Faculty of Actuaries Institute of Actuaries

EXAMINATIONS

14 April 2000 (am)

Subject 401 — UK Fellowship Investment

Paper One

You must answer this subject only,

you may not attempt another subject in the 400 series.

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. You have 15 minutes at the start of the examination in which to read the
questions. You are strongly encouraged to use this time for reading only but
notes may be made. You then have three hours to complete the paper.

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

3. Write your surname in full, the initials of your other names and your
Candidate’s Number on the front of the answer booklet.

4. Mark allocations are shown in brackets.

5. Attempt all 9 questions, beginning your answer to each question on a

separate sheet.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet and this question paper.

In addition to this paper you should have available

Actuarial Tables and an electronic calculator.

 Faculty of Actuaries
401(1)—A2000  Institute of Actuaries
1 A project sponsor has decided to build an industrial plant which converts
waste product into energy. The sponsor plans to inject 10% equity into the
project and to borrow the remaining 90% from institutional investors, financed
by a bond issue. The lenders will not have any guarantees from the sponsor.

(i) Describe the likely features of the bond regarding:

(a) term

(b) the schedule for repayment of principal

(c) type and timing of interest payments

(d) the method for setting the interest rate at inception (and for the
duration of the issue, if necessary)

(e) the security offered

(f) the financial covenants [6]

(ii) List two other features of the bond which might make it more attractive
to an institutional investor. [2]

The bank which is underwriting the issue has approached your institution, as
a potential investor. The bank has asked you to consider investing in the loan
at inception.

(iii) Describe the factors you would take into account when conducting the
credit analysis of the bond. [2]
[Total 10]

2 (i) Explain the expression “buying the basis”, in the context of futures
trading. [2]

(ii) The FTSE 100 Index future expiring in three months time is currently
trading at 6,150 whilst the index stands at 6,000.

(a) Determine the number of contracts which should be purchased

to simulate an investment of £1.23 million in the stock making up
the FTSE 100 index. [2]

(b) Analyse whether buying in the cash market or the futures

market is the most cost effective means of achieving a long
position, assuming three-month money trades at 6.25% and the
yield on the FTSE 100 index is 2.25%. State all assumptions
made. [4]

(iii) Explain how option contracts can be used to replicate a futures

contract. [4]
[Total 12]

401(1)—2
3 You are an investment manager at a life office offering a range of life
insurance products. All of the investments of the life office are placed in one
of four funds:

• a fixed interest fund

• an equity fund
• a commercial property fund, and
• a managed fund being a fund based on a combination of the above three
funds

You have been approached by a property developer who intends to build 100
homes in a rural area. The development is intended to be a mixture of houses
and flats. The development is proposed to provide rental accommodation to
lower income families. The authorities have approved the development as it
will offer much needed rental housing for local workers in a nearby city. The
city is accessible by road and by rail.

The development is due to be completed in one year’s time. The property

developer has offered to sell the entire project to you.

(i) Describe the considerations which might lead you to decline the
investment. [4]

Six months later, the development is still on target for completion on its
original date. The property developer returns with the following alternative
offer.

The property developer has contracted with a major financial institution

which will guarantee a minimum return of at least 2% per annum compound
over the eight years following the commencement of the contract, with a
maximum return capped at 25%. In return for accepting the risk, the major
financial institution will receive an up-front single premium at the date of
commencement of the contract (the date that construction is completed).

The developer has agreed terms with a specialist residential property

management company to manage the development for the first 8 years. The
management company has guaranteed that rent voids will not exceed one
week per property per annum. This guarantee commences from the date the
construction is completed.

The property developer wishes you to reconsider investment.

(ii) Explain in detail your response to the property developer, including

the following:

• a list of the future expected income and outgo from the investment,
• a list of the main features of the investment, with reasons as to
whether those features are fixed income in nature or not.
[9]
[Total 13]

401(1)—3 PLEASE TURN OVER

4 A private investor, who chooses his own stocks, has an equity portfolio valued
at £100,000. The investor has selected ten securities in order to provide
diversification. Further, he always chooses stocks which can be classified as
conglomerates, e.g. a major chemical company with divisions covering bulk and
speciality chemicals, pharmaceuticals, construction supplies and distribution.
His premise is that this provides added diversification within his ten stock
portfolio.

(i) Outline the advantages and disadvantages of this approach. [3]

(ii) Compare the investor’s approach with alternative diversification

approaches, e.g. the use of a collective investment vehicle. [3]
[Total 6]

5 (i) State the main factors that will influence an institution’s long-term
investment strategy. [5]

The trustees of a large UK pension fund have, in conjunction with the

company, established a committee to look at the strategic asset allocation of
the fund. You are a consultant advising this committee.

(ii) Outline a process for undertaking the review which makes use of asset-
liability modelling techniques. Comment on the limitations of the
approach. [5]

(iii) You have been asked to advise on the time horizon to be adopted when
setting a strategic asset allocation. Identify the points you would make
in your response. [3]
[Total 13]

6 You are the adviser to a pension fund with wholly domestic liabilities. Its
assets are managed on a balanced basis across a mix of equity and fixed
interest assets which are also wholly domestic. The fund is domiciled in a
country where the major equity index is dominated by a single stock
comprising over 40% of the index.

(i) Describe the problems which might result from investing the equity
component of the pension fund’s portfolio in line with the domestic
index? [3]

(ii) Explain how you would assess the relative performance of the domestic
equity component of the fund, and its managers. [4]

It has been proposed that the fund introduce a global equity component.

(iii) Explain how you would determine a practical benchmark for managing
the total domestic and international equity exposure of the fund. [3]

(iv) Explain the asset considerations which influence the extent to which
currency hedging should be used in managing the portfolios. [4]
[Total 14]

401(1)—4
7 The equity investments of a substantial trust are invested in a range of funds
managed by a single manager, whose assets under management have grown
substantially over the last five years. Until one year ago, the investment
performance of each of the funds was significantly above average when
calculated on any rolling year basis and when compared with similar funds of
other managers.

In each of the past four quarters, the returns of three of the four funds have
performed well below the average of returns from comparable other funds.

You are the investment adviser to the trust.

(i) Explain the investigations you would conduct in order to advise

whether the Trust should terminate its existing mandate for the three
funds which are performing poorly. [6]

(ii) Explain the further investigations you would conduct in order to advise
whether the Trust should terminate its mandate for the fund which
continues to perform significantly above average. [3]

(iii) Comment on whether funds which are withdrawn should be reinvested

on an active basis or an index-tracking basis. [3]
[Total 12]

8 An investment management company has provisionally been awarded an

investment mandate for managing an international bond portfolio. In its
standard agreement, the manager has proposed a target which is modestly in
excess of the performance of the market index return. The client wishes to
include an explicit constraint which states the portfolio must not
underperform the benchmark by more than a certain margin.

(i) Explain the factors which the investment manager should consider
when deciding whether to accept the mandate. [4]

The manager accepts the revised mandate. After eighteen months, the
portfolio has outperformed its benchmark by 13%. You are the consultant
advising the client.

(ii) Comment on the manager’s performance, stating the investigations

which you recommend should be undertaken. [6]
[Total 10]

401(1)—5 PLEASE TURN OVER

9 You are the recently appointed investment manager of a global fixed interest
portfolio of a major UK life office. The chief investment manager has allocated
you additional funds for investment.

Recent published statistics suggest that the UK economy has been performing
strongly and that inflation may be increasing. In the past, the UK
Government, operating through the Bank of England, has demonstrated a
willingness to change base lending rates sharply in order to try to keep prices
inflation within a targeted area.

With this in mind you are considering investing the moneys in one or more of
the following:

• a range of UK Gilts

• a range of US Treasury Bonds

• a recently issued AA-rated Corporate Eurobond

• a collateralised mortgage obligation; and

• an unlisted bond denominated in Sterling issued recently by a FTSE

company

Explain the investment considerations you would apply in order to make your
investment decision. [10]

401(1)—6