.

(iii) Comment on the assertion
At first sight, the higher value for the information ratio attained by the equity manager
does appear to support the assertion that he has out-performed the property manager. [½]
However, the different information ratios may largely reflect the different conditions in
the two markets. [½]
One the one hand, lack of marketability and high expenses are likely to make it more
difficult to actively generate out-performance in the property market compared to the
equity market. [½]
Conversely, the property market is likely to be less efficient than the equity market and
so may offer greater scope for actively identifying mispriced assets. [½]
It is also possible that the benchmark index used to calculate the figures for the equity
manager is not entirely appropriate, ie not entirely consistent with the objectives given
to him. [½]
We know from earlier in the question the property manager’s performance is based on
his benchmark index.
relative return
The information ratio is defined as . [½]
tracking error
As the tracking error is measured in standard deviations, might not be a true reflection
of the nature of the active risk taken by the managers. In particular, equity returns are
often thought to be negatively skewed and demonstrate fat tails, features not captured by
the standard deviation, which measures risk symmetrically about the mean. Likewise
voids may lead to asymmetric property returns. [1]
The information ratio it is possible to achieve may depend significantly on the level of
active risk taken, eg it may be easier to achieve a higher information ratio by taking a
lower level of active risk (by exploiting only a small number of “the best” price
anomalies). So the comparison made here may be inappropriate if the two managers
took very different levels of active risk. [1]
[Total 5]

Solution 6.16
(i) Main reasons for investing in corporate bonds
Corporate bonds will probably offer higher expected returns than government bonds due
to lower marketability and increased default risk. [1]
Investing in a wide variety of corporate bonds will increase the fund’s diversification
within the fixed interest portfolio (and also within the fund as a whole) and so may
reduce the overall variability of fund portfolio returns. [½]
Relative performance risk against other pension funds may also be reduced if they other
funds already invest a portion of their fixed interest portfolio in corporate bonds. [½]
Types of corporate bonds
These include:
 investment grade corporate bonds, which have a credit rating of BBB or above
according to Standard and Poors [½]
 non-investment grade corporate bonds (ie junk bonds), which have a credit
rating of BB or below according to Standard and Poors [½]
 high-yielding bonds, which offer a particularly high running yield, so as to
appeal to investors with a requirement for income [½]
 convertible bonds, which offer the investor the possibility of converting the
bonds into shares in the issuing company at a later date [½]
 distressed debt issued by companies that are either already in default, under
bankruptcy protection, or in distress and heading towards bankruptcy [½]
 event-linked bonds, whose coupons and redemption payments are conditional on
the non-occurrence of a defined event, such as an earthquake [½]
 asset-backed securities, whose payments are linked to the income generated by a
defined pool of securitised assets [½]
 mortgage-backed securities, whose payments are linked to the income generated
by a defined pool of mortgages. [½]
[Total 6]

(ii) How the swap would work
This is an inflation swap under which ABC would make regular series of fixed interest
payments (probably quarterly) and receive a corresponding series of payments linked to
the rental incomes received on a specified portfolio of properties. [1]
Both sets of payments would be based on a principal amount of 10% of $100 million =
$10 million (though no principal would be exchanged) and would continue for a
specified number of years. [1]
[Total 2]
(iii) Advantages of the swap arrangement
The swap would give ABC pension fund exposure to a series of rental income
payments, which are likely to be broadly linked to inflation, thereby enabling it to hedge
its own inflation-linked pensions in payment liabilities. [1]
The swap would give ABC exposure to property income without having to invest
directly in property itself. Thus it would save the high level of expenses involved in
property investment (agents’ fees, stamp duty, property maintenance, negotiation of rent
reviews etc). [1]
This is a particular advantage if, as is likely, the current investment managers have little
expertise in commercial property investment. Such expertise would then be
time-consuming and costly to obtain. [½]
It is also likely to much quicker to negotiate the swap than to buy individual properties,
meaning that the required investment exposure could be obtained much more quickly.
[½]
In addition, it may be possible to specify the swap so as obtain exposure to:
 exactly the desired mix of property types and sectors (prime or non-prime,
offices, shops and/or industrial properties etc) [½]
 a greater variety of property than is possible via direct investment with only a
relatively small amount of money to spend ($10 million). [½]
Main risks associated with the swap
By entering into the swap, ABC will expose itself to credit risk. [½]
First, there is the risk of rental defaults and voids (ie periods of no rental income) on the
properties underlying the swap, in which case the income passed through to ABC would
be less than anticipated and needed to covert he pensions in payment. [½]

Secondly, there is the risk that even if the underlying properties continue to generate the
anticipated cashflow, DEF might default on the agreed series of payments under the
swap – for example, if it runs into more general financial difficulties. [½]
It may be possible to reduce this risk via some form of collaterisation, perhaps on the
underlying properties themselves. [½]
ABC will also face liquidity risk in that the swap arrangement could be cancelled only
at great expense (as it is likely to contain a cancellation penalty) and after
time-consuming negotiation. [1]
However, if it instead bought actual properties, these would equally be very expensive
and time-consuming to sell. [½]
ABC will face a basis risk, in the sense that the income stream from the portfolio of
properties underlying the swap is unlikely to exactly hedge the pensions in payment. [½]
This is because although both income streams would be related to inflation, the index
link is unlikely to identical. For example, the pensions may increase annually in line
with a particular price index, whilst rents are typically renegotiated every few years. [½]
In addition, it is possible that commercial property rental increases may fail to keep up
with pension increases, for example due to an over supply of property in a recession. [½]
Finally, it is likely that the swap would be negotiated for a certain term (say five or ten
years) after which it would need to be renegotiated on terms that cannot be predicted
now. This need would not arise with direct property investment, where the properties
could be held indefinitely. [½]
[Maximum 8]





the course.

This part contains 100 marks of questions testing the material from the whole course.
You may like to try these questions under exam conditions as a mock exam.
Question 7.1
Outline the basic regulatory requirements that an investment exchange ought to satisfy
in order to obtain authorisation. [6]
Question 7.2
Explain what is meant by a split-rate corporate tax system and an imputation tax system,
and state the main advantages of each. [6]
Question 7.3
Pilrig plc is a small investment management firm. Its marketing literature states that its
main asset is the expertise of its fund managers.
(i) Explain briefly why the expertise of its fund managers is an asset of the firm and
list the other intangible assets the firm owns. [4]
(ii) Over the last financial year, the firm has generated revenues of £33m and in so
doing incurred costs of £30m, £2.5m of which relate to advertising expenditure
aimed at attracting new business. The management of Pilrig plc ask you to
assess the firm’s performance by estimating the risk-adjusted return on capital
over the year. They suggest that you use the following assumptions:
 an estimated equity risk premium of 4% pa
 the start-year market capitalisation of £85m
 the current bank base rate of 3% pa
 the industry average beta of 0.8.
Use these assumptions to estimate Pilrig plc’s risk-adjusted return on capital

over the last year. State any further assumptions you make and comment on
your answer. [6]
[Total 10]

Question 7.4
The assets of a UK-based pension fund were valued on 31 December 2013 at £100m by
the actuary to the scheme as part of an investigation into the funding level of the
scheme. During 2014 there was only one net contribution made into the fund of £30m
on 1 July. Immediately after this contribution the fund had a market value of £145m.
All investment income was reinvested in the investment class from which it arose and
there were no other cashflows into or out of the fund. The value placed on the fund at
31 December 2014 by the actuary was £162m.
On 31 December 2013 the investment manager decided to hedge the fund’s currency
exposure over 2014 by entering into a one-year forward deal to sell $35m in exchange
for £22.5m. All fund values quoted above include the value of this forward agreement.
The manager’s investment performance is assessed against a benchmark portfolio

consisting of an investment of 80% in UK equities and 20% US equities with no
currency hedging. The benchmark portfolio is rebalanced every six months. The total
returns on the benchmarks expressed as effective six-month rates in local currency
were:
UK equities US equities
31/12/13 to 30/6/14 15% 25%

30/6/14 to 31/12/14 10% 10%
Assume that sterling appreciated against the dollar from £1=$1.60 on 31/12/13, to
£1=$1.65 on 30/6/14 and to £1=$1.70 on 31/12/14.
(i) (a) Calculate the money-weighted rate of return and the time-weighted rate
of return on the fund.
(b) Explain why the fund values used in (a) may not give a fair measure of
the fund manager’s ability.
(c) Calculate the value of the forward agreement on 30 June 2014 and on
31 December 2014 if the six-month spot effective rates of interest on
30 June 2014 were 4% for sterling and 3% for the US dollar. [6]

On 31/12/13 the manager invested 70% of the portfolio in UK equities and 30% in US
equities. On the 30/6/14 he rebalanced the equity portfolio to be 75% UK equities and
25% US equities.
(ii) Calculate the monetary contribution to the performance of the fund against the
benchmark arising from stock, sector and derivative allocations in each half of
the year and for the full year. [12]
(iii) Comment on your results, including any limitations of your attribution analysis.
[5]
[Total 23]
Question 7.5
(i) Define the Jensen and Sharpe measures of risk-adjusted performance and
describe the circumstances under which it is appropriate to use each of them. [4]
(ii) An active investment manager has achieved an information ratio of +0.5 over the
last calendar year on his portfolio. Discuss how useful this information alone is
as an indicator of the manager’s investment management skills. [4]
[Total 8]
Question 7.6
Consider a new hedge fund that is about to invest $100k in high-risk information
technology (IT) shares. Based on the available historical performance data, the annual
investment return on similar existing hedge funds investing in IT shares is assumed to
follow a normal distribution with mean 10% pa and standard deviation 20% pa.
(i) Use the above information to calculate the hedge fund’s 1-year Value at Risk
based on the 5% lower tail. [2]
(ii) Comment in detail on the validity of your calculation in (i). [5]
(iii) The hedge fund now decides to leverage its returns by borrowing $100k at a
fixed rate of 5% pa, the new money being invested entirely in additional IT
shares. Calculate the increase in the hedge fund’s estimated 1-year Value at
Risk based on the 5% lower tail due to leveraging. [2]
[Total 9]

Question 7.7
A bank is about to issue a 10-year mortgage-backed security (MBS). The MBS will
offer a 6% annual coupon and a credit spread of ½% pa over the 4½% pa gross
redemption yield offered by an otherwise identical Government bond.
(i) Define default risk and prepayment risk in the context of an MBS. [2]
(ii) What are the key factors that an investor will need to consider when assessing
these risks in order to determine whether to invest in the MBS? [4]
(iii) An investor who has decided to purchase the mortgage-backed security but is
concerned about the default risk also purchases (for a single premium) a credit
default swap from another bank. Estimate the cost of the credit default swap and
comment on your answer. [5]
[Total 11]
Question 7.8
An investment bank has decided to offer a range of over-the-counter (OTC) derivatives

based on the prices of commercial forests.
(i) What are the main advantages and disadvantages of OTC derivatives compared
to exchange-traded derivatives? [4]
Before first offering the new derivatives, the bank needs to calculate an index for forest
prices.
(ii) Outline the main difficulties that it is likely to encounter in calculating such an
index series. [4]
(iii) Amongst the new derivatives is a 3-year commodity swap linked to the forest
price index. This enables the investor to pay a series of fixed annual payments
in return for receiving a payment linked to the increase in the forest index.
Calculate the annual fixed payment on the assumption that the forest index is
based at 100 and that it is expected to increase by 10% in the first year and 5%
in the two subsequent years. Assume that spot yields are 4% pa effective at all
terms. [4]
[Total 12]

Question 7.9
British Airwaves is a large quoted company that operates a service of domestic and
international flights for customers. As part of its business, British Airwaves (BA)
requires a fleet of 100 small, medium and large aeroplanes, which it buys from one of a
number of aeroplane manufacturers. It also sells its excess aeroplanes on to other
airline companies when its stock of aeroplanes is deemed to be too high. As part of its
buying and selling operations BA makes extensive use of forwards, over-the-counter
call options and commodity futures.
(i) Explain in detail what each of these three instruments is and how BA might use
them. [7]
BA’s business suffers when interest rates (particularly those in the US) rise. At the
present time BA believes that US interest rates will rise by 2% over the coming 2 years.
BA has “short-sold” 3,500 contracts of the 2-year Eurodollar future in order to hedge its
exposure to interest rates.
(ii) Describe the Eurodollar short interest rate future and calculate how much BA
will gain through its Eurodollar exposure if its estimates prove to be correct. [3]
(iii) Briefly explain what you believe to the main operational risks that BA faces with
regard to its derivative operations and explain how these can be controlled. [5]
[Total 15]





the course.

Solution 7.1
An investment exchange ought to be required to demonstrate to the regulator that:
 it has adequate financial resources to provide the requisite exchange services,

particularly if it operates a clearing house system whereby it incurs legal
liabilities to traders [1]
 proper conduct of business rules exist, and that all parties (traders and issuers of
securities) are aware of and understand them [1]
 it operates orderly, transparent and sufficiently liquid markets in the securities

traded [1]
 appropriate procedures for recording transactions exist, eg time, price and

volume of each trade, plus the parties involved [1]
 it effectively monitors and enforces the conduct of business rules, so as to

prevent impropriety such as insider trading and fraud [1]
 proper arrangements exist for the performance and clearing of transactions,

again to prevent fraud. [1]
[Total 6]
Solution 7.2
Split-rate and imputation systems
A split-rate tax system is one in which corporate profits are taxed at different rates
depending on whether the income is being distributed to shareholders or being retained
in the company. [1]
It is often used to counterbalance a tax system for individuals under which capital gains
and dividend income are taxable in the investor’s hands at different rates. However, it
is similar to the classical rate system in that income is taxed twice; once in the hands of
the company and once in the hands of the investor. [1]

An imputation tax system is one in which the company pays tax on the shareholder’s
behalf when it makes a distribution of profits, but it can offset this amount against its
corporation tax bill at the end of the financial year. Thus the more it pays as dividends,
and the more tax shareholders pay on receipt of dividends, the less additional
corporation tax the company has to pay at the end of the year. [1]
Individuals who are subject to more or less than the amount of tax paid by the company
must then either pay an additional amount or reclaim the tax paid by the company on
their behalf. [1]
The advantage of the split-rate system is that it is simple and it can be adjusted to
encourage distribution of income or the retention of earnings. [1]
The advantage of an imputation system is that shareholders are not penalised for
investing in companies that make a higher distribution of profits in the form of
dividends rather than retaining earnings. [1]
[Total 6]
Solution 7.3
(i) Expertise of its fund managers as an asset
The expertise of its fund managers is an asset because it is used by the firm to generate
future positive net cashflows for the firm’s shareholders. The firm’s profits will be
higher if it employs the managers than if it does not. As such, it would appear on a
CAPM-based balance sheet. [½]
The expertise is an intangible asset, as it is a non-physical resource. [½]
The other intangible assets are likely to include: [½]

 the expertise of the firm’s back office and administration staff [½]
 the current portfolio of clients for whom the firm provides fund management
services [½]
 the firm’s reputation as a (successful) fund manager [½]
 any specialist software it uses to aid successful stock and sector selection [½]
 its relationships with suppliers of information and research. [½]
[Total 4]

(ii) Estimation of risk-adjusted return on capital and comment
Profits are equal to revenues less costs. [½]
The risk-adjusted return on capital (RAROC) calculation should exclude the

expenditure on advertising, as this represents an investment in new intangible assets,
rather than an cost associated with generating revenues from the existing assets. [½]
Thus, the RAROC profits for the year are equal to:
33m – (30m – 2.5m) = £5.5m [½]
Dividing this through by the market capitalisation of £85m gives a return of:
5.5
= 0.0647 [½]
85
Finally, deducting the firm’s expected risk premium gives the RAROC as:
0.0647 - 0.8 ¥ 0.04 = 0.0327
ie about 3.3%, which is slightly more than the current risk-free rate of 3%. [½]
This number suggests that the firm has out-performed after allowing for risk. [½]
However, this conclusion must be treated with caution because of the assumptions
involved. [½]
In particular:
 The equity risk premium is only an estimate, we do not what the “true” risk
premium should be. 4% pa may have been chosen to ensure a RAROC ahead of
the risk-free rate – ie the management may have deliberately chosen the
assumptions in order to obtain a favourable result. [1]
 The calculation is based on the start-year market capitalisation, whereas an

average market capitalisation across the year might be a more appropriate
measure of capital. [½]
 3% pa is the current risk-free rate. The actual rate may have been higher than
this during the course of the year. [½]

 The beta used is an industry average. The true beta for this firm could be
different and in particular higher – for example, because this firm is smaller than
average and so may have higher operational gearing. [½]
 It is probably a simplification to assume that the advertising expenditure had no

impact on the existing intangible assets and therefore that the entire expense
should be excluded when calculating profits for the year. [½]
[Maximum 6]
Solution 7.4
(i)(a) Rates of return
MWRR
100(1 + i) + 30(1 + i)½ = 162
 i = 27.8% pa (using (1 + i)½  1 + ½ i) [1]
The exact answer is 28.1%
TWRR
(145 - 30) 162

¥ - 1 = 28.5% pa [1]
100 145
(i)(b) Reasons why the fund values may not be appropriate
Note that the question asks about the fund values.
We are not told the basis of the fund value calculations. For example, if the values
reflect a discounted cashflow value (as may be the case for an on-going valuation to
assess the funding level of a pension scheme) we would not normally want to use them
for performance measurement purposes. [1]
The end-year values may not be consistent with the market value given in the middle of
the year, so the time-weighted rate of return may be distorted. [½]
The two end-year values may not even be consistent with each other if the valuation
basis is not the same in both cases. [½]

(i)(c) Value of forward agreement
35
30/6/14 value: 22.5 v0.04 - v0.03 = £1.04m [1]
1.65
35
31/12/14 value: 22.5 - = £1.91m [1]
1.7
[Total 6]
(ii) Attribution analysis
Notional/notional performance
Had the fund manager not entered into the forward agreement and had he invested in line
with the benchmark 80/20 split with performance in line with the benchmarks then the
fund would have developed as follows:
1.6
30/6/14 value: 1000.81.15 + 1000.21.25 = 116.24
1.65
1.65
31/12/14 value: (116.24+30)0.81.1 + (116.24+30)0.21.1 = 159.92
1.7
[2]
Actual/notional performance
Had the fund manager not entered into the forward agreement and had performance
been in line with the benchmarks but with the actual sector allocations chosen by the
manager then the fund would have developed as follows:
1.6
30/6/14 value: 1000.71.15 + 1000.31.25 = 116.86
1.65
1.65
31/12/14 value: (116.86+30)0.751.1 + (116.86+30)0.251.1 = 160.36
1.7
[2]
Attribution
Sector selection contributed:

116.86 – 116.24 = +£0.62m in the first six months [1]
160.36 – 159.92 = +£0.44m over the full year [1]
The contribution of the forward was £1.04m in the first six months and £1.91m over the
full year. [1]

Total out-performance was:

(145 – 30) – 116.24 = –£1.24m in the first six months [1]
162 – 159.92 = +£2.08m over the full year [1]
The remaining numbers (shown in bold italics) in this table are calculated as balancing
items.
Attribution (£m) Derivative Sector Stock Total

1st half year +1.04 +0.62 –2.90 –1.24
2nd half year +0.87 –0.18 +2.63 +3.32
Full year +1.91 +0.44 –0.27 +2.08
[½ for each number in bold]

[Maximum 12]
(iii) Comments
Observations
The fund out-performed the benchmark by about £2m over the year. [½]
Most of the out-performance was due to the forward transaction. Over the full year
sector allocation gave a small positive contribution that was largely offset by negative
stock selection. [½]
Stock selection was highly variable over the year; strongly positive in the second half of
the year but strongly negative in the first half. [½]
The decision to be over-weight in US equities, particularly in the first half of the year,
was sensible given the out-performance of the US equity market. [½]
Some of this gain was removed by the depreciation of the dollar (although the fund’s
hedge compensated for this loss). [½]
[2½ for observations]

Limitations
The figures are highly dependent upon the fund values given in the question, which are
suspect as discussed in (i)(b). [½]
No allowance has been made for the impact of taxation nor for expenses. [½]
No allowance has been made for the level of risk taken by the manager relative to the
benchmark. [½]
The assessment is over one year, which may not be long enough to draw any
meaningful conclusions about possible future performance. [½]
We do not know if the benchmarks are sensible nor if they allow for any constraints to
which the manager was subject. [½]
[Maximum 2½ for limitations]
Solution 7.5
(i) Jensen and Sharpe measures
The Jensen measure is:
Î (
J = R p - È R f + b p Rm - R f ˘
˚ ) [½]
The Sharpe measure is:
Rp - R f
S= [½]
sp
where:
 Rp = (time-weighted) return achieved on portfolio
 Rf = risk-free rate of return
 bp = beta of the portfolio
 Rm = return on the market
 sp = standard deviation of the return on the portfolio [½]

The Jensen measure is appropriate where the following are all true:
 the CAPM is believed to hold (at least approximately) [½]
 the portfolio is only a small part of the investor’s total wealth [½]
 the appropriate level of systematic risk has been pre-specified. [½]
The Sharpe measure is appropriate where:

 the CAPM is believed to hold (at least approximately) [½]
 the portfolio represents the substantial element of the wealth of the investor. [½]
[Total 4]
(ii) Information ratio as indicator of investment management skills
A positive information ratio indicates that the investment manager has out-performed
his chosen benchmark over the last calendar year. [½]
However, beyond this we are unable to draw any firm conclusions about his investment
management skills as we do not have enough information. [½]
For example, we cannot be certain that this positive information ratio indicates any great
skill at actively selecting out-performing stocks. [½]
This is because:
 The time period considered is far too short to indicate consistent out-
performance due to skilful active management. We would need to investigate
how the manager performed over a number of years before drawing any firm
conclusions. [½]
It may in fact be the case that the manager is not very good at stock selection,
but was instead lucky with how things turned out over the last year. [½]
 We do not know the benchmark used in the calculation of the information ratio.
[½]
 We do not know whether the manager actually selected stocks that are similar to
those included in the benchmark, and so out-performed purely via stock
selection, or whether he picked systematically different stocks (eg high beta
ones) that would be expected to out-perform on average, and so out-performed
purely by taking more risk. [½]

 We do not know the mandate given to the investment manager and whether he
complied with that mandate and successfully achieved the investment objectives
that he was given. [½]
 For example, there may be (maximum and/or minimum) limits on investment in

particular stocks, limits on the overall volatility of the fund and/or ethical
restrictions. [½]
 Performance may have been poor relative to the peer group. An information
ratio of +0.5 might have been below the average for that year and/or type of
fund. [½]
[Maximum 4]
Solution 7.6
(i) Hedge fund’s 1-year Value at Risk
The distribution of the annual investment returns from existing IT hedge funds (R) is
assumed to be:
R ~ N ÈÎ10, 202 ˘˚
Thus, the 5% lower tail value for the investment return over the next year is:
+10% - 1.645 ¥ 20% = -22.9% [1]
The 1-year Value at Risk at the 5% lower tail is therefore given by:
100k - 77.1k = $22.9k [1]

[Total 2]

(ii) Comment in detail on the validity of your calculation
This may well be an under-estimate of the true Value at Risk because the assumption of
normality of investment returns is unlikely to be true for hedge funds investing in high-
risk information technology (IT) shares. [½]
In particular, the actual distribution of returns is likely to exhibit both negative skew and
fat tails, due to the high possibility of company failure amongst such shares. [½]
In addition, the estimated figure for the historical average return on IT-based hedge
funds is likely to be an over-estimate, as it is likely to exclude some such hedge funds
that have been wound up due to poor performance. In other words, the estimate is likely
to be biased upwards due to survivorship bias. [1]
It may also be an overstatement of the true average return if surviving IT-based hedge
funds with poor performance records are not included in the database from which the
mean has been estimated. In other words, the estimate of the mean is likely to be biased
upwards due to selection bias. [1]
Likewise, the estimate of the standard deviation of returns is likely to be too small. [½]
This may be due to:

 marking to market bias – reflecting the fact that some of the IT shares may not
be publicly quoted, and so the hedge fund performance will be based on
occasional and subjective estimates of the value of then underlying assets [½]
 survivorship bias – resulting from the exclusion of wound-up hedge funds,
which are likely to be those that perform very poorly. [½]
Finally, the “similar” hedge funds on whose performance the parameter estimates are
based may actually be very different in terms of the shares in which they invest,
eg start-up and/or more mature IT shares. [½]
Likewise, the “similar” funds may differ greatly in terms of their use of short selling,
leveraging and derivatives. [½]
[Maximum 5]

(iii) Hedge fund’s 1-year Value at Risk allowing for leverage
Recall that the 5% lower tail for the annual return on the IT shares is –22.9%.
Based on this, and remembering that the leverage allows the fund to increase its current
IT share exposure to $200k, the 5% lower tail value for the value of the IT share
portfolio in a year’s time is:
200k ¥ (1 - 0.229) = $154.2k [½]
And so allowing for the cost of the $100k debt at 5% pa, the corresponding 5% lower
tail value for the overall portfolio value is:
154.2k - 100k ¥ 1.05 = $49.2k [½]
The 1-year Value at Risk at the 5% lower tail is therefore given by:
100k - 49.2k = $50.8k [½]
So the increase in the estimated Value at Risk due to leveraging is:
50.8k - 22.9k = $27.9k [½]

[Total 2]
In this case, leveraging to double the exposure of the fund has more than doubled the
estimated Value at Risk.

Solution 7.7
(i) Default risk and prepayment risk
Default risk is the risk that mortgagees default on their mortgage payments and so the
investor will not receive the coupons promised by the MBS. [1]
Prepayment risk is the risk that more mortgagees than expected repay their mortgages
earlier than anticipated and so the investor receives his capital back sooner than
expected (and consequently receives fewer coupon payments than anticipated). [1]
[Total 2]
(ii) Key factors to consider when assessing risks
Future economic conditions – a recession may lead to more defaults, it may also lead to
an increase in job mobility leading to more people switching between mortgages and so
a greater volume of prepayments. [1]
In particular, higher interest rates could lead to more defaults. Conversely, lower
interest rates could lead to more mortgagees (especially those on fixed rates) refinancing
their mortgages elsewhere, leading to more prepayments. [1]
Average age of the mortgagees – younger people may be more likely to switch jobs and
so switch houses and mortgages. Conversely, older people may be able to pay off a
mortgage using a retirement lump sum. Security of employment and hence default risk
could also vary with age. [1]
The prepayment rate may vary with the average term since the start of the mortgage.[½]
Future changes in the mortgage market – new financial innovation or increased

competition may lead to more refinancing and hence to more prepayments. [½]
Average multiple of loan value to income – a higher multiple may correspond to a

higher level of defaults. [½]
[Maximum 4]

(iii) Cost of credit default swap
The current price of the Government bond is given by:
6a10 + 100v10 @ 4½% = 111.87 [1]
So the issue price of the MBS must be given by:
6a10 + 100v10 @ 5% = 107.72 [1]
The cost of the credit default swap should be equal to the difference between the
Government bond and the MBS, ie:
Value = 111.87 – 107.72 = 4.15 [1]
This value is only an estimate because this calculation:

 assumes that the difference between the Government bond price and the MBS
price is due entirely to credit risk … [½]
… in particular, it ignores the lower marketability and also the risk aversion of
investors … [½]
… and also the prepayment risk faced by investors, which is an option against
them. [½]
 assumes that the bank selling the credit default swap is risk-free and will never
default on the swap [½]
 ignores arrangement costs and the bank’s desire to make a profit on the deal. [½]
[Maximum 5]

Solution 7.8
(i) Main advantages and disadvantages of OTC derivatives
+ Unlike standardised derivatives, they can be tailored to meet the exact

requirements of investors, eg with regard to term, nominal value and underlying
asset. [1]
– The investor faces the risk that the counterparty (ie the bank) defaults, which
risk is negligible when the counterparty to a traded derivative is the exchange’s
clearing house. [1]
– Unlike with a traded derivative, the investor cannot quickly and easily close out
an OTC position should they wish to do so. Instead they will need to go back to
the bank and negotiate closure terms. [1]
– Arranging an OTC derivative is much more costly than for a traded derivative,
as it involves negotiation with a bank [½]
– Unlike a traded derivative, an OTC derivative does not have readily available
quoted market price, rather it needs to be specially valued. [½]
[Total 4]
(ii) Main difficulties in calculating index series
The production of a reliable forest index will require knowledge of the values of the
constituent forests at regular intervals. There are likely to be a number of problems in
obtaining reliable information in practice. [½]
 Each forest will be unique, eg with regard to location and mix of age and type of
tree. Consequently, it may be difficult to group forests into homogeneous
groups and still obtain sufficient price data for each group. [½]
 In addition, the characteristics of any particular forest may change through time,
eg with regard to age, mix and number of trees. [½]
 The market value of a particular forest will only be known for certain if and
when the forest changes hands. Even then the value of a similar forest may be
different. [½]
 Sales of forests are likely to relatively infrequent. [½]
 The prices agreed when a sale occurs are likely to be treated with a degree of
confidentiality and thus difficult to obtain. [½]

 In between sales, estimates of forest values could be obtained, but these will be
subjective and also costly to obtain. [½]
 Sales and valuations will be carried out at different points in time, so at any time
some of the values used in the index are likely to be out-of-date, making the
index an unreliable indicators of current forest values. [1]
[Maximum 4]
(iii) Calculate the annual fixed swap payment
The forecast forest index values are:

End of Year 1 100 ¥ 1.10 = 110
End of Year 2 100 ¥ 1.10 ¥ 1.05 = 115.50
End of Year 3 100 ¥ 1.10 ¥ 1.05¥ 1.05 = 121.275 [1]
The increases in the index each year on which the “floating” payments will be based are
therefore:
Year 1 110 – 100 = 10
Year 2 115.50 – 110 = 5.50
Year 3 121.275 – 115.50 = 5.775 [½]
If we denote the amount of the fixed annual payment by F, then the net cashflows at the
end of each year will be:
Year 1 10 - F
Year 2 5.50 - F
Year 3 5.775 - F [½]
In order for the swap to have a zero net present value at outset, we require that:
(10 - F ) v + (5.50 - F ) v 2 + (5.775 - F ) v3 = 0 [1]
 10v + 5.50v 2 + 5.775v3 = Fa3 @4%
From which:
F = 7.147 [1]
[Total 4]

Solution 7.9
(i) Three instruments
Forwards
A forward is an over-the-counter agreement between BA and its supplier (or its

customer) to buy or sell an underlying asset at a certain time in the future for a certain
price. [1]
It is an obligation rather than an option. [½]
If BA needs to increase its stock of aeroplanes, it is unlikely that the supplying

companies will have aeroplanes “in stock” ready for BA to buy immediately as the
items are very large and likely to be manufactured to suit the needs of each individual
customer. [½]
BA will order its aeroplanes in advance from the suppliers through forward agreements,
possibly several years in advance of requiring the aeroplanes. [½]
It may also sell its surplus stock to other airlines using forward agreements. [½]
[Maximum 2½]
Over-the-counter call options
This is an option agreed between two parties to buy an underlying asset at a point in the
future for a pre-specified price (called the strike price), and is not an exchange-traded
instrument. [1]
If demand is uncertain, and BA is unsure of how many planes it will need, it is risky to
order the planes through forward agreements. In these circumstances it might be better
to take out a call option with suppliers so that BA has the right to buy planes, but is not
obliged to (if demand turns out to be lower than expected). [1]
If BA is uncertain whether it will require additional small, medium or large aeroplanes,

it can take out several options on each type of plane, but only exercise those that it
requires at the time. [½]
[Maximum 2]
Commodity futures
These are similar to forwards, but are standardised products that trade on an exchange
and are very liquid and marketable. [1]

Commodity futures are used to hedge changes in the price of commodities or goods, and
not used to actually obtain the goods. [½]
Traders are required to deposit a margin payment with the clearing house when trading
in futures. [½]
It would be impossible for BA to hedge the cost of aeroplanes as there will not be such a
product on any exchange, but BA could, for example, hedge a rise in the cost of fuel by
buying oil futures at the current price. [1]
Give marks for other examples such as aluminium futures to hedge the cost of materials.
[Maximum 2½]
(ii) BA’s Eurodollar exposure
Description
Eurodollar futures are available in a variety of terms up to 10 years. [½]
Eurodollar futures all relate to a period of 90 days, so for example, the 2-year contract
will relate to the period from 2 years to 2.25 years in the future. [½]
Delivery dates are in March, June, September and December as well as other months
very close to the current date for short-term contracts. [½]
Calculation of profit
If Z is the quoted price for a Eurodollar futures contract, the contract price is:
$10, 000 ÈÎ100 - 0.25 (100 - Z ) ˘˚ [½]
A change of one basis point, ie 0.01, in a Eurodollar futures quote corresponds to a

contract price change of $25. [½]
Therefore a 200 basis point change for 3,500 contracts will give a profit of:
3,500 ¥ 200 ¥ $25 = $17.5m [1]
Note that this can also be calculated directly from the formula by considering a 2-point
movement in Z, and deriving the profit as: $10, 000 ¥ [0.25 ¥ 2] ¥ 3,500 .
[Maximum 3]

(iii) Operational risks
Operational risks relate to losses due to the mismanagement of funds through

incompetence of staff or through fraud. [1]
The main risks that BA is exposed to through its derivative dealing are:
 insufficient training and knowledge by the front office dealing staff that are
arranging the derivative transactions
 insufficient training and skills of the back office staff that settle the trades and
move the finances between bank accounts
 fraudulent use of funds by staff
 poor risk management within the company to track and manage all the risks that
arise from derivative dealing (credit risk, interest rate risk, currency risk,
commodity price risk). [½ for each, total 2]
Give credit for other operational risks provided they are spread across risk control,
incompetence and fraud.
Control of operational risk
Control of operational risk essentially depends on good management practices including

having established and documented chains of reporting and responsibility. [1]
In particular it is important that all those concerned have the required skills, which may
involve training for traders, back office staff and for management. [½]
Separation of front and back office functions is important to avoid fraud (perhaps by
using an independent custodian to perform the back office function). [½]
A thorough process of documenting trades and having a clear audit trail is important. [½]
Having modern computer systems to report the exposure is also important. [½]
[Maximum 5]

Subject ST5: Assignment X1
2016 Examinations
Time allowed: 2½ hours, plus 15 minutes reading time
Instructions to the candidate
1. Please:
– attempt all of the questions, as far as possible under exam conditions
– begin your answer to each question on a new page
– leave at least 2cm margin on all borders
– write in black ink using a medium-sized nib because we will be unable to mark
illegible scripts
– note that assignment marking is not included in the price of the Course
Materials. Please purchase Series Marking or Marking Vouchers before
submitting your script.
– note that we only accept the current version of assignments for marking, ie you
can only submit this assignment in the sessions leading to the 2016 exams.
2. Please do not:
– use headed paper
– use highlighting in your script.
At the end of the assignment

If your script is being marked by ActEd, please follow
the instructions on the reverse of this page.
In addition to this paper, you should have available actuarial tables

and an electronic calculator.

Submission for marking
You should aim to submit this script for marking by the recommended submission date. The
recommended and deadline dates for submission of this assignment are listed on the summary
page at the back of this pack and on our website at www.ActEd.co.uk.
Scripts received after the deadline date will not be marked, unless you are using a Marking
Voucher. It is your responsibility to ensure that scripts reach ActEd in good time. ActEd
will not be responsible for scripts lost or damaged in the post, or for scripts received after the
deadline date. If you are using Marking Vouchers, then please make sure that your script
reaches us by the Marking Voucher deadline date to give us enough time to mark and return
the script before the exam.
When submitting your script, please:
 complete the cover sheet, including the checklist
 scan your script and cover sheet (and Marking Voucher if applicable) to a pdf
document, then email it to: ActEdMarking@bpp.com
 do not submit a photograph of your script
 do not include the question paper in the scan.
In addition, please note the following:
 Please title the email to ensure that the subject and assignment are clear
eg “ST5 Assignment X1 No. 12345”, inserting your ActEd Student Number for 12345.
 The assignment should be scanned the right way up (so that it can be read normally
without rotation) and as a single document. We cannot accept individual files for each
page.
 Please set the resolution so that the script is legible and the resulting PDF is less than
3 MB in size. The file size cannot exceed 4 MB.
 Do not protect the PDF in any way (otherwise the marker cannot return the script to
ActEd, which causes delays).
 Please include the “feedback from marker” sheet when scanning.
 Before emailing to ActEd, please check that your scanned assignment includes all
pages and conforms to the above.

2016 Examinations
Please complete the following information:
Name: Number of following pages: _______
Please put a tick in this box if you have

Email address: solutions and a cross if you do not:
Please tick here if you are allowed extra

time or other special conditions in
ActEd Student Number (see Note below): the profession’s exams:
Time to do assignment
(see Note below): _____ hrs _____ mins
Note: Your ActEd Student Number is printed on all
personal correspondence from ActEd. Quoting it will help Under exam conditions
us to process your scripts quickly. If you do not know
(delete as applicable): yes / nearly / no
your ActEd Student Number, please email us at
ActEd@bpp.com.
Note: If you take more than 2½ hours, you should
Your ActEd Student Number is not the same as your indicate how much you completed within this time
IFoA Actuarial Reference Number or ARN. so that the marker can provide useful feedback on
your chances of success in the exam.
Score and grade for this assignment (to be completed by marker):

Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Total
=_____%
11 9 6 9 20 7 8 10 80
Grade: A B C D E Marker’s initials: ________
Please tick the following checklist so that your script can be marked quickly. Have you:
[ ] Checked that you are using the latest version of the assignments, ie 2016 for the
sessions leading to the 2016 exams?
[ ] Written your full name and email address in the box above?
[ ] Completed your ActEd Student Number in the box above?
[ ] Recorded your attempt conditions?
[ ] Numbered all pages of your script (excluding this cover sheet)?
[ ] Written the total number of pages (excluding the cover sheet) in the space above?
[ ] Included your Marking Voucher or ordered Series X Marking?
Please follow the instructions on the previous page when submitting your script for marking.

This page has been left blank in case you wish to submit your
script by fax.

Feedback from marker
Notes on marker’s section
The main objective of marking is to provide specific advice on how to improve your chances
of success in the exam. The most useful aspect of the marking is the comments the marker
makes throughout the script, however you will also be given a percentage score and the band
into which that score falls.
A = Clear Pass B = Probable Pass C = Borderline D = Probable Fail E = Clear Fail
Please note that you can provide feedback on the marking of this assignment at:
www.ActEd.co.uk/marking

script by fax.

ST5: Assignment X1 Questions Page 1
Question X1.1
(i) Outline the role of the clearing house on a derivatives exchange. [4]
An investor sets up the following positions in traded options based on 1,000 shares in
Company X:
 she buys a 3-month call option at $10, with a strike price of $200
 she sells a 3-month call option at $20, with a strike price of $180.
(ii) Explain how her total profit or loss will vary with the share price at expiry and
also why she might undertake such a strategy. [4]
(iii) Discuss the following alternative strategies:

 buy a put on the share
 sell a call on the share. [3]
[Total 11]
Question X1.2
Explain why institutional investors might be reluctant to invest in hedge funds. [9]
Question X1.3
Describe the advantages and disadvantages of investing through a financial intermediary

rather than investing directly. [6]
Question X1.4
(i) Define monetary policy. [1]
(ii) Describe the ways in which a central bank can control the money supply. [4]
(iii) Explain why monetary policy is not always successful in achieving inflation rate
targets. [2]
(iv) Explain what is meant by quantitative easing. [2]

[Total 9]

Page 2 ST5: Assignment X1 Questions
Question X1.5
(i) Explain what is meant by:

(a) an asset swap
(b) an extendable swap
(c) a puttable swap
(d) a swaption. [4]
(ii) Describe the main risk faced by each of the following institutions and discuss
how each could use an appropriate swap to reduce that risk.
(a) Insurance Company A has a large block of fixed income annuities in

payment, matched by conventional government bonds.
(b) Pension Scheme B has the majority of its fund invested in conventional
government bonds in order to back a block of pensions in payment. The
pension payments are linked directly to a price index, although the
annual increases are capped at 3% each year. [6]
(iii) Suppose that Companies X and Y enter into a 5-year currency swap. Under the
terms of the agreement, Company X borrows £100m on which it pays interest at
a fixed rate of 4.5% pa payable annually in arrear. In return, Company Y pays
interest annually in arrears at a fixed rate of 5.5% pa on its borrowing of €170m.
Suppose that immediately after the second interest payments have been made
under the swap agreement, the sterling interest rate is 5.0% pa at all terms, the
Euro interest rate is 5.75% pa at all terms (both continuously compounded) and
the exchange is €1.00/£0.61. What is the value of the swap to Company X in
Euro? [5]
(iv) A life insurance company has a block of pension business on which it has given
a guarantee to policyholders specifying minimum terms on which they can
convert their pension fund values into annuities at their retirement date. The
guarantee states that the annuity factor on which this conversion is based will be
calculated at the then market rate of interest (defined as the gross redemption
yield on 15-year government bonds) or 3% pa if greater.
The company would like to use derivatives to protect itself from the risk it faces
in providing this guarantee. Discuss how the company could do this and
describe the assumptions it would have to make in the process. [5]
[Total 20]

Question X1.6
(i) Describe with the aid of an example how a credit default swap issued in relation
to a corporate bond works. [4]
(ii) Why might an institution participate in a credit default swap? [3]

[Total 7]
Question X1.7
(i) Explain the term private equity, giving examples of its different forms. [4]
(ii) A biotechnology start-up company is considering approaching a venture capital

firm for finance. Explain why venture capital may be an appropriate means of
finance for this company. [4]
[Total 8]
Question X1.8
(i) Explain the characteristics that distinguish infrastructure assets from more
traditional equity or debt investments. [3]
A government in a developing country has been working for many years to expand its
road network in response to the growing public demand and the increased number of
vehicles on the existing roads. In recent times, the government has run short of funds
and the road network expansion has slowed.
A private consortium has approached the government offering to continue the road
expansion at a faster pace in return for being able to collect tolls from drivers for the
twenty year period following each road’s completion.
(ii) Explain the advantages and disadvantages of the government accepting this
proposal rather than funding the road-building itself. [7]
[Total 10]





the course.

2016 Examinations
1. Please:
illegible scripts
2. Please do not:



page.

2016 Examinations


ActEd@bpp.com.

Q1 Q2 Q3 Q4 Q5 Q6 Q7 Total
=_____%
7 6 13 10 8 21 15 80
Please grade your Assignment X1 marker by ticking the appropriate box.
[ ] Excellent – the marker’s comments were thorough and very helpful

[ ] Good – the marker’s comments were generally helpful
[ ] Acceptable – please explain below how the marker could have been more helpful
[ ] Poor – the marker’s comments were generally unhelpful; please give details below
Please give any additional comments here (especially if you rate the marker less than good):
Note: Giving feedback on your marker helps us to improve the quality of marking.

script by fax.

[ ] Written your full name and email address in the appropriate box?
[ ] Completed your ActEd Student Number in the appropriate box?
[ ] Rated your Assignment X1 marker?

script by fax.

Question X2.1
(i) State what is meant by a conglomerate merger. [1]
(ii) Explain why two firms might undertake a conglomerate merger. [6]
[Total 7]
Question X2.2
A regulatory regime is being introduced to cover the operations of hedge funds located in
Country X. List the operational (ie non-investment) aspects of the hedge funds that might
be covered by the new regulations. [6]
Question X2.3
(i) Explain fully what is meant by short-term financial planning. [5]
(ii) Discuss how and why the opportunity cost of capital should be interpreted for
use as an operational tool for financial management. [4]
(iii) Describe how the opportunity cost of capital can be used as an operational tool
for financial management. [4]
[Total 13]
Question X2.4
A developing country has historically had a large number of family-run companies.

There is a trend amongst these companies to move into the public domain by issuing
shares. The government is considering whether to tighten regulation in this area.
(i) Outline the pros and cons of the government regulating the issue of shares. [4]
(ii) Describe the regulations that could be imposed at each stage of the process for a
private company wishing to issue shares for the first time. [6]
[Total 10]

Question X2.5
(i) Explain with the aid of a diagram the insight yielded by prospect theory into
decision making by individuals. [4]
(ii) Define anchoring and explain how it may affect the choice of an investment
strategy in response to a reduction in the long-term level of inflation. [4]
[Total 8]
Question X2.6
Your friend has recently been appointed as trustee to a small charitable organisation.
(i) Explain his role and key responsibilities. [4]
(ii) He has been given the task of setting the investment agreement for the next period.
Outline his key considerations in carrying out this task, explaining how they might
be affected by existing mandates and discussing the details of what might be
included in the future investment agreement. [11]
(iii) Explain the rationale behind the various restrictions that may appear in the
investment agreement. [6]
[Total 21]

Question X2.7
A risk-averse individual coming up to retirement age has around 1% of their retirement

funds invested in the shares of a highly respected bank. The bank has historically been
involved in low-risk activities, producing steady returns. Since new management was
put in place 3 years ago the bank has been involved in a number of high profile risky
investments which have gone wrong. As a result there has been a sharp decline in the
share price.
(i) Outline how the change in management has affected the risk and return profile
of the investment and of the individual’s investment portfolio. [2]
The individual had the opportunity to sell the stock 6 months ago, but decided to hold
onto the stock. Since then, the share price has fallen further.
(ii) Outline the various reasons why the stock might not have been sold. [5]
(iii) Discuss whether the investment is suitable for the individual’s circumstances. [2]
The investor believes the share price has reached its lowest point and expects it to rise in
the near future. The investor wants to try to make back some of their losses.
(iv) Describe a technique, using the current share price, that the investor could use to
make a profit on their holding without selling any shares. [2]
The investor decides to use the technique in (iv).
(v) Describe the effect on the investor’s exposure to the bank if the bank’s share
price rose by 30%. [2]
(vi) Describe the effect on the investor’s exposure to the bank if the bank’s share
price fell by 30%. [2]
[Total 15]





the course.

2016 Examinations
1. Please:
illegible scripts
2. Please do not:



page.

2016 Examinations


ActEd@bpp.com.

Q1 Q2 Q3 Q4 Q5 Q6 Q7 Total
=_____%
13 5 10 15 12 14 11 80


script by fax.


script by fax.

Question X3.1
Outstanding term in Annual coupon, Bond price,

whole years per 100 nominal per 100 nominal
1 5 99.779
2 4.5 98.549
3 5.5 100.314
The above table shows the observed market prices of three short-term fixed-interest
bonds.
(i) Use bootstrapping to estimate the 1-year, 2-year and 3-year continuously-
compounded spot rates. [3]
(ii) Estimate the continuously-compounded forward rates in the second and third
years and hence the instantaneous forward rate in two years’ time. [3]
(iii) Outline the likely circumstances in which a company might choose to purchase
an interest rate collar. [2]
(iv) Explain how an interest rate collar can be used to convert a floating interest rate
into a fixed interest rate. Hence calculate the value of a 3-year interest rate
collar with annual payments, based on a principal amount of €5m, a fixed
interest rate of 5% pa and spot rates as in (i) above. [5]
[Total 13]
Question X3.2
A one-year call option with a strike price of 92 is available on a three-year zero-coupon

bond. The 1-year, 2-year and 3-year annual effective spot rates are equal to 3.8%, 3.9%
and 4% pa respectively and the forward bond price volatility is 2.75%.
(i) Find the current price of the bond. [1]
(ii) Calculate the current price of the call option. [4]

[Total 5]

Question X3.3
(i) Explain what is meant by fundamental analysis in the context of ordinary share
valuation. [5]
(ii) Discuss the factors that you should consider when analysing the outlook for
shares in a firm that provides professional education services. [5]
[Total 10]
Question X3.4
The following table shows (hypothetical) US$ LIBOR interest rates at 1 January 2014
and 1 July 2014 for a variety of terms – all rates are expressed as effective annual rates.
Maturity date Rate at 1 January 2014 Rate at 1 July 2014

1 July 2014 6.71% –
1 January 2015 6.58% 6.56%
1 July 2015 6.51% 6.52%
1 January 2016 6.47% 6.50%
1 July 2016 6.45% 6.47%
1 January 2017 6.44% 6.45%
A 3-year interest rate swap was arranged on 1 January 2014 based on a principal of
$50m. Under the terms of the swap, Investor A agreed to pay a series of variable
interest payments based on annual LIBOR rates to Bank B in return for a series of
annual fixed interest payments. The first payment was to be on 1 January 2015.
(i) (a) Explain how the swap can be viewed as the exchange of a fixed rate and
a floating rate bond.
(b) Hence, calculate the annual coupon payment (to the nearest dollar) on the
fixed side of the swap on the assumption that it is chosen so that initial
value of the swap is zero to both parties.
(c) Calculate the value of the swap to Investor A on 1 July 2014. [7]
(ii) Explain how the swap is similar to a series of FRAs and, by valuing the swap in
this way, verify your answer from (i)(c). [8]
[Total 15]

Question X3.5
(i) Describe the main reasons why an investment bank might choose to buy a 5-year
interest rate cap based on 3-month LIBOR. [4]
(ii) An investor believes that short-term interest rates are likely to rise shortly and to
remain higher for the next couple of years. Discuss the different ways in which
he could use over-the-counter derivatives to try and take advantage of this view.
[8]
[Total 12]
Question X3.6
A public listed company that owns a chain of coffee shops in a country that has recently
experienced two small recessions has acquired a company that produces coffee beans (ie
plantations).
(i) Explain what type of acquisition this is. [1]
(ii) Outline the possible motives for the acquisition. [4]
Market reports are now suggesting that the country is at risk of a third recession (a
“triple-dip recession”). In addition, statutory regulation has forced some recent wage
increases, which will mean that the cost of cultivating coffee beans is to increase by
20% from last year.
(iii) Discuss the business impact on both the coffee bean company and the coffee
shop chain of:
(a) the possible third recession

(b) the recent increase in the cost of cultivating coffee beans. [6]
After the acquisition, the head of the tax team has suggested that the company
restructures itself to lower its corporation tax bill in the country where the coffee bean
company is based. The restructure is entirely legal.
(iv) State the main advantage of such a restructure. [1]
(v) Explain the main disadvantage of such a restructure. [2]

[Total 14]

Question X3.7
The domestic equity portion of a pension fund is split equally between two investment
managers. One manager invests in high income, “value” stocks, whereas the other
invests in high “growth” stocks. The value of the equity fund is currently £20m. The
trustees are concerned that the stock market is likely to fall over the coming quarter and
on the advice of their investment consultant have decided to hedge against this
possibility using 4-month equity index futures.
(i) Explain what is meant by basis risk and discuss its relevance in this instance. [4]
(ii) Give a formula for the optimal hedge ratio for a hedge involving a futures
contract. Define the symbols used. [3]
(iii) The investment consultant estimates that the annualised 3-month volatility of the
equity index future is about 20%, whereas those of the value and growth stock
portfolios are about 25% lower and 40% higher respectively. Assuming that:
 there is an 84% correlation between the price of the value stock portfolio
and the equity index future
 there is a 76% correlation between the price of the growth stock portfolio
and the equity index future
 equity index futures currently have a value of £100k
determine the number of equity index FTSE 100 futures that are required for the
optimal hedge (to the nearest whole number) and state whether a long or short
futures position is required. [4]
[Total 11]

2016 Examinations
Time allowed: 3 hours, plus 15 minutes reading time
1. Please:
illegible scripts
2. Please do not:



page.

2016 Examinations


ActEd@bpp.com.
Note: If you take more than 3 hours, you should

Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Total
=_____%
11 5 7 17 9 8 13 30 100


script by fax.


script by fax.

Question X4.1
(i) Describe the two main problems for portfolio performance measurement for a
fund invested in global equities. [4]
(ii) State which two indices you would use to assess the performance of a portfolio of
US equities and explain why. [4]
(iii) Give three reasons for measuring the performance of an institutional investment
portfolio. [3]
[Total 11]
Question X4.2
Describe the types of companies in the oil and gas industry group and their main features.
[5]
Question X4.3
The domestic equities portion of an investment fund is managed by two different

investment managers. Over the past year, the overall equity market return has been
+10%, which is 6% above the return on Treasury bills. In addition, the two equity sub-
funds have performed according to the figures in the following table.
Manager A B
Actual return 12.4% 9.0%
Beta 1.2 0.7
(i) Assess the performance of the two managers using the Jensen risk-adjusted
measure and comment on your results. [3]
(ii) (a) Discuss whether the Jensen measure is suitable for performance
comparisons in this instance.
(b) Assess the performance of the two managers using another risk-adjusted
measure and comment on your results. [4]
[Total 7]

Question X4.4
You have been asked to construct an index to be used by UK institutional investors as a

benchmark for assessing the performance of their property portfolios. Discuss the factors
you would consider in constructing such an index, in terms of:
(i) method of construction of the index [2]

(ii) coverage of different properties in the index [6]
(iii) sources of valuation and income data [5]
(iv) allowance for rental income [2]
(v) frequency of publication. [2]
[Total 17]
Question X4.5
Consider a share market that includes two listed football teams, Gooners Utd and Red
Devil Rovers. At the start of the football season, a merchant bank decides to construct
an index that can be used to assess the investment performance of football shares. On
the proposed base date of the index, Gooners Utd have 500 shares in issue priced at 100,
whilst Red Devil Rovers have 1000 shares in issue, priced at 200.
(i) (a) The merchant bank decides that a weighted-average market-capitalisation

arithmetic index is most appropriate for the measurement of investment
performance. Explain why.
(b) Calculate the base value of the divisor required if the initial index value
is to be 1,000. [3½]
(ii) At the end of the football season, the respective share prices of Gooners Utd and
Red Devil Rovers have increased to 135 and 222, no dividends having been paid
during the intervening period. Following their success in winning both league
and cup competitions, the Gooners board decides to have a 1-for-5 rights issue,
at an issue price of 110, in order to fund the purchase of some new players for
the following season’s European tournaments. Calculate the revised value of:
(a) the index divisor following the rights issue
(b) the index immediately following the rights issue, assuming that the actual
price of the Gooners shares is 128. [5½]
[Total 9]

Question X4.6
You have recently been appointed as the fund manager of a fixed interest unit trust,
which has a stated objective as follows:
“the fund aims to beat the performance of a 10-year government bond index over every
calendar quarter”, calendar quarters being defined as January to March, April to
June, etc.
(i) Discuss any clarification of this objective you would request before taking over
management of the fund. [2]
(ii) The 10-year bond index is a weighted arithmetic index of government bonds
with periods to maturity of between 8 and 12 years.
(a) Give a formula that you could use to calculate a weighted arithmetic
index and define the terms used.
(b) Explain the meaning of “chain-linking” with respect to the calculation of

indices, and give two examples of when chain-linking might be required
in the calculation of the index described above. [6]
[Total 8]
Question X4.7
Describe the main equity investment indices used for:
(i) Japan [4]

(ii) Germany [1]
(iii) France [1]
A stock exchange in a developing country with a growing economy is planning to

launch a new equity index. The index will be an arithmetic weighted average index for
the country’s 50 largest companies.
(iv) Describe the possible uses for such an index. [7]

[Total 13]

Question X4.8
An investment manager is comparing two of his portfolios to investigate why the

returns of these two portfolios have differed substantially over the last year.
(i) Outline reasons why the performance, of two portfolios run by the same
investment manager, might differ. [4]
The investment manager wants to assess the performance of one of his portfolios
against its benchmark. The benchmark portfolio, which rebalances quarterly, is as
follows:
● 45% domestic equities
● 30% overseas equities
● 20% bonds and
● 5% cash.
The portfolio’s value at the start of the year was £3.5m. The investment manager had
deviated from the benchmark by transferring 5% each from both domestic and overseas
equities into bonds. At the end of the second quarter, the investment manager
rebalanced the portfolio back in line with the strategic benchmark but no other
rebalancing occurred during the year. There were no external cashflows into or out of
the fund.
The following information is available, which shows the fund value at the end of each
quarter, prior to any rebalancing, and the benchmark returns.
Value at the end of Quarter 1 Quarter 2 Quarter 3 Quarter 4
Domestic equities:
portfolio value 1,456 1,485 1,778 1,746
benchmark return 3.1% 0.9% 0% 2.0%
Overseas equities:
portfolio value 919 946 1,129 1,186
benchmark return 8.1% 1.0% –2.0% 0%
Bonds:
portfolio value 1,082 1,113 768 803
benchmark return 0.5% 0% 0% 2.5%
Cash:
portfolio value 175.35 175.70 183.21 183.57
benchmark return 0.3% 0.2% 0.2% 0.1%
All figures are quarterly and portfolio values are in £000’s.

(ii) (a) Calculate the quarterly and the yearly returns for each asset class in the
portfolio, and for the total portfolio.
(b) Calculate the yearly benchmark returns for each asset class and the
quarterly and yearly returns for the total benchmark portfolio.
(c) State the under or outperformance of the fund relative to the benchmark
for each quarter and for the year.
State any assumptions you make. [8]
(iii) Calculate, for each quarter, the returns attributed to:

 stock selection profits for each asset class
 stock selection profits at the total fund level
 asset allocation profits for each asset class
 asset allocation profits at the total fund level
showing whether each had a positive or negative impact on the performance of
the portfolio relative to the benchmark. [10]
(iv) Explain the limitations and disadvantages associated with measuring the
performance of the investment manager. [8]
[Total 30]





the course.

2016 Examinations
1. Please:
illegible scripts
2. Please do not:



page.

2016 Examinations


ActEd Student Number: (see Note below): the profession’s exams:
ActEd@bpp.com.

Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Total
=_____%
10 6 12 8 5 12 9 11 5 6 16 100


script by fax.


script by fax.

Question X5.1
(i) A collective investment vehicle invests only in shares that have under-performed
the stock market by more than 5% over the past six months. Discuss why this
method of choosing shares may be appropriate. [3]
(ii) Discuss methods by which an investment manager might use to increase the total
return on a fixed interest fund that is designed to back a portfolio of retirement
annuities in a very competitive market. [7]
[Total 10]
Question X5.2
Outline the main stages in an asset liability modelling exercise and list the additional
information yielded by a stochastic approach compared to a traditional actuarial
valuation. [6]
Question X5.3
(i) Define liquidity risk both generally and within the specific context of a clearing
bank. [2]
(ii) Describe two methods that could be used to monitor and control liquidity risk.[7]
(iii) The balance sheet of RSB plc bank is as follows (figures in $m):
Assets Liabilities
Government bonds 400 Share capital 100
Fixed-rate mortgages 800 Reserves 100
Treasury bills (3- 1,000 Deposits (sight) 1,200
month)
Deposits (30-day) 800
Total 2,200 Total 2,200
Calculate the liquidity gap of RSB plc using a six-month gap. [3]
[Total 12]

Question X5.4
(i) Outline the main risks inherent in the management of a unitised fixed interest
fund invested entirely in domestic currency stocks. Explain how these risks
might be mitigated in practice. [5]
(ii) “If investors expect short-term interest rates to fall, they should invest in the
most volatile stocks.” Explain how this statement is potentially wrong. [3]
[Total 8]
Question X5.5
You have been given the following statistics on 4 equity shares. List the 5 most
common types of active management styles and for each of the 4 shares, discuss
whether it would be favoured by a manager with any of the above styles.
Market Earnings Dividend Return Performance

price per share per share on equity
(p) (p) (p)
1 month 1 year
A Plc 320 24 16 8% 2% 5%
B Plc 589 29 23 12% –2% –6%
C Plc 121 3 0 21% –6% 15%
D Plc 63 3 2.5 12% 8% –2%
[5]
Question X5.6
The fund management company for which you work has decided to set up a new
investment trust aimed primarily at individual investors. The objective of the trust is to
invest in securities issued in the currently fashionable emerging market of Mergia.
(i) Explain the factors that should be considered when setting up the trust. [7]
(ii) Discuss the relative merits of index tracking compared to active fund
management for this trust. [5]
[Total 12]

Question X5.7
You are the bond investment manager of a pension fund that currently has $100m
invested in a range of domestic fixed interest bonds. You have just read an analyst’s
market report that confirms your belief that bond yields are likely to fall in the near
future. You therefore think that it might be appropriate to switch $10m from short-term
government bonds into long-term government bonds. Discuss the factors you ought to
consider before proceeding with this switch. [9]
Question X5.8
(i) Describe what is meant by a passive investment strategy and explain how betas
might help in its implementation. [6]
(ii) Explain in detail how asset liability modelling is used in both the banking sector
and in pension fund work and distinguish between the different interpretations of
asset liability modelling in these areas. [5]
[Total 11]
Question X5.9
Outline the sources of financial risks faced by an institutional investor. [5]
Question X5.10
(i) Explain what is meant by asset liability mismatch reserving. [2]
(ii) Discuss the deterministic approach to asset liability mismatch reserving. [2]
(iii) Discuss the stochastic approach to asset liability mismatch reserving. [2]
[Total 6]

Question X5.11
(i) Define the term liability hedging. [1]
A small soft drinks production company is conducting an analysis of the rental

payments that it makes on its head office based in a developing country. The company
has entered into a 20-year agreement to rent the fifth floor of a large building in a prime
location at a fixed but significant cost. The company has surplus funds available at the
present time. To meet the cost of the rental payments, a financial manager at the
company suggests holding a portfolio of government bonds. The coupon and principal
proceeds from the bond portfolio can be used to meet the obligation to make the rental
payments.
(ii) Outline the possible difficulties with this approach. [4]
Following a discussion about these difficulties the fund manager suggests instead
hedging the rental payments through the use of interest rate swaps.
(iii) Discuss the use of interest rate swaps to hedge the rental payments. [6]
(iv) Give specific examples of operational risk that the soft drinks company faces. [5]
[Total 16]

2016 Examinations
1. Please:
illegible scripts
2. Please do not:



page.

2016 Examinations


ActEd Student Number: (see Note below): the profession’s exams:
ActEd@bpp.com.

Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Total
=_____%
12 11 7 13 10 12 7 6 15 7 100


script by fax.


script by fax.

Question X6.1
(i) State possible reasons why two investors trading in a particular asset may have
different net of tax returns when they have identical gross (ie before tax) returns.
[4]
(ii) Describe the classical corporation tax system and the effect it can have on
companies’ dividend policies. [4]
(iii) Describe the main principles underlying the imputation system of corporate
taxation. [4]
[Total 12]
Question X6.2
(i) Explain how an investor can use futures contracts to effect a rapid switch from
domestic equities to domestic long-dated fixed interest stocks, without carrying
out rapid transactions in the underlying securities. [4]
An investor knows that she will be receiving a positive cashflow in three months’ time,
which will be invested in domestic equities. She is worried that the level of the stock
market will increase in the meantime and so decides to hedge the risk of this occurring
by purchasing call options on an equity index.
(ii) Suppose that the current value of the equity index is 155 and the call options are
available with the appropriate strike date and with a strike price of 160. The
premium for such options is 5. Derive an expression for the overall profit or
loss made by the investor over the next three months depending on movements
in the equity market. Comment on your answer. (Your answer should assume
that the investor effectively has negative exposure to the shares that she has yet
to purchase.) [5]
(iii) Calculate the profit or loss made if the index value at expiry turns out to be 165
and explain why the actual profit or loss per option will/is likely to differ from
the amount. [2]
[Total 11]

Question X6.3
You are the investment manager of a large investment fund with 30% of the fund’s assets
invested in overseas equity markets. Currencies have recently been volatile and a number
of the funds directors have expressed concern at the possible implications for returns.
(i) Describe briefly two methods whereby the fund could use derivatives to hedge
the foreign currency risk while retaining the full exposure to overseas markets.
[2]
(ii) Discuss the advantages and disadvantages of each approach. [5]

[Total 7]
Question X6.4
Two wealthy actuarial students are both managers of their respective father’s personal
portfolios, each worth in excess of £10 million. In order to diversify the first student
has invested half the portfolio in international equities, whereas the second student has
invested the entire portfolio in domestic equities.
Given the current turmoil in equity markets the second student has decided that her
portfolio needs some international diversification and has approached the first student
for advice. The three ways that the second student envisages achieving the exposure
are:
1. using the futures markets
2. using options
3. undertaking an equity swap with the first actuarial student.
(i) Describe how the second student might achieve international exposure through
each of the three routes and give the advantages and disadvantages that each
route might offer relative to the others. (Do not describe the advantages of
international exposure for the purposes of diversification!) [10]
(ii) Suppose the second student was to decide on using one of the above forms of
derivative to gain international diversification. Set out the key items of
information she should include in a regular report to her father outlining the
investment strategy undertaken on his behalf. [3]
[Total 13]

Question X6.5
(i) Define Value at Risk. [1]
(ii) Calculate the Value at Risk at the 5% significance level over a 30-day period for
a portfolio of £500m equity shares and £300m of bonds. You should assume the
following:
● (
the annual return on equities Re  N 10%, (14%)
2
)
● (
the annual return on bonds Rb  N 5%, (8%)
2
)
● the correlation between bonds and equities is 0.6. [4]
(iii) Discuss the drawbacks of using this calculation to measure the risk of the
portfolio. [5]
[Total 10]
Question X6.6
You have recently been appointed as the investment consultant to the trustees of a new
charitable fund that will aim to provide relief over the long term to victims of natural
disasters in third-world countries. The fund has been set up with an initial donation of
$100 million.
Outline the steps you would take and the factors you would consider when modelling
the outgo in order to establish a suitable investment portfolio for the charitable fund.
[12]
Question X6.7
(i) Keep-m-safe is a small company that undertakes custodial services for its
clients. It is considering taking over Global1 in order to expand the range of
services that it can offer to its clients. List the full range of services that a
custodian can traditionally offer to its clients. [3]
(ii) Keep-m-safe is a custodian whereas Global1 describes itself as “the world’s

biggest global custodian trustee”. Describe in detail what this says about
Global1. [4]
[Total 7]

Question X6.8
Explain what is meant by technical analysis and describe briefly its three main forms. [6]
Question X6.9
(i) Define the terms strategic risk, structural risk and active risk in the context of
portfolio construction. [3]
(ii) A small pension fund with total assets of £100m is in the process of choosing a
number of specialist managers. Following an asset/liability study by the scheme
actuaries, the trustees have been told that 75% of the fund’s liabilities are linked
to salary inflation and 25% are fixed in nominal terms. The actuaries have
therefore recommended that the following liability benchmark portfolio would
be suitable for matching purposes:
 50% domestic equities
 25% domestic property
 25% fixed interest undated bonds
As a result the trustees have set up a strategic benchmark portfolio consisting of:
 80% equities (all in domestic currency)
 20% fixed interest undated bonds.
The trustees have chosen two specialist managers to manage the fund: a
domestic equity manager whose style is described as “growth” and a passive
bond manager that aims to match the FTSE Actuaries over 15-year government
bond index. (They were unable to find a passive manager that targeted undated
bonds.)
Describe the risks inherent in the set-up of this pension fund. [4]

Suppose a pension fund investment manager estimates:

 the mean and standard deviation of equity returns to be 8% pa and 20% pa
respectively
 the mean and standard deviation of bond returns to be 5% pa and 10% pa
respectively
 the correlation coefficient between equity and bond returns to be +0.4.
The strategic benchmark for the pension fund is deemed to be 80% equities and 20%
bonds. However, the investment manager decides to invest the portfolio 60% in
equities and 40% in bonds in order to boost investment returns.
(iii) Calculate the size of the asset allocation positions in equities and bonds
compared to the strategic benchmark. [1]
(iv) Calculate the mean of the resulting relative return that he should expect to make
compared to the strategic benchmark. [2]
(v) Calculate the standard deviation of the resulting relative return, ie the forward-
looking tracking error. [2]
(vi) After a year, the manager has achieved a return of 5% versus a return on the
strategic benchmark portfolio of 2%. The volatility of the portfolio and the
benchmark portfolio were as expected in part (v). Calculate the information
ratio and comment on your answer. [3]
[Total 15]
Question X6.10
You are advising the government of a country on how to set up a tax system. The chief
minister wants to tax investment income at a higher rate than earned income, and to
exempt capital gains from tax. His aims are to encourage entrepreneurial activity and
investment and to redistribute wealth from the rich to the poor. Explain the flaws and
unintended consequences of his proposed approach. [7]





the course.

Assignment deadlines
For the session leading to the April 2016 exams – ST Subjects
Marking vouchers
Subjects Assignments Mocks
ST4, ST6, ST9 16 March 2016 22 March 2016
ST1, ST2, ST5, ST7, ST8 22 March 2016 30 March 2016
Series X Assignments
Recommended
Subjects Assignment Final deadline date
submission date
ST1, ST2, ST4 – ST9 X1 11 November 2015 13 January 2016
ST1, ST2, ST4 – ST9 X2 9 December 2015 27 January 2016
ST1, ST2, ST4 – ST9 X3 6 January 2016 10 February 2016
ST1, ST2, ST4 – ST9 X4 20 January 2016 24 February 2016
ST1, ST2, ST4 – ST9 X5 3 February 2016 9 March 2016
ST4, ST6, ST9 17 February 2016 16 March 2016

X6
ST1, ST2, ST5, ST7, ST8 24 February 2016 22 March 2016
Mock Exams
Recommended
Subjects Final deadline date
submission date
ST4, ST6, ST9 9 March 2016 22 March 2016
ST1, ST2, ST5, ST7, ST8 16 March 2016 30 March 2016
We encourage you to work to the recommended submission dates where possible.
We strongly recommend that you submit your mock exam electronically in order for us to return your marked
script to you in plenty of time before your exam. If you submit your mock on the final deadline date you are
likely to receive your script back less than a week before your exam.

Assignment deadlines
For the session leading to the September/October 2016 exams – ST Subjects
Marking vouchers
Subjects Assignments Mocks
ST4, ST6, ST9 31 August 2016 7 September 2016
ST1, ST2, ST5, ST7, ST8 7 September 2016 14 September 2016
Series X Assignments
Recommended Final deadline

Subjects Assignment
submission date date
ST1, ST2, ST4 – ST9 X1 8 June 2016 27 July 2016
ST1, ST2, ST4 – ST9 X2 22 June 2016 3 August 2016
ST1, ST2, ST4 – ST9 X3 6 July 2016 10 August 2016
ST1, ST2, ST4 – ST9 X4 20 July 2016 17 August 2016
ST1, ST2, ST4 – ST9 X5 3 August 2016 24 August 2016
ST4, ST6, ST9 10 August 2016 31 August 2016

X6
ST1, ST2, ST5, ST7, ST8 17 August 2016 7 September 2016
Mock Exams
Recommended Final deadline

Subjects
submission date date
ST4, ST6, ST9 24 August 2016 7 September 2016
ST1, ST2, ST5, ST7, ST8 31 August 2016 14 September 2016
We encourage you to work to the recommended submission dates where possible.
We strongly recommend that you submit your mock exam electronically in order for us to return your marked
script to you in plenty of time before your exam. If you submit your mock on the final deadline date you are
likely to receive your script back less than a week before your exam.

ST5 PC 16

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

ST5 PC 16

Uploaded by

Copyright:

Available Formats

ST5 – P C – 16

Combined Materials Pack

ActEd Study Materials: 2016 Examinations

Study Guide for the 2016 exams

*Note: The Series X Assignment Solutions should also be supplied

How to use the Combined Materials Pack

Important: Copyright Agreement

The Actuarial Education Company

Unless prior authority is granted by ActEd, you may not hire

You must take care of your study material to ensure that it is

Legal action will be taken if these terms are infringed. In

These conditions remain in force after you have finished using

© IFE: 2016 Examinations The Actuarial Education Company

2016 Study Guide

When studying for the UK actuarial exams, you will need:

 a copy of the Formulae and Tables for Examinations of the Faculty of

 a “permitted” scientific calculator – you will find the list of permitted

Section 1 The Subject ST5 course structure Page 2

The Actuarial Education Company © IFE: 2016 Examinations

1 The Subject ST5 course structure

© IFE: 2016 Examinations The Actuarial Education Company

2 ActEd study support

LEARNING LEARNING & REVISION REVISION & REHEARSAL

Course Notes Q&A Bank Flashcards Revision Notes Mock Exam A

X Assignments Sound ASET Additional

The Actuarial Education Company © IFE: 2016 Examinations

“Learning & revision” products

Question and Answer Bank

Combined Materials Pack (CMP)

© IFE: 2016 Examinations The Actuarial Education Company

However, if a large proportion of the material has changed significantly, making it

Don’t underestimate the benefits of doing and submitting assignments:

The Actuarial Education Company © IFE: 2016 Examinations

© IFE: 2016 Examinations The Actuarial Education Company

We run a range of different tutorials including face-to-face tutorials at various locations,

Regular and Block Tutorials

You can choose one of the following types of tutorial:

At the heart of the Online Classroom in each subject is a comprehensive,

The Actuarial Education Company © IFE: 2016 Examinations

© IFE: 2016 Examinations The Actuarial Education Company

Choice of revision product

 Do you have a regular train or bus journey?

 Do you want to fit more study into your routine?

The Actuarial Education Company © IFE: 2016 Examinations

 Do you have a preference for auditory learning, eg do you remember

 Do you tend to avoid studying topics you find difficult?

 Do you want to fit in some study at work?

 Do you like being at your computer?

Choosing more than one revision product

“Revision & rehearsal” products

© IFE: 2016 Examinations The Actuarial Education Company

ActEd Solutions with Exam Technique (ASET)

The Actuarial Education Company © IFE: 2016 Examinations

Additional Mock Pack (AMP)

Mock / AMP Marking

Queries and feedback

© IFE: 2016 Examinations The Actuarial Education Company

The Actuarial Education Company © IFE: 2016 Examinations

3 How to study to pass the exams

The ST Subject exams

© IFE: 2016 Examinations The Actuarial Education Company

Overall study plan

A sample ST subject study plan is available on our website at: