Summer 2012 Examination

ST226
Actuarial Investigations: Financial Suitable for all students

Instructions to candidates Time allowed: 3 hours This paper contains 10 questions. Answer All questions.

You are supplied with:

Formulae and Tables for Actuarial Examinations (Institute of Actuaries) Murdoch and Barnes Statistical Tables Electronic calculator (as prescribed by the examination regulations).

You may also use:

LSE 2012/ST226

Page 1 of 5

Taxes and expenses should be ignored unless otherwise indicated. You may nd the following information useful: If Y N (, 2 ), i.e. Y is normally distributed with mean and variance 2 , we have 1 2 2 E esY = es+ 2 s .

1. Consider the function b (i, p, n) = a n an . Investigate whether b (i, p, n) is increasing or decreasing in each one of the variables i, p and n (keeping the other two constant). (1+1+1=3 marks ) 2. What is a forward contract ? What is a European call option ? What is a European put option ? (2+2+2=6 marks ) 3. The force of interest at time t is given by ( t) = 1 . 10 + t
(p) (p)

An increasing annuity pays an amount of 11 at the end of the year 1, 12 at the end of year 2 and so on till the nal payment which is 20 at the end of year 10. Calculate the present value of the annuity at time 0 and the accumulation of the annuity at time 10. (4+2=6 marks ) 4. An investor invested 100 in a fund on each one of the 1st of January of 2009, 2010 and 2011. The following table gives the price of a unit in the fund on the 1st of January of each year: Year 2009 2010 2011 2012
LSE 2012/ST226

Unit Price 100 105 103 107 Page 2 of 5

Show that the money weighted rate of return for the period 1.1.20091.1.2012 is approximately 2.1% and calculate the time weighted rate of return. (3+3=6 marks ) 5. Two companies A and B are competing for the same contract that will be awarded in one years time. The current share price of both companies is 100. If company A wins the contract, its share price will rise to 104 and the share of company B will fall to 96. If company B wins the contract, its share price will rise to 108 and the share price of A will become Y . The risk free rate of interest is 2% per annum. Calculate Y assuming there are no arbitrage opportunities. (6 marks ) . 6. Calculate the present value of 3 per annum payable annually in arrears for 10 years followed by 2 per annum payable annually in arrears for a further 10 years assuming that the eective rate of discount is 2% per annum for the rst 5 years, the eective interest rate is 3% for the next 10 years and the force of interest is 4% for the nal 5 years. Calculate also the accumulated value of this series of payments at time 20. (8+2=10 marks ) 7. A bond having nominal value of 200 is repayable in two equal instalments at par. The rst half is redeemable after 5 years and the second half after 10 years. It is also subject to a coupon of 4% per annum payable half yearly in arrears. (a) An investor is subject to income tax at 30%. Find the price she should pay to realise a yield of 3%. (6 marks ) (b) Suppose now that in addition to income tax at 30%, she is also subject to capital gains tax at 30%. In calculating her capital gain the investor is allowed to inate her cost of acquisition at 1% per annum to the time of the capital gain. Find the price she should pay to realise a yield of 3% in this case. (4 marks )
LSE 2012/ST226 Page 3 of 5

8. A loan is repayable over 10 years by a special decreasing annuity payable annually in arrears, calculated on the basis of an eective interest rate of 8% per annum. The annuity payment each year is divided into an interest payment (equal to 8% of the loan outstanding at start of the year) and a capital payment, which is used to reduce the amount of the loan outstanding. The annuity decreases in a such a way, that if income tax of 50% were to be deducted from the interest content of each annuity payment then the capital repayment plus the interest payment net of tax would be 1000 each year. There are two investors that are considering purchasing the loan. Investor A is liable to income tax at 50% and investor B is liable to income tax at 20%. (a) Calculate the price investor A should pay to purchase the loan to achieve a net eective yield of 4%. (3 marks ) (b) What is the amount of the loan? (2 marks ) (c) Calculate the price investor A should pay to to purchase the loan to achieve a net eective yield of 6%. (3 marks ) (d) Calculate the price investor B should pay to to purchase the loan to achieve a net eective yield of 6%. (6 marks ) 9. Consider three bonds all with nominal amount 100 redeemable at par. Bond A: A one year zero coupon bond with price 96.15. Bond B: A three year zero coupon bond with price 83.96. Bond C: A two year bond paying coupons annually in arrears at a coupon rate of 7% with price 103.78. (a) Use this information to nd the one year, two year and three year spot rates. (4 marks ) (b) Derive the two year forward rate in one years time. (3 marks ) (c) Suppose now that the spot rate curve is at and equal to 6%. Compute the new price for each bond. (3 marks )
LSE 2012/ST226

Page 4 of 5

(d) Continuing from (c), suppose that an investor has a liability of 10000 in two years time and wants to hedge against the risk of interest rate changes by investing in bonds of type A and B. Use Redingtons theory to calculate how many bonds of each type he should hold. (6 marks ) (e) Based on the questions above explain the limitation of Redingtons theory. (2 marks ) 10. The yield of a fund for year t where t = 1, 2, 3 is represented by the random variable Zt . Zt is such that ln (1 + Z1 ) = Y1 + Y2 , ln (1 + Z2 ) = Y2 + Y3 , and ln (1 + Z3 ) = Y3 + Y4 , where Y1 , Y2 , . . . is a sequence of independent and identically distributed random variables with a normal distribution with mean and variance 2 . (a) An amount 1 is invested at time 0. Find expressions in terms of and 2 for the expected value and the variance of its accumulated value at time 3. (4 marks ) (b) Suppose now that 1 is invested at time 0 as well as 2 at time 1. Find expressions in terms of and 2 for the expected value and the variance of the accumulated value at time 3. (4+4=8marks ) (c) Suppose now that E (Zt ) = 0.05 and V ar (Zt ) = 0.04 Calculate the probability that the accumulation at time 3 of the investment in part (a) is larger than 1. (7 marks ) (d) What diculty would you encounter if you wanted to calculate the probability the accumulation in (b) will exceed any given value at time 3. (2 marks )

LSE 2012/ST226

Page 5 of 5