INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

26 September 2018 (pm)

Subject CT8 – Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. You have 15 minutes of planning and reading time before the start of this examination.
You may make separate notes or write on the exam paper but not in your answer
booklet. Calculators are not to be used during the reading time. You will then have
three hours to complete the paper.

4. Mark allocations are shown in brackets.

5. Attempt all 11 questions, beginning your answer to each question on a new page.

6. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT8 S2018 © Institute and Faculty of Actuaries

1 Describe the key findings in behavioural finance. [10]

2 An investor has taken out a $100,000 loan at a 10% per annum rate of interest,
annually compounded. The investor uses the loan to buy a portfolio of stocks whose
value follows a lognormal distribution, with parameters μ = 12% per annum and
σ2 = 25% per annum.

The investor plans to sell the stocks and repay the loan after five years.

(i) Calculate the mean and the variance of the lognormal distribution. [1]

(ii) Calculate the probability that the investor will have enough money to repay the
loan plus interest. [2]

After five years the stocks are only worth $120,000 so the investor cannot afford to
repay the loan plus interest.

(iii) Calculate the one-year 95% value at risk of the investor’s stock portfolio from
time t = 5 to time t = 6. [2]

The annual standard deviation of the investor’s stock portfolio at time t = 5 is $81,708.

The bank agrees to continue the loan for another five years, as long as the investor can
prove that the annual standard deviation of his portfolio is no higher than $40,000 at
time t = 5.

(iv) Calculate the proportion of the investor’s stock portfolio he would have to sell
in order to bring the value at risk down to a level acceptable to the bank. [1]

The bank also offers a cash deposit account returning a 6% per annum rate of interest,
annually compounded.

The investor sells the proportion of the stock portfolio in part (iv) and invests the
funds in the cash deposit account. The bank therefore continues the loan for another
five years.

(v) Calculate the probability that the investor’s stocks and cash deposit combined
are sufficient to repay the loan plus interest at time 10. [3]

(vi) (a) Comment on this result.

(b) Propose an alternative course of action for the investor. [2]
 [Total 11]

CT8 S2018–2
3 In a market in which the Arbitrage Pricing Theory (APT) model holds, the expected
return is given by:

E[Ri] = l0 + l1bi,1 + l2bi, 2 + …

(i) Define all the terms in the equation. [2]

Assume the risk-free rate rf = 0.04. Consider two well diversified portfolios Pi with
the following features in a two factor model:

P1 P2
E Ri 15.50% 11.95%
bi,1 (a) (b)
bi,2 1.5 0.7

(ii) Determine the values (a) and (b) for l1 = 0.05 and l2 = 0.06. [3]
 [Total 5]

4 An investor has £100 and is considering investing in two different stocks. The prices
of both stocks are assumed to follow the lognormal model with the parameters below.

Stock Current price Drift µ Volatility σ

A £5 5% 20%
B £5 8% 30%

(i) Calculate the expected value at time 3 of £100 invested in:

(a) stock A
(b) stock B. [2]

(ii) Calculate the standard deviation at time 3 of £100 invested in:

(a) stock A
(b) stock B. [4]

The investor decides to invest £50 in each stock.

(iii) Calculate the expected value of the investor’s portfolio at time 3. [1]

The correlation of the two stocks is 0.3.

(iv) Calculate the standard deviation of the value of the investor’s portfolio at
time 3. [3]

(v) Comment on the expected return and standard deviation of the portfolio
compared to investing the whole £100 in one stock. [4]
 [Total 14]

CT8 S2018–3 PLEASE TURN OVER

5 The Ornstein-Uhlenbeck process is the solution to the equation dXt = – γXt dt + σdBt
where γ and σ are positive parameters.

Derive the solution for Xt.[8]

6 Consider a call option ct and a put option pt written on a non-dividend paying stock St.

(i) Prove the put-call parity relationship by constructing two portfolios that
produce the same value at maturity. [4]

A stock market includes four options set out below. All the options are for a term of
10 years and relate to a single non-dividend paying stock, currently priced at $5. The
continuously compounded risk-free rate is 3% per annum.

Type Strike price Option price

Option A European Call $8 $0.32
Option B European Put $8 ?
Option C European Put $10 ?
Option D American Put $10 ?

(ii) Calculate the price of Option B. [2]

(iii) Determine lower and upper bounds for the price of option C. [2]

(iv) Determine lower and upper bounds for the price of option D. [2]
 [Total 10]

CT8 S2018–4
7 A company is currently financed entirely by equity with 100,000 shares in issue and
no debt. The current share price is $1. The company has total assets of $100,000 with
volatility of 15% per annum.

The company is considering raising $250,000 by issuing zero-coupon debt with a five-
year maturity date. The continuously compounded risk-free rate of interest is 3% per
annum.

The company intends to set the redemption value of the debt such that the share price
will remain unchanged under the Merton model.

(i) Give the value of the company’s assets immediately after issuing the debt. [1]

(ii) Calculate the redemption value of the debt using the Merton model. [5]

(iii) Calculate the credit spread on the debt. [2]

One year later, the company is struggling. The share price has fallen to $0.50 and the
current value of the debt has fallen to $50 per $100 of redemption value.

(iv) Calculate the proportionate fall in the value of:

(a) the equity.
(b) the debt.[2]

(v) Suggest why the value of the equity has fallen by proportionately more than
the fall in the value of the debt. [3]
 [Total 13]

8 Consider a binomial tree model for the non-dividend paying stock with price St .
Assume this price either rises by 30% or falls by 20% each quarter (3 months) for the
next three quarters. Assume also that the risk-free rate is 2% per annum continuously
compounded. Let S0 = £60.

(i) Calculate the price of a vanilla European call option with maturity in nine
months’ time and a strike price of £55. [3]

(ii) Calculate the price of a vanilla European put option with the same maturity
and strike price as the contract in part (i). [1]

Assume the investor has a portfolio formed by a short position in the call option given
in part (i) and a long position in the put option given in part (ii).

(iii) Determine how the value of the portfolio would differ if the possible change in
the stock price was a fall of 30% instead of 20%. [3]
 [Total 7]

CT8 S2018–5 PLEASE TURN OVER

9 The price process of a non-dividend paying stock St satisfies the following stochastic
differential equation

dSt = μ St dt + σSt dWt ,

where Wt is a Brownian motion under the real-world probability measure P. Let V(t)
be the value at t of a self-financing portfolio, consisting of Ft stocks and Yt cash
bond.

(i) Show that d(e–rtV (t)) = Ft d(e–rtSt).[3]

(ii) Determine the conditions under which the discounted value e–rtV (t) is a
martingale.[3]
 [Total 6]

10 (i) State the main assumptions underpinning the Black-Scholes model. [3]

Consider a put option on a non-dividend paying stock when the stock price is £8, the
exercise price is £9, the continuously compounded risk-free rate of interest is 2% per
annum, the volatility is 20% per annum. and the time to maturity is three months.

(ii) Calculate the price of the option using the Black-Scholes model. [4]

(iii) Discuss how the price of the contract in part (ii) would change if the rate of
interest increases. (There is no need to carry out further calculations.) [2]
 [Total 9]

CT8 S2018–6
11 Consider a market in which the Capital Asset Pricing Model (CAPM) holds.

(i) Write down the equation of the Security Market Line, defining all the notation
you use. [2]

In this market, the risk-free rate of interest is 9.44% per annum. There are only two
risky assets in the market with the following attributes.

Rate of return (per annum) Variance/Covariance Matrix

State Probability Asset 1 Asset 2 Asset 1 Asset 2
1 0.2 10.00 % 11.00 % Asset 1 0.00142 0.00379
2 0.3 15.00 % 30.00 % Asset 2 0.00379 0.01146
3 0.1 18.00 % 25.00 %
4 0.4 20.00 % 40.00 %

(ii) Determine the weight of each asset in the market portfolio to be consistent
with β1 = 0.46, β 2 = 1.36. [3]

(iii) Calculate the Market Price of Risk. [2]

 [Total 7]

END OF PAPER

CT8 S2018–7 PLEASE TURN OVER

 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2018

Subject CT8 – Financial Economics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that
the examination was set. Candidates should take into account the possibility that
circumstances may have changed if using these reports for revision.

Mike Hammer
Chair of the Board of Examiners
December 2018

 Institute and Faculty of Actuaries

 Subject CT8 (Financial Economics Core Technical) – September 2018 – Examiners’ Report

A. General comments on the aims of this subject and how it is marked

1. The aim of the Financial Economics subject is to develop the necessary skills to
construct asset liability models and to value financial derivatives. These skills are
also required to communicate with other financial professionals and to critically
evaluate modern financial theories.

2. The marking approach for CT8 is flexible in the sense that different answers to
those shown in the solution can earn marks if they are relevant and appropriate.
Marks for the methodology are also awarded.

B. General comments on student performance in this diet of the examination

1. In general, the real differentiators in those who scored well were attention to detail
in their algebraic steps, and the breadth of knowledge in being able to score the
knowledge marks and even attempt most questions. A number of candidates did not
gather relevant information from the text of the question, and translate it in the
appropriate equivalent statistical concepts. For example, candidates struggled with
formulating the probability that an event occurs in appropriate mathematical terms,
and determining from the information in the question the direct way to recover
required variances and covariances.

2. Students performed relatively well on knowledge based questions, although many

missed the opportunity to be awarded full marks.

C. Pass Mark

The Pass Mark for this exam was 60.

Page 2
 Subject CT8 (Financial Economics Core Technical) – September 2018 – Examiners’ Report

Solutions

Q1
Anchoring and adjustment Anchoring is a term used to explain how people will produce estimates.
They then adjust away from this initial anchor to arrive at their final judgement. [1]
Prospect theory A theory of how people make decisions when faced with risk and uncertainty. It
replaces the conventional risk averse / risk seeking decreasing marginal utility theory. [1]
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. [1]
Myopic loss aversion This is similar to prospect theory, but considers repeated choices rather than a
single “gamble”. [1]
Estimating probabilities Issues (other than anchoring) which might affect probability estimates
include: [0.5]
• 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.
[0.5]
• 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). [0.5]
• 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. [0.5]
Overconfidence People tend to overestimate their own abilities, knowledge and skills. This may be a
result of: [0.5]
• 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. [0.5]
• 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). [0.5]
Mental accounting People show a tendency to separate related events and decisions and find it
difficult to aggregate events. [1]
Effect of options Other issues include:
• Primary effect – people are more likely to choose the first option presented, but [0.5]
• 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.) [0.5]
• Other research suggests that people are more likely to choose an intermediate option than one at
either end! [0.5]
• 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. [0.5]
• Status Quo bias – people have a marked preference for keeping things as they are. [0.5]
• Regret aversion – by retaining the existing arrangements, people minimise the possibility of regret
(the pain associated with feeling responsible for a loss). [0.5]
• Ambiguity aversion – people are prepared to pay a premium for rules. [0.5]
[Max 10]

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 Subject CT8 (Financial Economics Core Technical) – September 2018 – Examiners’ Report

The majority of students scored either full marks or nearly full

marks on this knowledge based question.

Some students confused Behavioural Finance with Expected Utility

Theory or the Efficient Market Hypothesis, for which there were no
marks on offer.

Q2
i) Mean = exp(µ+0.5*σ2) = exp(0.12+0.5*0.25) = 1.2776 [0.5]
Variance = exp(2µ+σ )*(exp(σ )-1) = exp(2*0.12+0.25)*(exp(0.25)-1) = 0.4636
2 2

[0.5]

ii) L(5) = 100,000 * 1.1^5 = 161,051 [0.5]

P(S(5) > 161,051) = P(S(5)/S(0) > 1.61051) = P(ln(S(5)/S(0)) > ln(1.61051))
= P(Z > ((ln(1.61051) – 5*0.12) / (0.25*5)^0.5) [0.5]
= P(Z > -0.110416) [0.5]
= 54.4% [0.5]
0.1*5
[If students have used continuous compounding (e ) deduct one mark]

iii) P(S(6)/S(5) < t) = 0.05 => P(Z < (ln(t)-0.12) / 0.25^0.5) = 0.05 [0.5]
=> (ln(t)-0.12) / 0.25^0.5 = -1.645 [0.5]
=> t = exp( -1.645 * 0.25^0.5 + 0.12) = 0.4954 [0.5]
=> VaR = £120,000 * 0.4954 = $59,446 [0.5]
[Or for £120,000 * (1 – 0.4954) = £60,552 lose one mark]

iv) The investor can retain 40,000 / 81,708 = 48.95% of his stocks, so he would need
to sell $61,254 of stocks. [1]

v) The loan at time 10 will be 161,051 * 1.1^5 = $259,374. [0.5]

The cash deposit account holds $61,254 at time 5, hence 61254 * 1.06^5 =
$81,972 at time 10. [0.5]
So we need the stocks to be worth at least 259,374-81,972 = $177,402 at time 10.
[0.5]
This needs a return of 177,402 / 58,746 = 3.0198 [0.5]
P(S(10)/S(5) > 3.0198) = P(Z > (ln(3.0198) – 5*0.12) / (0.25*5)^0.5) = P(Z >
0.4519) [0.5]
= 32.6% [0.5]

vi) There is a slightly less than 50:50 chance that the investor would be able to repay
the loan at time t=5. [1]
The cash account pays a lower rate of interest than the loan charges, so the
investor would be better off repaying $61,254 of the loan at time 5 if this is
possible. [1]
The investor could also seek other assets that deliver a higher potential return. [1]

Page 4
 Subject CT8 (Financial Economics Core Technical) – September 2018 – Examiners’ Report

Or the investor could try to find other funds to cut his losses and repay the loan at
time 5. [1]
[Max 2]

Overall, students did not score well on the application of the

lognormal model.
A proportion of students confused the lognormal model and the
solution to Geometric Brownian Motion so had the incorrect drift
term. Another common mistake was not including the time factor
in the drift and volatility components.
Most students made suggestions in (vi) for how the investor could
reduce the risk in their portfolio.

Q3
i. 𝐸𝐸[𝑅𝑅𝑖𝑖 ] is the expected return of security i; [0.5]
𝑏𝑏𝑖𝑖,𝑘𝑘 is the responses of the rates of return on security i to factor k (alternatively the
sensitivity of security i to index k). [1]
𝜆𝜆𝑘𝑘 is the risk premium corresponding to factors k. [0.5]

ii. The risk free portfolio has zero exposure to any risk factor, i.e. 𝑏𝑏𝑖𝑖,𝑘𝑘 = 0 for all 𝑘𝑘, which
implies 𝜆𝜆0 = 𝑟𝑟𝑓𝑓 . [1]

Then, we look for the solution to

0.155 = 0.04 + 0.05𝑏𝑏1,1 + 0.06 × 1.5
[0.5 each]
0.1195 = 0.04 + 0.05𝑏𝑏2,1 + 0.06 × 0.7
which returns 𝑏𝑏1,1 = 0.5, 𝑏𝑏2,1 = 0.75 [0.5 each]

The majority of students scored either full marks or nearly full marks on
this knowledge question.

For part (i), common mistakes were confusing the different parameters
such as describing lambas as sensitivities and vice versa.

For part (ii), common mistakes were not including the risk-free rate in the
equations or minor calculation errors.

Page 5
 Subject CT8 (Financial Economics Core Technical) – September 2018 – Examiners’ Report

Q4
i)
a. E[A 3 ] = A 0 exp(µt+0.5σ2t) = 100exp(0.05*3+0.5*0.22*3) = £123.37 [1]
b. E[B 3 ] = B 0 exp(µt+0.5σ2t) = 100exp(0.08*3+0.5*0.32*3) = £145.50 [1]
ii)
a. SD[A 3 ] = √(A 0 2exp(2µt+σ2t)(exp(σ2t)-1)) [0.5]
= √(1002exp(2*0.05*3+0.22*3)(exp(0.22*3)-1)) [1]
= £44.05 [0.5]
b. SD[B 3 ] = √(B 0 2exp(2µt+σ2t)(exp(σ2t)-1)) [0.5]
= √(1002exp(2*0.08*3+0.32*3)(exp(0.32*3)-1)) [1]
= £81.01 [0.5]

iii) E[P 3 ] = 0.5E[A 3 ] + 0.5E[B 3 ] = £134.44 [1]

iv) V[P 3 ] = 0.52V[A 3 ] + 0.52V[B 3 ] + 2*Correlation*0.5*0.5*SD[A 3 ]*SD[B 3 ] [1]

= 0.25*44.052 + 0.25*81.012 + 2*0.3*0.5*0.5*44.05*81.01
= 2,661.03 [1]
=> SD[P 3 ] = £51.59 [1]

v) The expected return of the portfolio falls halfway between the expected return on
each of the one-stock investment strategies. [1]
But the standard deviation is well below halfway between the two one-stock
strategies.
[1]
The price of risk for stock A is 23.37/44.05 = 0.53 [1]
The price of risk for stock B is 45.5/81.01 = 0.56 [1]
But the price of risk for the portfolio is 34.44/51.59 = 0.67 [1]
So the portfolio delivers a better expected return per unit of risk [1]
This is because the assets are not fully correlated… [1]
Which shows the benefit of diversification. [1]
[Max 4]

In general, students struggled with this question. The most common

difficulty was making the link between the price and the number of
shares held.

For part (iv), some students did not calculate a standard deviation
for the portfolio that was consistent with their answers in part (ii).
Their portfolio standard deviation was either much higher or much
lower.

Page 6
 Subject CT8 (Financial Economics Core Technical) – September 2018 – Examiners’ Report

Some students calculated the proportion invested in the minimum

variance portfolio under Mean Variance Portfolio Theory despite this
not being asked for in the question.

Q5

[1]

[1]

[1]

[1]

[1]

[1]

[1]

[1]

[Or using a Taylor expansion:

𝑑𝑑𝑑𝑑(𝑋𝑋𝑡𝑡 ,𝑡𝑡) 1 𝑑𝑑 2 𝑓𝑓(𝑋𝑋𝑡𝑡 ,𝑡𝑡) 𝑑𝑑𝑑𝑑(𝑋𝑋𝑡𝑡 ,𝑡𝑡)

𝑑𝑑𝑑𝑑(𝑋𝑋𝑡𝑡 , 𝑡𝑡) = 𝑑𝑑𝑋𝑋𝑡𝑡 + 𝑑𝑑𝑋𝑋𝑡𝑡 2 + 𝑑𝑑𝑑𝑑 [1]
𝑑𝑑𝑋𝑋𝑡𝑡 2 𝑑𝑑𝑋𝑋𝑡𝑡 2 𝑑𝑑𝑑𝑑

𝑑𝑑𝑑𝑑(𝑋𝑋𝑡𝑡 ,𝑡𝑡) 𝑑𝑑 2 𝑓𝑓(𝑋𝑋𝑡𝑡 ,𝑡𝑡) 𝑑𝑑𝑑𝑑(𝑋𝑋𝑡𝑡 ,𝑡𝑡)

Where 𝑑𝑑𝑋𝑋𝑡𝑡
= 𝑒𝑒 𝛾𝛾𝛾𝛾 , 𝑑𝑑𝑋𝑋𝑡𝑡 2
= 0 and 𝑑𝑑𝑑𝑑
= 𝛾𝛾𝑋𝑋𝑡𝑡 𝑒𝑒 𝛾𝛾𝛾𝛾 [1]

So 𝑑𝑑𝑑𝑑(𝑋𝑋𝑡𝑡 , 𝑡𝑡) = 𝑒𝑒 𝛾𝛾𝛾𝛾 𝑑𝑑𝑋𝑋𝑡𝑡 + 𝛾𝛾𝑋𝑋𝑡𝑡 𝑒𝑒 𝛾𝛾𝛾𝛾 𝑑𝑑𝑑𝑑 [1]

But 𝑑𝑑𝑋𝑋𝑡𝑡 = −𝛾𝛾𝑋𝑋𝑡𝑡 𝑑𝑑𝑑𝑑 + 𝜎𝜎𝜎𝜎𝐵𝐵𝑡𝑡 so 𝑑𝑑𝑑𝑑(𝑋𝑋𝑡𝑡 , 𝑡𝑡) = 𝑒𝑒 𝛾𝛾𝛾𝛾 𝜎𝜎𝜎𝜎𝐵𝐵𝑡𝑡 [1]

Page 7
 Subject CT8 (Financial Economics Core Technical) – September 2018 – Examiners’ Report

𝑡𝑡 𝑡𝑡
Integrating between 0 and t gives ∫0 𝑑𝑑𝑑𝑑(𝑋𝑋𝑠𝑠 , 𝑠𝑠) = 𝜎𝜎 ∫0 𝑒𝑒 𝛾𝛾𝛾𝛾 𝑑𝑑𝐵𝐵𝑠𝑠 [1]

𝑡𝑡
So 𝑓𝑓(𝑋𝑋𝑡𝑡 , 𝑡𝑡) − 𝑓𝑓(𝑋𝑋0 , 0) = 𝜎𝜎 ∫0 𝑒𝑒 𝛾𝛾𝛾𝛾 𝑑𝑑𝐵𝐵𝑠𝑠 [1]

𝑡𝑡
So 𝑋𝑋𝑡𝑡 𝑒𝑒 𝛾𝛾𝛾𝛾 − 𝑋𝑋0 = 𝜎𝜎 ∫0 𝑒𝑒 𝛾𝛾𝛾𝛾 𝑑𝑑𝐵𝐵𝑠𝑠 [1]

𝑡𝑡
So 𝑋𝑋𝑡𝑡 = 𝑋𝑋0 𝑒𝑒 −𝛾𝛾𝛾𝛾 + 𝜎𝜎 ∫0 𝑒𝑒 𝛾𝛾(𝑠𝑠−𝑡𝑡) 𝑑𝑑𝐵𝐵𝑠𝑠 ] [1]

[Or using an integrating factor:

Use the integrating factor 𝑒𝑒 𝛾𝛾𝛾𝛾 . [1]

Then 𝑒𝑒 𝛾𝛾𝛾𝛾 𝑑𝑑𝑋𝑋𝑠𝑠 = −𝛾𝛾𝑋𝑋𝑠𝑠 𝑒𝑒 𝛾𝛾𝛾𝛾 𝑑𝑑𝑑𝑑 + 𝑒𝑒 𝛾𝛾𝛾𝛾 𝜎𝜎𝜎𝜎𝐵𝐵𝑠𝑠 [1]

So 𝛾𝛾𝑋𝑋𝑠𝑠 𝑒𝑒 𝛾𝛾𝛾𝛾 𝑑𝑑𝑑𝑑 + 𝑒𝑒 𝛾𝛾𝛾𝛾 𝑑𝑑𝑋𝑋𝑠𝑠 = 𝑒𝑒 𝛾𝛾𝛾𝛾 𝜎𝜎𝜎𝜎𝐵𝐵𝑠𝑠 [1]

𝑑𝑑
So (𝑒𝑒 𝛾𝛾𝛾𝛾 𝑑𝑑𝑋𝑋𝑠𝑠 ) = 𝑒𝑒 𝛾𝛾𝛾𝛾 𝜎𝜎𝜎𝜎𝐵𝐵𝑠𝑠 [1]
𝑑𝑑𝑑𝑑

𝑡𝑡 𝑑𝑑 𝑡𝑡
Then ∫0 (𝑒𝑒 𝛾𝛾𝛾𝛾 𝑑𝑑𝑋𝑋𝑠𝑠 ) = ∫0 𝑒𝑒 𝛾𝛾𝛾𝛾 𝜎𝜎𝜎𝜎𝐵𝐵𝑠𝑠 [1]
𝑑𝑑𝑑𝑑

𝑡𝑡
So 𝑒𝑒 𝛾𝛾𝛾𝛾 𝑋𝑋𝑡𝑡 − 𝑒𝑒 𝛾𝛾0 𝑋𝑋0 = 𝜎𝜎 ∫0 𝑒𝑒 𝛾𝛾𝛾𝛾 𝜎𝜎𝜎𝜎𝐵𝐵𝑠𝑠 [1]

𝑡𝑡
So 𝑒𝑒 𝛾𝛾𝛾𝛾 𝑋𝑋𝑡𝑡 = 𝑋𝑋0 + 𝜎𝜎 ∫0 𝑒𝑒 𝛾𝛾𝛾𝛾 𝜎𝜎𝜎𝜎𝐵𝐵𝑠𝑠 [1]

𝑡𝑡
So 𝑋𝑋𝑡𝑡 = 𝑋𝑋0 𝑒𝑒 −𝛾𝛾𝛾𝛾 + 𝜎𝜎 ∫0 𝑒𝑒 𝛾𝛾(𝑠𝑠−𝑡𝑡) 𝑑𝑑𝐵𝐵𝑠𝑠 ] [1]

The majority of students scored more than half marks on this

knowledge based question.

Common approaches to solve the SDE included using an

integrating factor or Ito’s Lemma.

Some students went on to calculate the distribution of the solution

and its long-term mean and variance despite not being asked for
this in the question.

6 Q6
i) Portfolio A = one call plus cash of Kexp(-r(T-t)) [1]
Portfolio B = one put plus one share [1]
Both portfolios have value max{K,S T } at expiry, hence by the principle of no
arbitrage they must have the same value at all earlier times. [1]

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 Subject CT8 (Financial Economics Core Technical) – September 2018 – Examiners’ Report

Hence c t + Ke-r(T-t) = p t + S t [1]

[Note to markers: any alternative valid solution is acceptable]

ii) By put-call parity [0.5]

B = 0.32 + 8exp(-0.03*10) – 5 [1]
= $1.25 [0.5]

iii) C >= max{ 0 , 10exp(-0.03*10) – 5 } [0.5]

= $2.41 [0.5]
C<= 10exp(-0.03*10) [0.5]
= $7.41 [0.5]

Alternatively, option C is the same as B but with a strike price $2 higher. It can never be in
the money by more than $2 more than B, so it can never be worth more than $2 more than B.
[1]
Hence it can’t be worth more than $3.25. [1]
[Max 2]

iv) D >= 10 – 5 = $5 [1]

D <= $10 [1]

(The American option can be exercised early, but its value will never be more than $10.)

[Or the American option is worth at least as much as the European option for 0.5 marks.]

Part (i) was a knowledge based question with well-prepared

students having little difficulty answering. Common mistakes
included using incorrect portfolios or not explicitly applying the
assumption of no arbitrage to prove the portfolios had the same
value at the beginning.

In parts (iii) and (iv) most students identified the correct bounds but
some struggled with the American option.

Q7

i) 100,000 + 250,000 = $350,000 [1]

ii) Under the Merton model, we consider that the shareholders have a call option on the
company’s assets, with a strike price equal to the nominal value of the debt. [1]
We want the share price to remain unchanged, so the value of the ‘call option’ after
the debt has been issued must be $1 per share = $100,000 in total. [1]

Page 9
 Subject CT8 (Financial Economics Core Technical) – September 2018 – Examiners’ Report

We need to find the nominal value of the debt at maturity, which will be the strike
price of this option. [1]
[Max 2 so far]
Trying a strike price of $250,000 gives a call value of $137,811 [1]
Trying a strike price of $350,000 gives a call value of $71,960 [1]

Sample answers to help with marking:

Strike price d1 d2 Call option value
$200,000 2.2834 1.948 $178,363
$250,000 1.6181 1.2827 $137,811
$300,000 1.0745 0.7391 $101,703
$350,000 0.6149 0.2795 $71,960
$400,000 0.2168 -0.1186 $49,148

Interpolating gives a strike price (i.e. nominal debt value at maturity) of $307,419
(actual value is $302,582) [1]

iii) The required yield on the debt is i where 250,000e5i = 302,582 => i = 3.82% [1]
=> credit spread = 3.82% - 3% = 0.82% [1]

iv) The equities fell to 50% of their original value [1]

The debt fell to (0.5 * 302,582) / 250,000 = 60.5% of its original value [1]
[Alternatively the debt fell by 39.5%.]

v) The debt ranks above the equities on company default. [1]

Hence the debt holders have a more secure investment. [1]
They will almost always receive something at maturity, and may receive the whole
value. [1]
The equity holders will receive nothing on default. [1]
And might receive nearly nothing even if the company does not default. [1]
[Max 3]
[Max 3]

Most students struggled with this question with most failing to score
more than a few marks.

In general, students did not understand they had been given the
value of equity and debt and had to solve for the redemption value
that was consistent with the values given.

Common mistakes included calculating the value of the equity using

the current value of the debt as a redemption value and then
proceeding through the question. This led to students using a

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 Subject CT8 (Financial Economics Core Technical) – September 2018 – Examiners’ Report

present value of debt that was higher than the redemption value,
leading to a negative credit spread.

Q8
i.
Stock tree
time 0 3 month 6 month 9 month
60.00 78.00 101.40 131.82
48.00 62.40 81.12
38.40 49.92
30.72
The price C 0 of the option is computed via Risk Neutral Valuation; let 𝑝𝑝̂ denote the risk neutral
probability of an up movement, then
𝑒𝑒 0.02∗0.25 −0.80
𝑝𝑝̂ = = 0.41 [1]
1.30−0.80
and
3
𝐶𝐶0 = 𝑒𝑒 −𝑟𝑟𝑟𝑟 � �𝑘𝑘3 �𝑝𝑝̂ 𝑘𝑘 (1 − 𝑝𝑝̂ )3−𝑘𝑘 𝑚𝑚𝑚𝑚𝑚𝑚�0, 𝑆𝑆0 𝑢𝑢𝑘𝑘 𝑑𝑑3−𝑘𝑘 − 𝐾𝐾� [1]
𝑘𝑘=0
= 𝑒𝑒 −0.02∗0.75 (76.82 × 𝑝𝑝̂ 3 + 26.12 × 3𝑝𝑝̂ 2 (1 − 𝑝𝑝̂ ) ) = 12.87 [1]

The detailed workings are provided below – in case attempts to answer this
question go through the whole tree.
CALL
time 0 3 month 6 month 9 month
12.87 25.30 46.67 76.82
4.35 10.66 26.12
0.00 0.00
0.00

ii. Either from the put-call parity or by repeating calculation: 𝑃𝑃0 = 7.05 [1]

iii. The value of the position is 𝐶𝐶0 − 𝑃𝑃0 = 𝑆𝑆0 − 𝐾𝐾𝐾𝐾 −𝑟𝑟𝑟𝑟 [1].
This value would not change as it is independent of the expected movements of the
stock (i.e. its volatility) [2]
[Or students can recalculate the value for full marks.]

Parts (i) and (ii) were well-answered by the majority of candidates.

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 Subject CT8 (Financial Economics Core Technical) – September 2018 – Examiners’ Report

For part (ii), some students calculated the put price from first
principles rather than simply using the put-call parity relationship.
This was a valid approach but took up more time in the exam.

For part (iii), the majority of students re-calculated the prices of

the put and call directly, though many made mistakes and hence
failed to conclude that the portfolio value remains unchanged.

Q9

i. From the definition, 𝑉𝑉 (𝑡𝑡) = Φ𝑡𝑡 𝑆𝑆𝑡𝑡 + Ψ𝑡𝑡 𝐵𝐵𝑡𝑡 [1]

−𝑟𝑟𝑟𝑟 −𝑟𝑟𝑟𝑟
therefore 𝑒𝑒 𝑉𝑉 (𝑡𝑡) = Φ𝑡𝑡 𝑒𝑒 𝑆𝑆𝑡𝑡 + Ψ𝑡𝑡 [1]
because the portfolio is self-financing it follows that 𝑑𝑑(𝑒𝑒 −𝑟𝑟𝑟𝑟 𝑉𝑉 (𝑡𝑡)) = Φ𝑡𝑡 𝑑𝑑(𝑒𝑒 −𝑟𝑟𝑟𝑟 𝑆𝑆𝑡𝑡 )
[1]
as required.

ii. Using the result from the previous part, the martingale property for the discounted
value of the portfolio is the same as for the discounted stock price. [1]
(𝜇𝜇 − 𝑟𝑟)�
This requires a change of measure to adjust for the market price of risk 𝜆𝜆 = 𝜎𝜎
[2]
[Or we can apply Taylor’s theorem to d(S t e-rT) and check that the drift is zero.]
[Or we could use Ito’s Lemma.]
[Or just 𝜆𝜆 = 𝑟𝑟 as a possible solution for one mark.]

Several approaches were used to prove that this is a martingale. A

common approach included Ito's Lemma, while other students used
the five-step method and applied the Martingale Representation
Theorem.

In part (ii), some students simply repeated the definition or

properties of a martingale rather than considering the conditions
for the discounted share price process that would make it a
martingale.

Q10

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

1. The price of the underlying share follows a geometric Brownian motion. [1/2]
2. There are no risk-free arbitrage opportunities. [1/2]

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 Subject CT8 (Financial Economics Core Technical) – September 2018 – Examiners’ Report

3. The risk-free rate of interest is constant, the same for all maturities and the same
for borrowing or lending. [1/2]
4. Unlimited short selling (that is, negative holdings) is allowed. [1/2]
5. There are no taxes or transaction costs. [1/2]
6. The underlying asset can be traded continuously and in infinitesimally small
numbers of units. [1/2]
ii.
Data: 𝑆𝑆 = 8; 𝐾𝐾 = 9; 𝑟𝑟 = 2%; 𝜎𝜎 = 20%; 𝑇𝑇 = 0.25
By the Black-Scholes formula:
−𝑑𝑑1 = 1.0778 [0.5]
−𝑑𝑑2 = 1.1778 [0.5]
𝑁𝑁(−𝑑𝑑1 ) = 0.8594 [0.5]
𝑁𝑁(−𝑑𝑑2 ) = 0.8806 [0.5]
Therefore 𝑃𝑃0 = 9𝑒𝑒 −0.02×0.25 × 0.8806 −8 × 0.8594 [1]
= 1.01 [1]

iii. As interest rates increase in the market, the expected return required by investors in stock
tends to increase [0.5]
However, the present value of any future cash flow generated by option contracts decreases
[0.5]
The combined impact of these two effects is to decrease the value of the put option [1]
Rho is negative for a put option [0.5]
put options become less valuable in times of increasing interest rates because they
effectively defer the selling of a share and so delay access to the cash required to obtain the
risk-free rate
[0.5]
[Or students could explain how the terms in the formula change.]
[Max 2]

This was well-answered overall by the majority of students.

For part (i), some students included assumptions from Expected

Utility Theory, the Efficient Market Hypothesis or CAPM which
scored no marks.

For part (ii), simple calculation errors were the most common
mistake.

Q11
i. SML: 𝐸𝐸𝑅𝑅𝑖𝑖 = 𝑅𝑅𝑓𝑓 + 𝛽𝛽𝑖𝑖 (𝐸𝐸𝑅𝑅𝑀𝑀 − 𝑅𝑅𝑓𝑓 ) [1]
for
• 𝐸𝐸𝑅𝑅𝑖𝑖 : expected return on Asset i. [1/4]
• 𝑅𝑅𝑓𝑓 : risk-free rate. [1/4]
• 𝛽𝛽𝑖𝑖 : beta factor of security i defined as 𝐶𝐶𝐶𝐶𝐶𝐶(𝑅𝑅𝑖𝑖 , 𝑅𝑅𝑀𝑀 )/𝑉𝑉𝑉𝑉𝑉𝑉(𝑅𝑅𝑀𝑀 ). [1/4]

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 Subject CT8 (Financial Economics Core Technical) – September 2018 – Examiners’ Report

• 𝐸𝐸𝑅𝑅𝑀𝑀 : expected return on the market portfolio. [1/4]

[Round up to nearest half mark.]

ii. Note that 𝐸𝐸𝑅𝑅𝑀𝑀 = 𝑥𝑥1 𝐸𝐸𝑅𝑅1 + 𝑥𝑥2 𝐸𝐸𝑅𝑅2 [1/4], and 𝑥𝑥1 + 𝑥𝑥2 = 1 [1/4]
Substitute into the SML and solve for 𝑥𝑥1 , so that
𝐸𝐸𝑅𝑅𝑖𝑖 −𝛽𝛽𝑖𝑖 𝐸𝐸𝑅𝑅2 −𝑅𝑅𝑓𝑓 (1−𝛽𝛽𝑖𝑖 )
𝑥𝑥1 = (𝐸𝐸𝑅𝑅1 −𝐸𝐸𝑅𝑅2 )𝛽𝛽𝑖𝑖
. [1]
From the data: 𝐸𝐸𝑅𝑅1 = 16.30% [1/4]
𝐸𝐸𝑅𝑅2 = 29.70% [1/4]
Substituting either for Asset 1 or Asset 2, 𝑥𝑥1 = 0.4 [1/2]
and therefore 𝑥𝑥2 = 0.6 [1/2]
[Alternatively, the beta of the market portfolio is 1, so x_1*0.46 + x_2*1.36 = x_1*0.46
+ (1-x_1)*1.36 = 1 => x_1=0.4]
[Round up to nearest half mark.]

iii. 𝑉𝑉𝑉𝑉𝑉𝑉(𝑅𝑅𝑀𝑀 ) = 0.42 ∗ 𝑉𝑉𝑉𝑉𝑉𝑉(𝑅𝑅1 ) + 0.62 ∗ 𝑉𝑉𝑉𝑉𝑉𝑉(𝑅𝑅2 ) + 2 ∗ 0.4 ∗ 0.6 ∗ 𝐶𝐶𝐶𝐶𝐶𝐶(𝑅𝑅1 , 𝑅𝑅2 ) = 0.00617.
[1]
Consequently �𝐸𝐸𝑅𝑅𝑀𝑀 − 𝑅𝑅𝑓𝑓 �/𝜎𝜎𝑀𝑀 = 1.897. [1]

The majority of students scored well in this question.

For part (i), some students confused the Security Market Line and
the Capital Market Line despite these being given in the Actuarial
Tables.

END OF EXAMINERS’ REPORT

Page 14
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

24 April 2018 (am)

Subject CT8 – Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. You have 15 minutes of planning and reading time before the start of this examination.
You may make separate notes or write on the exam paper but not in your answer
booklet. Calculators are not to be used during the reading time. You will then have
three hours to complete the paper.

4. Mark allocations are shown in brackets.

5. Attempt all 11 questions, beginning your answer to each question on a new page.

6. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT8 A2018 © Institute and Faculty of Actuaries

1 A horse racing fan assesses her utility of wealth using the utility function

U(w) = 2(w 0.5–1).

(i) Prove algebraically that the horse racing fan is:

(a) non-satiated
(b) risk averse. [2]

(ii) Prove that the horse racing fan exhibits constant relative risk aversion. [2]

The horse racing fan is attending a race and she intends to place bets on two horses.
The table below shows the pay-out per £1 bet on each of these horses if it wins the
race, and the investor’s estimated probabilities of each horse winning the race. The
pay-out is the total paid and is not in addition to the bet being returned.

Horse Winning pay-out per £1 bet Probability of winning

A £1.69 60%
B £6.25 10%

The horse racing fan has total wealth of £1,000 and she will bet all of her wealth on
this race. Negative bets are not allowed.

(iii) Calculate the amount she should bet on each horse to maximise her expected
utility of wealth. [7]

(iv) Calculate the expected wealth resulting from the bets in part (iii). [1]

(v) Explain how and why this differs from the utility of the horse racing fan’s
initial wealth. [2]
 [Total 14]

2 Describe the difficulties in estimating parameters for asset pricing models. [5]

3 The value of an investment asset follows the equation A(t) = exp(Bt ), where Bt follows
standard Brownian motion.

(i) State the five defining properties that apply to Bt as a standard Brownian
motion.[5]

An actuarial student invests $1,000 in the asset at time 0.

(ii) Calculate the expected value of this investment at time 5. [2]

(iii) Calculate the probability that the value of the student’s investment is less than
$10,000 at time 5. [2]
 [Total 9]

CT8 A2018–2
4 Mr and Mrs Jones both wish to buy stocks in Widgets Inc. They don’t have enough
money right now, so they are considering buying either forwards or options on the
stocks, both with a term of 4 years.

The stock price at time 0 is £10 with standard deviation of 12% per annum. The stock
does not pay any dividend. The continuously compounded risk-free rate of interest is
5% per annum.

(i) Calculate the 4 year forward price on one stock. [1]

(ii) Calculate the price at time 0 of a 4 year call option on one stock with a strike
price of £12.21. [3]

Mrs Jones enters into one forward contract, while Mr Jones buys one call option. At
time 4 the stock is worth £12.

(iii) Calculate the accumulated profit or loss at time 4 for Mrs Jones. [1]

(iv) Calculate the accumulated profit or loss at time 4 for Mr Jones. [2]

(v) Explain why Mr Jones makes a loss despite having an option that does not
force him to buy the stock. [2]

(vi) Calculate the range of stock prices at time 4 which would leave Mr Jones
better off than Mrs Jones. [3]
 [Total 12]

5 Consider a zero-coupon bond Bt with three years to maturity. The bond pays $100
at maturity if it has not defaulted, or $30 if it has defaulted. The continuously
compounded risk-free rate is r. In a two-state model the default intensity is l under
the probability measure P, and the bond price is:

Bt = 30e–r(3 – t) if the bond has already defaulted by time t, or

Bt = e–r(3 – t)(30(1 – e–l(3 – t)) + 100e–l(3 – t)) if the bond has not yet defaulted by time t

(i) Show that P is an equivalent martingale measure. [4]

A derivative pays $35 at time 3 if the bond has defaulted and $0 otherwise.

(ii) (a) Determine a constant portfolio containing the bond and cash which
replicates this derivative.
(b) Derive an expression for the arbitrage-free price for the derivative at
time 0 in terms of r and l.[5]

(iii) Explain how your answers to parts (i) and (ii) are related through the value of
the portfolio in part (ii) also being a martingale. [3]
 [Total 12]

CT8 A2018–3 PLEASE TURN OVER

6 Consider a three-period binomial tree model for the non-dividend paying stock price
process St , in which the stock price either rises by u% or falls by d % each period till
maturity. Let r denote the continuously compounded risk-free rate of interest.

(i) State the conditions under which this market is arbitrage free. [1]

Let S0 = £95 and assume this price either rises or falls by 20% each year for the
next three years. Assume also that the risk-free rate is 5% per annum continuously
compounded.

(ii) Calculate the price of a vanilla European put option with maturity in three
years and strike price 110. [4]

Assume a change in market conditions such that the same share price now either rises
or falls by 5% each year for the next three years.

(iii) Determine how this change would impact on the option price. [2]
 [Total 7]

7 (i) Define a complete market. [1]

The price process of a traded security satisfies the following stochastic differential
equation

dSt = μSt dt + σSt dWt ,

where Wt is a Brownian motion under the real-world probability measure P. Let r > 0
be the continuously compounded risk-free rate of interest, with r ≠ μ.

(ii) Show that the discounted stock price e–rtSt is not a martingale under the real-
world probability measure P.[3]

(iii) Demonstrate how the discounted asset price e–rtSt can be a martingale under
an equivalent martingale measure Q. [3]
 [Total 7]

CT8 A2018–4
8 The current price of a non-dividend paying stock is £65 and its volatility is 25% per
annum. The continuously compounded risk-free interest rate is 2% per annum.

Consider a European call option on this share with strike price £55 and expiry date in
six months’ time. Assume that the Black-Scholes model applies.

(i) Calculate the price of the call option.  [4]

(ii) Define algebraically the delta of the call option. [1]

(iii) Calculate the value of the delta of the call option. [2]

(iv) Calculate the value of the delta of a European put option written on the same
underlying, with the same strike and maturity as above. [2]
 [Total 9]

9 Consider a market with the following bonds in issue.

Principal Expire (years) Coupon Price Zero rate Forward rate

value T (annual*) R(0, T) F(0, S, T)
100 0.25 0 97.5 (a)
100 0.5 0 94.9 (b) F(0, 0.25, 0.5) = 10.81%
100 1 0 90.0 10.54% F(0, 0.5, 1) = (d)
100 1.5 8% (c) 10.68% F(0, 1, 1.5) = (e)
(* half the stated coupon is paid every 6 months)

(i) Calculate the values of (a), (b), (c), (d), (e) in the table above. [5]

(ii) Write down the stochastic differential equations of two standard models for the
short rate of interest.  [2]
 [Total 7]

CT8 A2018–5 PLEASE TURN OVER

10 Consider a call option on a non-dividend paying stock S when the stock price is £15,
the exercise price, K, is £12, the continuously compounded risk-free rate of interest
is 2% per annum, the volatility is 20% per annum and the time to maturity is three
months.

(i) Calculate the price of the option using the Black-Scholes model. [4]

(ii) Determine the (risk neutral) probability of the option expiring in the money.
[1]

A special option called a “digital cash-or-nothing” option has a payoff in three

months’ time of:

1 if ST > K
0 otherwise

(iii) Calculate the price of the digital option. [2]

(iv) Describe the limitations of the Black-Scholes model. [2]

 [Total 9]

CT8 A2018–6
11 Consider a market in which the Capital Asset Pricing Model (CAPM) holds.

(i) List the assumptions, additional to those used in modern portfolio theory, of
the CAPM. [2]

(ii) Prove that the market portfolio has unit beta. [2]

In the same market as above, there are two assets with the following attributes.

Rate of return (per annum) Variance/Covariance Matrix

State Probability Asset 1 Asset 2 Asset 1 Asset 2
1 0.2 5.00% 11.00% Asset 1 0.00068 0.00102
2 0.3 10.00% 15.00% Asset 2 0.00102 0.00181
3 0.1 8.00% 12.00%
4 0.4 4.00% 5.00%

Market capitalisation 40,000 60,000

(iii) Calculate the beta of each security. [3]

(iv) Determine the value of the risk-free rate of interest which is consistent with
the results obtained in part (iii), under the assumption that the CAPM holds.[2]
 [Total 9]

END OF PAPER

CT8 A2018–7 PLEASE TURN OVER

 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2018

Subject CT8 – Financial Economics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that
the examination was set. Candidates should take into account the possibility that
circumstances may have changed if using these reports for revision.

Luke Hatter
Chair of the Board of Examiners
June 2018

 Institute and Faculty of Actuaries

 Subject CT8 (Financial Economics Core Technical) – April 2018 – Examiners’ Report

A. General comments on the aims of this subject and how it is marked

1. The aim of the Financial Economics subject is to develop the necessary skills to
construct asset liability models and to value financial derivatives. These skills are
also required to communicate with other financial professionals and to critically
evaluate modern financial theories.

2. The marking approach for CT8 is flexible in the sense that different answers to
those shown in the solution can earn marks if they are relevant and appropriate.
Marks for the methodology are also awarded.

B. General comments on student performance in this diet of the examination

1. Performance by candidates on this paper was, on the whole, considerably worse

than in recent sittings.

2. In general, the real differentiators in those who scored well were attention to detail
in their algebraic steps, and the breadth of knowledge in being able to score the
bookwork marks and even attempt most questions. The majority of candidates
seemed unable to gather from the text of the question the relevant information, and
translate it in the appropriate equivalent statistical concepts. For example,
candidates struggled with formulating the probability that an event occurs in
appropriate mathematical terms, and determining from the information in the
question the direct way to recover required variances and covariances. This showed
a lack of sufficient confidence with the fundamental statistical concepts which
Financial Economics so heavily relies on.

3. Students performed relatively well on bookwork questions, although many missed

the opportunity to be awarded full marks due to relatively superficial knowledge.

4. The majority of candidates seemed to struggle on the application parts of the

questions, because they were not able to use and combine the information given to
them in the question.

C. Pass Mark

The Pass Mark for this exam was 60.

Page 2
 Subject CT8 (Financial Economics Core Technical) – April 2018 – Examiners’ Report

Solutions

Q1
i)
a. U’(w) = w-0.5 > 0 for w > 0 [1]
b. U’’(w) = -0.5w-1.5 < 0 for w > 0 [1]

ii) R(w) = w*(-U‘’(w)/U’(w)) = 0.5 [2]

iii) E[U] = 0.6U(1.69a) + 0.1U(6.25b) +0.3U(0) [½]

= 0.6*2*((1.69a)^0.5-1) + 0.1*2*((6.25b)^0.5-1) – 0.6 [½]
= 1.2*(1.3a^0.5-1) + 0.2*(2.5b^0.5-1) – 0.6
= 1.56a^0.5 + 0.5b^0.5 – 1.4 – 0.6 [½]
= 1.56a^0.5 + 0.5(1000-a)^0.5 –2 [½]
dE[U]/da = 0.78a^-0.5 – 0.25(1000-a)^-0.5 [1]
Setting dE[U]/da = 0 gives
0.78a^-0.5 = 0.25(1000-a)^-0.5 [½]
=> 0.78 = 0.25a^0.5(1000-a)^-0.5
=> 3.12 = (a/(1000-a))^0.5 [½]
Squaring both sides
=> 9.7344 = a/(1000-a) [½]
=> 9,734.4 = 10.7344a or 8.7344a
=> a = £906.8 or £1,114.50 [½]
Rejecting the figure >£1,000 gives
a = £906.80 and b=£93.20 [1]
Checking the second derivative
d^2E[U]/da^2 = -0.39a^-1.5 – 0.25(1000-a)^-1.5 < 0 [½]
hence this is a maximum [½]

[Note to markers: rounding accepted]

iv) E[U] = 49.801 [1]

[Note to markers: assign [1] mark to answers containing the expected wealth]

v) U(1000) = 61.2456 [1]

So the maximum expected utility of wealth is less than the current utility of
wealth. [½]
This is because the odds offered pay out less than would be required based on the
investor’s estimated probabilities of each horse winning. [½]
Based on expected utility, the investor would be better off not betting at all. [½]
There may be other horses in the race where this position is reversed. [½]
[Note to markers: assign [1] mark to any valid comment]
[Max 2]

Page 3
 Subject CT8 (Financial Economics Core Technical) – April 2018 – Examiners’ Report

Part i) and ii) were very well answered with most students scoring full
marks.
Many students found iii) challenging with only a few able to formulate
the expected utility correctly allowing for the possibility of neither horse
winning. Some students understood the method required of setting the
first derivative to zero and so were able to score method marks even if
they were unable to obtain the correct formula for the expected utility.
Very few candidates checked for conditions on the second order
derivative.
Quite a few candidates were able to derive the expected wealth correctly
for iv) based on their answer in iii) and so were able to score this mark.
Some candidates were able to score a mark for calculating the utility of
the initial wealth although few were able to make sensible comments to
score additional marks.

Q2
The estimation of parameters is one of the most time-consuming aspects of [½]
stochastic asset modelling.
The simplest case is the purely statistical model, where parameters are [½]
calibrated entirely to past time series. Provided the data is available, and
reasonably accurate, the calibration [½]
can be a straightforward and mechanical process.

Of course, there may not always be as much data as we would like, and [½]
the statistical error in estimating parameters may be substantial.

Furthermore, there is a difficulty in interpreting data which appears to [½]

invalidate the model being fitted.

For example, what should be done when fitting a Gaussian model in the [½]
presence of large outliers in the data?

Perhaps the obvious course of action is to reject the hypothesis of [½]

normality, and to continue building the model under some alternative
hypothesis. After all, in many applications, the major financial risks lie in
the outliers, so it seems foolish to ignore them.

In practice, a more common approach to outliers is to exclude them from [½]

the statistical analysis, and focus attention instead on the remaining residuals
which appear more normal.

The model standard deviation may be subjectively nudged upwards after [½]
the fitting process, in order to give some recognition to the outliers which
have been excluded.

Page 4
Subject CT8 (Financial Economics Core Technical) – April 2018 – Examiners’ Report

It has often been the practice in actuarial modelling to use the same data [½]
set to specify the model structure, to fit the parameters, and to validate the
model choice.

A large number of possible model structures are tested, and testing stops [½]
when a model which is found which passes a suitable array of tests.

Unfortunately, in this framework, we may not be justified in accepting a [½]

model simply because it passes the tests.

Many of these tests (for example, tests of stationarity) have notoriously [½]
low power, and therefore may not reject incorrect models.

Indeed, even if the “true” model was not in the class of models being [½]
fitted, we would still end up with an apparently acceptable fit, because
the rules say we keep generalising until we find one.

This process of generalisation tends to lead to models which wrap [½]

themselves around the data, resulting in an understatement of future risk,
and optimism regarding the accuracy of out-of-sample forecasts.

In the context of economic models, the calibration becomes more [½]

complex. The objective of such models is to simplify reality by imposing

certain stylised facts about how markets would behave in an ideal world.

This theory may impose constraints, for example on the relative [½]
volatilities of bonds and currencies. Observed data may not fit these
constraints perfectly.

In these cases, it is important to prioritise the features of the economy [½]

that are most important to calibrate accurately for a particular application.

[Note to markers: please award ½ mark for any valid idea presented by the
candidates. We only need the concept to earn a half mark, not all the detail
above.]
[Max 5]

This was generally poorly answered with most candidates picking up one
or two marks at most. Many candidates focused on why the CAPM and
APT models were unrealistic rather than focusing specifically on the
challenges of estimating parameters and hence were unable to score
well.

Page 5
 Subject CT8 (Financial Economics Core Technical) – April 2018 – Examiners’ Report

Q3
i) EITHER Bt has independent increments, OR Bt - Bs is independent of {Br , r <=
s} whenever s < t, OR BOTH
EITHER Bt has stationary increments, OR the distribution of Bt - Bs depends
only on t – s, OR BOTH
EITHER Bt has Gaussian increments, OR the distribution of Bt - Bs is N(0, t - s),
OR BOTH
Bt has continuous sample paths t -> Bt.
B0 = 0.
[1 Mark each]
[Total of 5]

ii) A(0) = exp(0) = 1, so the students buys 1,000 units of the asset. [½]
E[A(5)] = exp(0.5*12*5) = 12.182 [1]
So the expected value of the investment is $12,182. [½]

iii) P(Investment<$10,000) = P(A(5)<10) [½]

= P(Z<(ln(10)/sqrt(5)) [½]
= P(Z<1.03) [½]
= 0.8484 (0.85) [½]

Part i) was bookwork and was well answered with the majority of
candidates scoring full or close to full marks.
Parts ii) and iii) proved challenging for many candidates although the
techniques required were quite standard. Students in general struggled
with identifying the correct parameters and which expectation and
probability to calculate.

Q4
i) F(4) = 10exp(4*0.05) = £12.21 [1]

ii) We can obtain d1 and d2 from the Black Scholes formula as:
d1 = 0.1214 [1]
d2 = -0.1186 [1]
Call price = £0.96 [1]

iii) Paid £12.21 for a stock worth £12 = loss of £0.21 [1]

iv) Paid £0.96 for call option = 0.96*exp(4*0.05) = £1.17 at time 4 [1]
Call expires worthless, hence loss of £1.17 [1]

Page 6
 Subject CT8 (Financial Economics Core Technical) – April 2018 – Examiners’ Report

[Note to marker: please award ½ mark for using £0.96 as the loss on the position]

v) Mr Jones must pay for the optionality. [1]

He makes a loss if the option expires worthless, but that loss is never [1]
larger than £1.17.
This capped loss has a cost. [1]
[Note to Markers: please accept valid answers carrying forward an erroneous
£0.96 as loss]
[Max 2]

vi) If the stock is worth more than £12.21 at time 4 then Mrs Jones will make [½]
a profit

and this profit will always be larger than Mr Jones’ profit because he had [1]
to buy the option.

If the stock is worth less than £12.21 at time 4 then Mrs Jones will make [½]
a loss
of £12.21 minus stock price [1]

Mr Jones will always make a loss of £1.17 [½]

So the crossover is at a stock price of 12.21 – 1.17 = £11.04 [1]
[Max 3]

ALTERNATIVE ANSWER: Profit from Call > Profit from forward [1]
Max{S(T) – 12.21, 0} – 1.17 > S(T) – 12.21 [½]
=> Max{– 12.21, – ST} > – 11.04 [½]
=> S(T) < 11.04 [1]

[Note to Markers: please accept valid answers carrying forward an erroneuos £0.96
as loss]

In general, parts i), ii) and iii) were well answered although there were
some calculation errors. Some candidates though did not reflect on the
magnitude of their answer to determine if it was realistic.
For iv) many candidates did not accumulate the premium paid to expiry
as required by the question and so were not able to score full marks.
In part v) most candidates did not explain properly why a premium is
required to enter the option and hence lost a mark.
Part vi) was quite poorly answered and quite a few candidates struggled
as they were unable to consider all the different possible outcomes.

Page 7
 Subject CT8 (Financial Economics Core Technical) – April 2018 – Examiners’ Report

Q5

i) We need E[e-rtB t | F s ] = e-rsB s [½]

If the bond has already defaulted by time s then e-rsB s = e-rs30e-r(3-s) = e-rtB t [1]

Otherwise e-rtB t = 30e-3r if the bond defaults before time t, or [½]

e-rtB t = e-3r(30(1 - e-λ(3-t)) + 100e-λ(3-t)) otherwise [½]

Then E[e-rtB t | F s ] = 30e-3r(1 - e-λ(t-s)) + e-3r(30(1 - e-λ(3-t)) + 100e-λ(3-t)) e-λ(t-s) [½]

= e-3r(30(1 - e-λ(3-s)) + 100e-λ(3-s)) [½]

= e-rsB s hence this is a martingale [½]

ii) (a) Let the portfolio contain x cash and y bonds.

We need the value at time 3 to be $35 if the bond has defaulted, [1]
so xe3r +30y = 35

We also need the value at time 3 to be zero if the bond has not defaulted, [1]
so xe3r +100y = 0

Hence x = 50 e-3r and y = -0.5. [1]

(b) The price at time zero must be the cost of buying this portfolio [½]

= x+ yB 0 = 50e-3r – 0.5e-3r(30(1 - e-3λ)) + 100e-3λ) [1]

= 35e-3r(1-e-3λ) [½]

iii) Let the portfolio value be V. [1]

We need the value of the portfolio at time 0 to be E[e-3rV 3 ] under
probability measure P.

E[e-3rV 3 ] = 35e-3r * [Probability that bond defaults] [1]

= 35e-3r(1-e-3λ) hence the requirement holds. [1]

This fits with the fact that being able to hedge a derivative price without [1]
arbitrage means we can price it under the Equivalent Martingale Measure.
[Max 3]

Page 8
 Subject CT8 (Financial Economics Core Technical) – April 2018 – Examiners’ Report

This was a difficult question that was very poorly answered with
candidates either not attempting or only superficially attempting this
question. Overall the lowest scoring question from the paper.
For i), the majority of candidates appeared unfamiliar with the term
“equivalent martingale measure”, and did not realise they needed to
focus on the discounted price process.
There were more attempts for ii) although the majority were unable to
formulate the required equations for the replicating portfolio.
Part iii) was very poorly attempted and any reasonable comment was
given credit.

Q6

i) EITHER: The market is arbitrage free if and only if there exists a probability
measure under which discounted asset prices are martingales. [1]
OR
The probability exists if 1 − 𝑑𝑑 < 𝑒𝑒 𝑟𝑟𝑟𝑟𝑟𝑟 < 1 + 𝑢𝑢. [1]
OR BOTH [max 1]
[Note to markers: please accept solutions with 𝑑𝑑 < 𝑒𝑒𝑒𝑒𝑒𝑒(𝑟𝑟𝑟𝑟𝑟𝑟) < 𝑢𝑢, and 𝛿𝛿𝛿𝛿 = 1.]

(Note to markers: both answers are acceptable)

ii)
Stock tree
time 0 1 2 3
95.00 114.00 136.80 164.16
76.00 91.20 109.44
60.80 72.96
48.64
The price P 0 of the option is computed via Risk Neutral Valuation; let 𝑝𝑝̂ denote the risk
neutral probability of an up movement, then

𝑒𝑒 0.05 − 0.80
𝑝𝑝̂ = = 0.6282
1.20 − 0.80
[1]

and

3
3
𝑃𝑃0 = 𝑒𝑒 −𝑟𝑟𝑟𝑟 � � � 𝑝𝑝̂ 𝑘𝑘 (1 − 𝑝𝑝̂ )3−𝑘𝑘 (𝐾𝐾 − 𝑆𝑆0 𝑢𝑢𝑘𝑘 𝑑𝑑3−𝑘𝑘 )+
𝑘𝑘
𝑘𝑘=0
[2]

Page 9
 Subject CT8 (Financial Economics Core Technical) – April 2018 – Examiners’ Report

= 𝑒𝑒 −0.05∗3 �0.56 × 3𝑝𝑝̂ 2 (1 − 𝑝𝑝̂ ) + 37.04 × 3𝑝𝑝̂ (1 − 𝑝𝑝̂ )2 + 61.36 × (1 − 𝑝𝑝̂ )3 �

= 11.23
[1]
The detailed working are provided below – in case attempts to answer this
question go through the whole tree.
PUT
time 0 1 2 3
11.23 4.87 0.20 0.00
23.53 13.44 0.56
43.84 37.04
61.36

iii) The given market conditions imply that 1 − 𝑑𝑑 = 0.95, 1 + 𝑢𝑢 = 1.05; [1]
however the discount factor is 𝑒𝑒 0.05 = 1.0513

Hence the condition of no arbitrage is violated and no pricing is [1]

possible

[Alternatively, candidates can recalculate the risk neutral probability 𝑝𝑝̂ , which in this
case would give 1.0127, hence there is arbitrage in the market
Alternatively, candidates can obtain a negative option price ].

Parts i) and ii) were well answered although there were a few
calculation errors in ii). Lost marks were mostly for getting an incorrect
probability value, forgetting the combination factor in the final
calculation or slipping up with the numbers. A few students also got
confused and tried to price a call option.
There were quite a few good answers to iii) although about half did not
spot that the no arbitrage condition would not hold under the new
scenario.

Q7
i) The market is complete if for any contingent claim X there is a [1]
replicating strategy (Φ𝑡𝑡 , Ψ𝑡𝑡 )

i.e. is a self-financing strategy, defined for 0 ≤ t < U , capable of [1]

reproducing the derivative terminal payment at 𝑈𝑈 without risk, for an
initial investment of 𝑉𝑉(0) at time 0.
[Max 1]

ii) The SDE of 𝑆𝑆̃𝑡𝑡 = 𝑒𝑒 −𝑟𝑟𝑟𝑟 𝑆𝑆𝑡𝑡 :

𝑑𝑑𝑆𝑆̃𝑡𝑡 = (𝜇𝜇 − 𝑟𝑟)𝑆𝑆̃𝑡𝑡 𝑑𝑑𝑑𝑑 + 𝜎𝜎𝑆𝑆̃𝑡𝑡 𝑑𝑑𝑊𝑊𝑡𝑡 , [1]

Page 10
 Subject CT8 (Financial Economics Core Technical) – April 2018 – Examiners’ Report

For this process to be a martingale, the drift should be zero [1]

but 𝑟𝑟 ≠ 𝜇𝜇 in general. Hence it is not a martingale. [1]

[Alternative solutions based on solving the SDE and checking the martingale condition
are equally acceptable. This is equivalent to check that the identity E[𝑆𝑆̃𝑇𝑇 |𝐹𝐹𝑡𝑡 ]= 𝑆𝑆̃𝑡𝑡 for
𝑆𝑆̃𝑡𝑡 = 𝑆𝑆0 exp((𝜇𝜇 − 𝑟𝑟 − 0.5𝜎𝜎 2 )𝑡𝑡 + 𝜎𝜎𝑊𝑊𝑡𝑡 ) does not hold.]

iii) We need to change the Brownian motion by means of the Girsanov [1]
�𝑡𝑡 = 𝑊𝑊𝑡𝑡 + 𝜆𝜆𝜆𝜆 be a Brownian motion under a new probability
Theorem. Let 𝑊𝑊
measure 𝑄𝑄
then the above SDE becomes: [1]

𝑑𝑑𝑆𝑆̃𝑡𝑡 = (𝜇𝜇 − 𝑟𝑟 − 𝜆𝜆𝜆𝜆)𝑆𝑆̃𝑡𝑡 𝑑𝑑𝑑𝑑 + 𝜎𝜎𝑆𝑆̃𝑡𝑡 𝑑𝑑𝑊𝑊

�𝑡𝑡 ,

For the martingale property to hold set the drift to zero, which implies
(𝜇𝜇 − 𝑟𝑟)�
𝜆𝜆 = 𝜎𝜎 . [1]
[Alternative solution carrying equal marks: change the Brownian motion as above
and take the conditional expectation under the new measure; this returns 𝐸𝐸 𝑄𝑄 �𝑆𝑆̃𝑇𝑇 �𝐹𝐹𝑡𝑡 � =
(𝜇𝜇 − 𝑟𝑟)�
𝑆𝑆̃𝑡𝑡 𝑒𝑒𝑒𝑒𝑒𝑒(𝜇𝜇 − 𝑟𝑟 − 𝜆𝜆𝜆𝜆)(𝑇𝑇 − 𝑡𝑡). The martingale condition requires 𝜆𝜆 = 𝜎𝜎 .]

In general, candidates who scored marks seemed to have a good

understanding of the underlying theory.
For i) many did not know the required bookwork definition although this
did not affect the rest of the question.
Part ii) was reasonably answered although many calculated an
expression for S(t) and struggled to show that the expectation condition
was satisfied rather than directly use the SDE.
Part iii) was not well answered and generally only the stronger
candidates scored well on this part.

Q8
i) Data: 𝑆𝑆0 = 65, 𝐾𝐾 = 55, 𝜎𝜎 = 25% 𝑝𝑝. 𝑎𝑎. , 𝑇𝑇 = 0.5 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦, 𝑟𝑟 = 2%
Let Ct be the price of the European call.
The Black-Scholes formula returns [½ Mark each]
𝑑𝑑1 = 1.09
𝑑𝑑2 = 0.9132
𝑁𝑁(𝑑𝑑1 ) = 0.8621
𝑁𝑁(𝑑𝑑2 ) = 0.8194
Therefore 𝐶𝐶0 = 65 × 0.8621 − 55𝑒𝑒 −0.02×0.5 × 0.8194 [1]

= 11.42 [1]

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 Subject CT8 (Financial Economics Core Technical) – April 2018 – Examiners’ Report

𝜕𝜕𝜕𝜕
ii) 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 = 𝜕𝜕𝜕𝜕
[1]
[Note to markers: please award ½ mark for stating 𝑁𝑁(𝑑𝑑1 ) ]
iii) In the Black-Scholes model 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 = 𝑁𝑁(𝑑𝑑1 ) [1]
Using the results from above 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 = 0.8621 [1]

iv) 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑎𝑎𝑝𝑝𝑝𝑝𝑝𝑝 = 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑎𝑎𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 − 1 [1]

Therefore, 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑎𝑎𝑝𝑝𝑝𝑝𝑝𝑝 = −0.1379 [1]
[Note to markers: if signs are incorrect in the formula and the actual value, award
½ mark for 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑎𝑎𝑝𝑝𝑝𝑝𝑝𝑝 = 0.1379 only]

This question was generally well answered with quite a few scoring full
marks or close to full marks. Many got (iv) correct, but a significant
number of candidates got the sign wrong.

Q9
i) Using continuous compounding.
[Note to markers: please accept any correct attempt using different compounding
convention]
1 97.5
a. − 0.25 𝑙𝑙𝑙𝑙 100 = 10.13% [1]
1 94.9
b. − 0.5 𝑙𝑙𝑙𝑙 100 = 10.47% [1]
c. 0.04 × (94.9 + 90) + 104 × 𝑒𝑒 −0.1068×1.5 = 96 [1]
(0.1054×1−0.1047×0.5)
d. 1−0.5
= 10.60% [1]
(0.1068×1.5−0.1054×1)
e. 1.5−1
= 10.97% [1]

ii) Two standard models for the short rate of interest are the Vasicek model
and the CIR model.
The corresponding SDEs are respectively
𝑑𝑑𝑟𝑟𝑡𝑡 = 𝑘𝑘(𝜃𝜃 − 𝑟𝑟𝑡𝑡 )𝑑𝑑𝑑𝑑 + 𝜎𝜎𝜎𝜎𝑊𝑊𝑡𝑡
𝑑𝑑𝑟𝑟𝑡𝑡 = 𝑘𝑘(𝜃𝜃 − 𝑟𝑟𝑡𝑡 )𝑑𝑑𝑑𝑑 + 𝜎𝜎�𝑟𝑟𝑡𝑡 𝑑𝑑𝑊𝑊𝑡𝑡
[1 mark each]

Alternatively: another standard model is the Hull and White model which extends
the Vasicek model to allow for time-inhomogeneity, therefore the parameters in
the SDE are time dependent.

Parts i) a) and b) were very well answered and d) was also well answered
by many. Parts c) and e) proved difficult with only a few getting the
marks here.

Page 12
 Subject CT8 (Financial Economics Core Technical) – April 2018 – Examiners’ Report

Part ii) was very well answered.

Q10
i) Data:
𝑆𝑆0 = 15, 𝐾𝐾 = 12, 𝜎𝜎 = 20% 𝑝𝑝. 𝑎𝑎. , 𝑇𝑇 = 0.25 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦, 𝑟𝑟 = 2%.
Let Ct be the price of the European call.

The Black-Scholes formula returns [½ mark each]

𝑑𝑑1 = 2.3314
𝑑𝑑2 = 2.2314
𝑁𝑁(𝑑𝑑1 ) = 0.9901
𝑁𝑁(𝑑𝑑2 ) = 0.9872

Therefore 𝐶𝐶0 = 15 × 0.9901 − 12𝑒𝑒 −0.02×0.25 × 0.9872 [1]

= 3.0650 [1]

ii) Probability of expiring in the money: 𝑃𝑃(𝑆𝑆𝑇𝑇 > 𝐾𝐾) = 𝑁𝑁(𝑑𝑑2 ) [½]
hence from above 𝑃𝑃(𝑆𝑆𝑇𝑇 > 𝐾𝐾) = 0.9872. [½]

iii) Risk neutral valuation applied to the given digital option returns
𝐸𝐸�𝑒𝑒 −𝑟𝑟𝑟𝑟 1𝑆𝑆𝑇𝑇>𝐾𝐾 � = 𝑒𝑒 −𝑟𝑟𝑟𝑟 𝑃𝑃(𝑆𝑆𝑇𝑇 > 𝐾𝐾) [1]
From above it follows that the price is 𝑒𝑒 −0.02×0.25 × 0.9872 = 0.98225 [1]

iv) Limitations [½ mark each]

a. Share prices can jump. This invalidates assumption that the stock price evolves
as geometric Brownian motion, as this process has continuous sample paths.
However, hedging strategies can still be constructed which substantially reduce
the level of risk.
b. The risk-free rate of interest does vary and in an unpredictable way. However,
over the short term of a typical derivative, the assumption of a constant risk-free
rate of interest is not far from reality. (More specifically the model can be
adapted in a simple way to allow for a stochastic risk-free rate, provided this is a
predictable process.)
c. Unlimited short selling may not be allowed, except perhaps at penal rates of
interest. These problems can be mitigated by holding mixtures of derivatives
which reduce the need for short selling. This is part of a suitable risk
management strategy.
d. Shares can normally only be dealt in integer multiples of one unit, not
continuously, and dealings attract transaction costs. Again we are still able to
construct suitable hedging strategies which substantially reduce risk.

Page 13
 Subject CT8 (Financial Economics Core Technical) – April 2018 – Examiners’ Report

e. Distributions of share returns tend to have fatter tails than suggested by the
lognormal model.
[Note to Markers: please award ½ mark for any valid idea/comment. Just the concept
is enough for a half mark, no need for all the detail above.]
[Max 2]

Part i) was well answered although there were some calculation errors.
Parts ii) and iii) proved challenging for some although quite a few
candidates were able to score full marks.
Part iv) was generally well answered although quite a number of
candidates struggled to generate enough points to score full marks for a
standard bookwork question.

Q11
i) CAPM assumptions [½ mark each]

a. All investors have the same one-period horizon.

b. All investors can borrow or lend unlimited amounts at the same risk-free rate.
c. The markets for risky assets are perfect. Information is freely and
instantly available to all investors and no investor believes that they can affect
the price of a security by their own actions.
d. Investors have the same estimates of the expected returns, standard deviations
and covariances of securities over the one-period horizon.
e. All investors measure in the same “currency” e.g. pounds or dollars or in
“real” or “money” terms.
[Max 2]

ii) By definition the beta of each security is 𝛽𝛽𝑖𝑖 = 𝐶𝐶𝐶𝐶𝐶𝐶(𝑅𝑅𝑖𝑖 , 𝑅𝑅𝑀𝑀 )/𝑉𝑉𝑉𝑉𝑉𝑉(𝑅𝑅𝑀𝑀 ) [½]
where 𝑅𝑅𝑖𝑖 is the rate of return on security 𝑖𝑖, 𝑅𝑅𝑀𝑀 , 𝑉𝑉𝑉𝑉𝑉𝑉(𝑅𝑅𝑀𝑀 ) are respectively
the rate of return on the market portfolio and its variance [½]
Hence
𝐶𝐶𝐶𝐶𝐶𝐶(𝑅𝑅𝑀𝑀 , 𝑅𝑅𝑀𝑀 )
𝛽𝛽𝑀𝑀 = =1
𝑉𝑉𝑉𝑉𝑉𝑉(𝑅𝑅𝑀𝑀 )
as required [1]
(Note to markers: the same conclusion can be reached from the Security Market
Line, and is equally acceptable)

iii) As the market portfolio is the weighted portfolio of the risky securities
in the market, and the given weights are 0.4 and 0.6, then
𝐶𝐶𝐶𝐶𝐶𝐶(𝑅𝑅𝑖𝑖 , 𝑅𝑅𝑀𝑀 ) = 𝐶𝐶𝐶𝐶𝐶𝐶(𝑅𝑅𝑖𝑖 , 0.4𝑅𝑅1 + 0.6𝑅𝑅2 )
[1]
from which it follows that [½ mark each]

Page 14
 Subject CT8 (Financial Economics Core Technical) – April 2018 – Examiners’ Report

𝐶𝐶𝐶𝐶𝐶𝐶(𝑅𝑅1 , 𝑅𝑅𝑀𝑀 ) = 0.4𝑉𝑉𝑎𝑎𝑟𝑟(𝑅𝑅1 ) + 0.6𝐶𝐶𝐶𝐶𝐶𝐶(𝑅𝑅1 , 𝑅𝑅2 ) = 0.00089

𝐶𝐶𝐶𝐶𝐶𝐶(𝑅𝑅2 , 𝑅𝑅𝑀𝑀 ) = 0.4𝐶𝐶𝐶𝐶𝐶𝐶(𝑅𝑅1 , 𝑅𝑅2 ) + 0.6𝑉𝑉𝑉𝑉𝑉𝑉(𝑅𝑅2 ) = 0.00150

Also:
𝑉𝑉𝑉𝑉𝑉𝑉(𝑅𝑅𝑀𝑀 ) = 0.42 ∗ 𝑉𝑉𝑉𝑉𝑉𝑉(𝑅𝑅1 ) + 0.62 ∗ 𝑉𝑉𝑉𝑉𝑉𝑉(𝑅𝑅2 ) + 2 ∗ 0.4 ∗ 0.6 ∗ 𝐶𝐶𝐶𝐶𝐶𝐶(𝑅𝑅1 , 𝑅𝑅2 ) =
0.00125
Consequently 𝛽𝛽1 = 0.70915, 𝛽𝛽2 = 1.1939 [½ each]
[Note to Markers: please accept any correct attempt with rounded figures. For
𝐶𝐶𝐶𝐶𝐶𝐶(𝑅𝑅1 , 𝑅𝑅𝑀𝑀 ) = 0.4𝑉𝑉𝑉𝑉𝑉𝑉(𝑅𝑅1 ) + 0.6𝐶𝐶𝐶𝐶𝐶𝐶(𝑅𝑅1 , 𝑅𝑅2 ) = 0.0009
we obtain 𝛽𝛽1 = 0.72, 𝛽𝛽2 = 1.2]
iv) From the Security Market Line it follows that 𝑅𝑅𝑓𝑓 = (𝐸𝐸𝑅𝑅𝑖𝑖 − 𝛽𝛽𝑖𝑖 𝐸𝐸𝑅𝑅𝑀𝑀 )⁄(1 − 𝛽𝛽𝑖𝑖 )
From the data 𝐸𝐸𝑅𝑅1 = 6.40%, 𝐸𝐸𝑅𝑅2 = 9.90% . [½ marks each]

Consequently
𝐸𝐸𝑅𝑅𝑀𝑀 = ∑2𝑖𝑖=1 𝑤𝑤𝑖𝑖 𝐸𝐸𝑅𝑅𝑖𝑖 = 8.5% [½]

and 𝑅𝑅𝑓𝑓 = 0.012797 [½]

[Note to Markers: if the rounding above and the corresponding betas are used, then
from the equation for asset 1 we obtain 𝑅𝑅𝑓𝑓 = 0.01, whilst from the equation for asset
2 we obtain 𝑅𝑅𝑓𝑓 = 0.015. Please accept any valid attempt.]

Part i) was answered reasonably although many candidates were unable

to identify the additional assumption of CAPM compared to modern
portfolio theory.
Part ii) was very well answered.
Part iii) was poorly answered with most candidates unable to calculate
the required covariances correctly. Many candidates indeed attempted
this task by only looking at the information regarding the rate of return
in each state (and corresponding probability), rather than actually using
the provided variance/covariance matrix
Part iv) was answered well and credit was given for calculating the
expected returns even if this was done in iii).

END OF EXAMINERS’ REPORT

Page 15
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

28 September 2017 (pm)

Subject CT8 – Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. You have 15 minutes of planning and reading time before the start of this examination.
You may make separate notes or write on the exam paper but not in your answer
booklet. Calculators are not to be used during the reading time. You will then have
three hours to complete the paper.

4. Mark allocations are shown in brackets.

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

6. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT8 S2017  Institute and Faculty of Actuaries

1 (i) Define the following terms:

(a) absolute dominance

(b) first order stochastic dominance
(c) second order stochastic dominance
[4]

Consider four assets which will deliver a one-year return ri on asset i with
probabilities as set out below:

P(ri = –5%) P(ri = –3%) P(ri = 0%) P(ri = +3%) P(ri = +5%)

Asset 1 0.2 0.2 0.2 0.2 0.2

Asset 2 0.3 0.2 0.1 0.2 0.2
Asset 3 0.1 0.3 0.2 0.3 0.1

(ii) Determine which type of dominance, if any, is exerted by:

(a) asset 2 over asset 3.

(b) asset 3 over asset 1.
(c) asset 1 over asset 2. [6]
[Total 10]

2 (i) Define in the context of mean-variance portfolio theory:

(a) an inefficient portfolio

(b) an efficient portfolio [2]

(ii) State the two assumptions about investor behaviour that are needed for the
existence of efficient portfolios. [1]

An investment universe includes two assets, A and B, with expected return on asset i
of ri and variance vi as set out below:

Asset i Expected return ri Variance of return vi

A rA = 0.05 vA = 0.16
B rB = 0.07 vB = 0.25

The correlation of returns is cAB = –0.2.

In an efficient portfolio, let a be the proportion which is held in asset A.

(iii) Express the portfolio variance V in terms of a quadratic function in a, showing

your workings. [3]

CT8 S2017–2
 Let R be the expected return on the portfolio.

(iv) Express the portfolio variance V in terms of a quadratic function in R, using

your result from part (iii) and showing your workings. [Your expression
should not include a.] [3]

The expression in part (iv) represents the efficient frontier.

An investor uses a utility function that gives rise to an indifference curve

V = 16R – 200R2.

(v) Determine the two portfolios on the efficient frontier that also lie on the
investor’s indifference curve. [4]

(vi) Comment on the implications for part (v) if short selling is not allowed in the
market. [2]
[Total 15]

3 Consider a European call option with price ct written on an underlying non-dividend-

paying security with price St at current time t.

(i) State whether each of the following changes in underlying factors would
increase or reduce the price of this option:

(a) a fall in the price of the underlying security

(b) an increase in the strike price of the option
(c) an increase in the volatility of the underlying security price
(d) a fall in the risk-free rate of interest

[You should assume that each change occurs on a standalone basis, i.e. all
other factors are unchanged.] [2]

(ii) Explain each of your statements in part (i). [4]

Consider a European put option with price pt written on the same underlying security,
with the same strike price K and the same maturity T as the call option described
above.

The continuously compounded risk-free rate of interest is r.

(iii) Write down a formula that relates the values of ct and pt. [1]

The call option has value £0.50 at time t = 0, and the put option has value £1.00. Both
options are written on a security with current value S0 = £5, and both options have
strike price £6.00 and maturity T = 3 years.

(iv) Determine the continuously compounded risk-free rate r. [2]

(v) Suggest, with justification, how the formula in part (iii) can be rewritten as an
inequality if both options are American options. [3]
[Total 12]

CT8 S2017–3 PLEASE TURN OVER

4 Consider a one-period binomial tree model for the stock price process St.

Let S0 = $100 and assume that in three months’ time the stock price is either $125 or
$105. No dividends are payable on this stock.

Assume also that the continuously compounded risk-free rate is 5% per annum.

(i) Verify that this market is not arbitrage-free by considering the relationship
between the risk-free rate and the stock price movements. [2]

(ii) (a) Identify a portfolio which would generate an arbitrage profit.

(b) Calculate this profit.
[4]

Now assume that the continuously compounded risk-free rate is 20% per annum.
Consider a European put option on this stock, expiring in three months’ time and with
strike price K = $120.

(iii) Calculate the current price of this put option. [3]

[Total 9]

5 (i) State the Cameron-Martin-Girsanov theorem. [3]

(ii) State an important property of the discounted value of a security price process
under the risk-neutral measure. [1]

The price process St of a traded security satisfies the following stochastic differential
equation:

dSt = μSt dt + σSt dWt ,

where Wt is a standard Brownian motion under the real-world probability measure,

and μ and σ are constants, with σ > 0.

Let r > 0 be the continuously compounded risk-free rate of interest.

(iii) Show, using parts (i) and (ii), that Wt + λt is a Brownian motion under the
risk-neutral probability measure, if λ = (μ − r ) . [3]
σ

(iv) Calculate the value of λ in the case in which μ = 0.04 + r and σ = 0.4. [1]

Another traded asset has a price process satisfying the stochastic differential equation

dAt = (0.06 + r ) At dt + γAt dWt .

(v) Determine the value of the volatility coefficient γ, using your result from
part (iv). [2]
[Total 10]

CT8 S2017–4
6 (i) Write down an expression for the price of a derivative in a Black-Scholes
market in terms of an expectation under the risk-neutral measure, defining any
additional notation that you use. [3]

Consider an option on a non-dividend-paying stock when the stock price is £50, the
exercise price is £49, the continuously compounded risk-free rate of interest is 5% per
annum, the volatility is 25% per annum, and the time to maturity is six months.

(ii) Calculate the price of the option using the Black-Scholes formula, if the option
is a European call. [4]

(iii) Determine the price of the option if it is an American call. [1]

(iv) Calculate the price of the option if it is a European put. [2]

(v) Determine how the prices of the contracts in parts (ii) to (iv) would change in
the case of a dividend-paying underlying stock. [Note that you do not have to
perform any further calculations.] [3]
[Total 13]

7 (i) State the main potential drawback of the Vasicek model. [1]

(ii) Discuss the extent to which this drawback may be a problem. [3]

(iii) Explain how the Cox-Ingersoll-Ross model avoids this drawback. [3]

The Vasicek term structure model is described by the following stochastic differential
equation:

drt = a(b − rt )dt + σdWt ,

and a, b, σ > 0.

Under this model, the short rate rt follows a Normal distribution with mean

E (rt ) = r0e− at + b (1 − e− at )

σ2
and variance Var (rt ) = (1 − e −2 at ).
2a

(iv) Assess, using the information provided above, whether the model generates
interest rates that are mean reverting and, if so, the value to which they revert.
[2]

(v) Assess, using the information provided above, the relevance of the
parameter a to any mean reversion. [2]
[Total 11]

CT8 S2017–5 PLEASE TURN OVER

8 In a market in which the Arbitrage Pricing Theory (APT) model holds, the expected
return is given by

E[ Ri ] = λ 0 + λ1bi ,1 +λ 2bi ,2 +…+ λ nbi ,n

(i) Define all the terms in this equation. [2]

Let rf denote the risk-free rate of interest.

(ii) Construct a risk-free portfolio to prove that λ0 = rf . [2]

Assume that rf = 0.075. Consider a two-factor model (i.e. n = 2) and two well-
diversified portfolios (P1 and P2) with the following features:

P1 P2

E[Ri] 0.18 0.15

bi,1 1.5 0.5
bi,2 0.5 1.5

(iii) Determine the values of λ1 and λ2. [3]

Suppose that in the market there is another portfolio with the following features:

E[ R3 ] = 0.16, b3,1 = 0.75, b3,2 = 0.7.

(iv) Comment on the feasibility of such a portfolio under the APT model
assumptions. [3]
[Total 10]

9 Consider the Merton model for credit risk.

Assume that a firm has issued a zero-coupon bond maturing in five years’ time with
maturity value €100m, and that the current value of the firm’s assets is €110m.

Further assume that the estimated volatility of the firm’s assets is 25% per annum and
the risk-free rate of interest is 2% per annum continuously compounded.

(i) Show that the current value of the debt of the firm is €76.88m. [5]

(ii) Calculate the yield to maturity of the debt. [3]

(iii) Calculate the credit spread on the debt. [2]

[Total 10]

END OF PAPER

CT8 S2017–6
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT

September 2017

Subject CT8 – Financial Economics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that
the examination was set. Candidates should take into account the possibility that
circumstances may have changed if using these reports for revision.

Luke Hatter
Chair of the Board of Examiners
December 2017

 Institute and Faculty of Actuaries

 Subject CT8 (Financial Economics Core Technical) – September 2017 – Examiners’ Report

A. General comments on the aims of this subject and how it is marked

1. The aim of the Financial Economics subject is to develop the necessary skills to
construct asset liability models and to value financial derivatives. These skills are
also required to communicate with other financial professionals and to critically
evaluate modern financial theories.

2. The marking approach for CT8 is flexible in the sense that different answers to
those shown in the solution can earn marks if they are relevant and appropriate.
Marks for the methodology are also awarded.

B. General comments on student performance in this diet of the examination

1. Students performed relatively well on bookwork questions, although many missed

the opportunity to be awarded full marks due to relatively superficial knowledge.

2. Some students seemed to struggle on the application parts of the questions,

because they were not able to combine and use the information given to them in
the question.

C. Pass Mark

The Pass Mark for this exam was 60.

Solutions

Q1 (i) (a) Absolute dominance exists when one investment portfolio [1]
provides a higher return than another in all possible circumstances.

(b) The first order stochastic dominance theorem states that, [½]
assuming an investor prefers more to less, A will dominate B
(i.e. the investor will prefer portfolio A to portfolio B) if:

FA ( x)  FB ( x), for all x, and [½]

FA ( x)  FB ( x) for some value of x. [½]

(c) The second order stochastic dominance theorem applies when the [½]
investor is risk averse, as well as preferring more to less.

In this case, the condition for A to dominate B is that

x x
 a FA ( y)dy   a FB ( y)dy, for all x, [½]

Page 2
Subject CT8 (Financial Economics Core Technical) – September 2017 – Examiners’ Report

with the strict inequality holding for some value of x, [½]

and where a is the lowest return that the portfolios can possibly [½]
provide.

[Max 4]

(ii)
PDF –5% –3% 0% 3% 5%
1 0.2 0.2 0.2 0.2 0.2
2 0.3 0.2 0.1 0.2 0.2
3 0.1 0.3 0.2 0.3 0.1

CDF –5% –3% 0% 3% 5%

1 0.2 0.4 0.6 0.8 1
2 0.3 0.5 0.6 0.8 1
3 0.1 0.4 0.6 0.9 1

[1 mark for CDF table]

∫CDF –5% –3% 0% 3% 5%

1 0 0.004 0.016 0.034 0.05
2 0 0.006 0.021 0.039 0.055
3 0 0.002 0.014 0.032 0.05

[2 marks for ∫CDF table]

(a) None [1]

(b) Second order [1]

(c) First order [1]

Most students knew the definitions of the different types of

dominance and stated them clearly, either in words or
formulae. Fewer students were able to determine the types of
dominance exhibited by the assets in part (ii). In particular,
very few students integrated the CDF correctly to check for
second order dominance. There was one anomaly in the
question whereby students were asked to “consider four assets”
when only three were given in the table.

Page 3
 Subject CT8 (Financial Economics Core Technical) – September 2017 – Examiners’ Report

Q2 (i) (a) A portfolio is inefficient if the investor can find another [½]
portfolio with the same expected return and lower variance,

or the same variance and higher expected return. [½]

(b) A portfolio is efficient if the investor cannot find a better one [½]
in the sense that it has both the same or higher expected return

and the same or lower variance. [½]

(ii) The assumptions are:

(a) Investors are never satiated. [At a given level of risk, they [½]
will always prefer a portfolio with a higher expected return to
one with a lower return.]

(b) Investors dislike risk. [For a given level of return, they will [½]
always prefer a portfolio with lower expected variance to one
with higher variance.]

(iii) V = a2VA + (1 – a)2VB + 2a(1 – a)(VAVB)0.5CAB [1]

= 0.16a2 + 0.25 (1 – a)2 – 2a(1 – a) (0.16  0.25)0.5  0.2 [1]

= 0.49a2 – 0.58a + 0.25 [1]

(iv) R = aRA + (1 – a)RB [1]

= –0.02a + 0.07

So R2 = 0.0004a2 – 0.0028a + 0.0049 [1]

So V = 1225R2 – 142.5R + 4.2225 [1]

(v) 1225R2 – 142.5R + 4.2225 = 16R – 200R2 [1]

So R = 0.0670 or 0.0442 [2]

Hence a = 0.1497 or 1.2889 [1]

(vi) The second solution implies a proportion of –0.2889 invested in asset B [1]

so would not be allowed, hence only the first solution would remain. [1]

Page 4
 Subject CT8 (Financial Economics Core Technical) – September 2017 – Examiners’ Report

This question was largely well-answered. Many students made

mistakes in the algebra but these were penalised only for the
mistake itself if the remaining workings were correct. Some
students found the point where the efficient frontier and the
indifference curve were tangential but did not check that they
touched.

Q3 (i) (a) reduce [½]

(b) reduce [½]

(c) increase [½]

(d) reduce [½]

(ii) (a) This is because there is a lower intrinsic value (or, where the [1]
intrinsic value is currently zero, a smaller chance that the option
is in-the-money at maturity).

(c) This is because there is again a lower intrinsic value, or a smaller [1]
chance that the option is in-the-money at maturity.

(d) This is because the higher the volatility of the underlying share, [1]
the greater the chance that the share price can move significantly
in favour of the holder of the option before expiry.

(e) This is because the money saved by purchasing the option rather [1]
than the underlying share has to be invested at this lower rate of
interest, thus decreasing the value of the option.

(iii) ct + Ke–r(T–t) = pt + St [1]

(iv) 0.5 + 6e–3r = 1 + 5 [1]

=> r = 2.9% p.a. [1]

(v) As no dividend is paid, American call options will never be exercised [1]
before maturity. Therefore, their price should be the same as for
European call options with the same characteristics.

It is sometimes optimal to exercise an American put option early, so the [1]

value of an American put option can be higher than a European put option.

and the formula becomes an inequality:

[1]
ct + Ke–r(T–t) ≤ pt + St

Page 5
 Subject CT8 (Financial Economics Core Technical) – September 2017 – Examiners’ Report

Almost all students stated the correct option price changes in

part (i), and most gave good reasons for the changes in part
(ii). The question did not state that the assumptions underlying
the Black-Scholes formula applied so explanations based on
this were not valid. Fewer students were able to explain clearly
what the impact was of changing the options to be American ,
though well-prepared students built an answer around the
impact of exercising each option early.

Q4 (i) The market is arbitrage free if and only if there exists a probability [1]
measure under which discounted asset prices are martingales

In this case, the probability exists iff d  ert  u [1]

The given market does not satisfy this property as [1]

er t  1.0126  d  1.05  u  1.25

Alternatively, it can be seen that investment in the stock will gain [1]
more than the risk-free rate…

… under any possible outcome / with no downside risk. [1]

[Max 2]

(ii) (a) The investor could buy the stock at 100 by borrowing money [1]
at the risk-free rate of interest.

In three months, the investor then could sell the stock and [1]
repay the loan + interest

(b) This would result in a profit of either 23.74 – in the case in [1]
which the stock is worth 125

Or 3.74 – in the case in which the stock is worth 105 [1]

(iii) The price C0 of the option is computed via risk-neutral valuation; let 𝑝̂ denote
the risk-neutral probability of an up movement, then

e0.20.25  1.05
pˆ   0.0064 [1]
1.25  1.05

C0  e0.20.25 (15  (1  pˆ ))  14.18. [2]

Page 6
 Subject CT8 (Financial Economics Core Technical) – September 2017 – Examiners’ Report

This question was broadly well-answered. Part (ii) caused the

most difficulty, with some students struggling to construct valid
portfolios or trying to explain in general terms without any
specific portfolios. There were also some solutions to part (iii)
involving probabilities either less than zero or greater than one,
which were clearly not valid.

Q5 (i) Suppose that Z t is a standard Brownian motion under P. [1]

Furthermore, suppose that  t is a previsible process. [½]

Then there exists a measure Q equivalent to P [½]

t
and where Zt  Zt  0  s ds is a standard Brownian motion under Q. [1]

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

equivalent to P then there exists a previsible process  t such that
t
Zt  Zt   0  s ds is a Brownian motion under Q. [1]

[Max 3]

(ii) Under the risk-neutral probability measure, the discounted value of asset
prices are martingales. [1]

(iii) First determine the SDE of St  e rt St :

dSt  (  r ) St dt  St dWt , [1]

Then change the Brownian motion and the probability measure (using the
CMG theorem) so that the above reads

dSt  (  r  )St dt  St dWˆt , [1]

(  r )
If    then the drift term is zero, as required (for a martingale). [1]

0.04  r  r
(iv)   0.1 [1]
0.4

Page 7
 Subject CT8 (Financial Economics Core Technical) – September 2017 – Examiners’ Report

(v) The risk driver is the same, therefore the market price of risk is identical. [1]

0.06 0.06
Hence     0.6 . [1]
 0.1

This question was answered poorly on the whole. Few students

knew the Cameron-Martin-Girsanov theorem well enough to
score full marks. The later parts were answered better, with
many students picking up marks in parts (iv) and (v).

Q6 (i) Ct  E (e r (T t )CT Ft ) [1]

where Ft denotes the filtration at time t > 0, [½]

CT is the payoff under the derivative [½]

at maturity time T, [½]

Ct is the derivative value at time t, [½]

and the expectation is taken under the risk-neutral martingale measure. [½]
[Max 3]

Data: S  50; K  49; r  5%;   25%;T  0.5

(ii) The Black-Scholes formula returns:

d1 = 0.3441 [½]

d2 = 0.1673 [½]

N(d1) = 0.6346 [½]

N(d2) = 0.5664 [½]

So Call  50  0.6346  49e0.050.50  0.5664  4.66 [2]

(iii) Same as European call (as the stock is non-dividend-paying), i.e. 4.66 [1]

(iv) Using put-call parity (or otherwise):

pt = ct + Ke-r(T-t) - St [1]

Hence pt = 2.45. [1]

Page 8
Subject CT8 (Financial Economics Core Technical) – September 2017 – Examiners’ Report

(v) If the stock is dividend-paying, the payment of the dividends would cause the
value of the underlying asset to fall – which follows from the no arbitrage
principle [1]

Alternatively: in valuing the option we must take account of the fact that
dividends are payable on the underlying asset which do not feed through to the
holder of the option. [1]

Therefore the price of the European call would decrease… [½]

… since by buying the option instead of the underlying share the investor
forgoes the income [½]

Similarly, the price of the European put would increase [½]

The American call would now be more expensive than the European call due
to potential early exercise opportunity [1]

[Max 3]

This question was answered well by most students. There were

a number of numerical mistakes in the Black-Scholes
calculations in part (ii) despite this being a very common skill
examined in CT8. Knowledge of how dividends affect the
option pricing was weak. There were also many cases of
students rounding d1 and d2 too aggressively in the Black-
Scholes calculations resulting in a materially incorrect answer.

Page 9
 Subject CT8 (Financial Economics Core Technical) – September 2017 – Examiners’ Report

Q7 (i) It allows negative interest rates. [1]

(ii) The extent of the problem depends on the probability of negative interest
rates… [½]

… within the timescale of the problem in hand (or, for example, less of an
issue if the time horizon is short)… [1]

… and their likely magnitude if they can go negative. [1]

It also depends on the economy being modelled, as negative interest rates have
been seen in some countries. [1]
[Max 3]

(iii) The CIR model does not allow interest rates to go negative. [1]

This is because the volatility under the CIR increases in line with the square
root of r(t). [1]

Since this reduces to zero as r(t) approaches zero… [½]

… and provided the volatility parameter is not too large… [½]

… r(t) will never actually reach zero. [½]

… provided σ2 ≤ 2αµ
[Max 3]

(iv) Letting t   , we note that the mean converges to b. [1]

Hence interest rates under the model are mean reverting [½]

To the long-run mean b [½]

(v) Letting t   , we note that the variance converges to 2 / 2a [1]

Hence, the variance of the short rate is inversely proportional to a [½]

This implies that the convergence of the rate to the long run mean b is faster
the bigger a [1]

So a controls the speed of the mean convergence [1]

[Max 2]

Page 10
 Subject CT8 (Financial Economics Core Technical) – September 2017 – Examiners’ Report

Most students here knew that the Vasicek model allows negative
interest rates, and were able to explain why the Cox-Ingersoll-
Ross model does not. Part (ii) required students to think about
why negative interest rates might (or might not) be a problem in
the real world –many students just repeated bookwork about the
Vasicek model and scored no marks. Parts (iv) and (v) were
answered fairly well, though not all students worked through
the algebra correctly.

Q8 (i) E[ Ri ] is the expected return on security i [½]

bi ,k is the response of (or sensitivity of) the rates of return on security i to

factor k [1]

 k is the risk premium per unit of exposure corresponding to factor k [1]

[Max 2]

(ii) The risk-free portfolio has zero exposure to all risk factors [1]

i.e. bi,k  0 for all i, k [½]

And the expected return on the risk-free portfolio is r f [½]

From which the result follows: λ0 = r f . [½]

[Max 2]

(iii) We need to solve the linear system: [1]

0.18  0.075  1.51  0.5 2

0.15  0.075  0.51  1.5 2

which returns 1  0.06,  2  0.03 [1 mark each]

(iv) The given portfolio represents an arbitrage opportunity [1]

as the given expected return does not satisfy the given APT equation [1]

Indeed E[ R3 ]  0.075  0.06  0.75 0.03  0.7  0.141 [1]

It is therefore not a feasible portfolio… [1]

… under an assumption of no arbitrage [½]

[Max 3]

Page 11
 Subject CT8 (Financial Economics Core Technical) – September 2017 – Examiners’ Report

This question was answered well by most students. Parts (ii)

and (iii) caused some difficulty, though most students spotted
what they needed to do.

Q9 The Merton model for credit risk is based on the Black-Scholes formula. Hence.

(i) The current value of the debt, say D0 , of the firm is the value of a risk-free
zero coupon bond with the same face value and maturity of the firm debt
corrected by the cost of default. That is, where F0 is the value of the firm’s
assets (=110) and L is the face value of the debt (=100):

D0  L e rT  ( L e rT N (d 2 )  F0 N (d1 )) [1½]

Alternative approach: Or equivalently it is the current value of the firm’s

assets less the value of equity, where the latter is the value of a call option on
the assets of the company with strike price equal to L, i.e.:

D0  F0  ( F0 N (d1 )  L e rT N (d 2 )) [Alternative 1½]

d1 0.6289
d2 0.0699
[½ for each]
N(d1) 0.7353
N(d2) 0.5279
N(-d1) 0.2647
N(-d2) 0.4721

[½ for each, but only give for either + or –, i.e. Max 1]

Giving overall value of either (in €m):

100 e0.1  (100 e0.1  0.4721  110  0.2647) or

110  (110  0.7353 100 e0.1  0.5279) [1]

= €76.88m as required [½]

(ii) The yield to maturity solves D0  Le yT [1]

i.e. 76.88 = 100 e5y [1]

Consequently y  5.26% per annum [1]

Note: may quote 5.25% if didn’t round to 76.88.

Page 12
Subject CT8 (Financial Economics Core Technical) – September 2017 – Examiners’ Report

Note to markers: give full marks for correct answer, even if no working
shown.

(iii) Credit spread: y  r [1]

= 3.26% per annum. [1]

Most students applied the Merton model correctly, though some

just explained the model. Parts (ii) and (iii) were also
answered well by most students.

END OF EXAMINERS’ REPORT

Page 13
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

20 April 2017 (pm)

Subject CT8 – Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. You have 15 minutes of planning and reading time before the start of this examination.
You may make separate notes or write on the exam paper but not in your answer
booklet. Calculators are not to be used during the reading time. You will then have
three hours to complete the paper.

4. Mark allocations are shown in brackets.

5. Attempt all 11 questions, beginning your answer to each question on a new page.

6. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT8 A2017  Institute and Faculty of Actuaries

1 (i) State the expected utility theorem. [2]

A risk averse investor makes decisions using a quadratic utility function:

U(w) = w + dw2.

(ii) Derive an upper bound for d for this investor. [2]

(iii) Explain why the investor can only use this utility function to make decisions
over a limited range of wealth, w. Your answer should include a statement of
this range. [2]

The investor states that the upper limit of wealth where she can use this utility
function is w = $1,000.

(iv) Determine the value of d in the investor’s utility function. [1]

The investor wins a prize of $250 in a gameshow. She is then offered the opportunity
to exchange this prize for a larger prize of $600 if she can answer one more question
correctly. However, she will receive no prize at all if she gets the question wrong.
She estimates her chances of answering the question correctly to be 50%.

(v) Determine whether the investor should take this opportunity to exchange. [3]
[Total 10]

2 Describe the empirical evidence relating to the continuous-time lognormal model for
security prices. [8]

CT8 A2017–2
3 Consider a non-dividend-paying security with price St at time t. The security price
follows the stochastic differential equation:

dSt = St(μdt + σdZt)

where:

• Zt is a standard Brownian motion

• μ = 16% per annum
• σ = 25% per annum
• t is the time from now measured in years
• S0 = 1

(i) Derive the distribution of St. [4]

An investor has taken out a house loan, with a repayment of £100,000 due in six
years’ time.

(ii) Determine the amount that the investor would need to invest in the security to
give a 75% probability of having an investment value of at least £100,000 in
six years’ time. [4]

The investor only has £50,000 available, which he invests in this security at time
t = 0.

(iii) Calculate the following risk measures applied to the difference between the
value of the security and £100,000 at time t = 6:

(a) 90% Value at Risk relative to £100,000

(b) expected shortfall or surplus relative to £100,000
[5]

(iv) Comment on the implications for the investor of your answers to part (iii). [2]

(v) Suggest two changes that the investor might therefore make to his portfolio.
[2]
[Total 17]

CT8 A2017–3 PLEASE TURN OVER

4 (i) Define the following Greeks algebraically:

(a) delta
(b) vega
(c) theta
(d) gamma
[4]

Consider a call option with price ct at time t (in years) written on an underlying non-
dividend-paying asset with price St at time t and volatility σ.

Using Taylor’s expansion, it can be shown that the change in value of the option is
approximately given by:

dct = delta × dSt + 0.5 × gamma × (dSt)2 + theta × dt + vega × dσ

At time t = 0, the underlying asset price is €23 and the volatility is 20% per annum.
The option is priced at €6.17 and has the following properties:

• delta = 0.822
• vega = 0.104
• theta = –0.855
• gamma = 0.033

At time t = 1, the security price has fallen to €20 and its volatility is now 15% per
annum.

(ii) Estimate the value of the call option at time t = 1. [2]

The delta of a call option is always positive, whilst the delta of a put option is always
negative.

(iii) Justify this result. [2]

The vega of both call and put options is always positive.

(iv) Justify this result. [1]

[Total 9]

CT8 A2017–4
5 Consider a three-period binomial tree model for a stock price process St , under which
the stock price either rises by 18% or falls by 15% each month. No dividends are
payable.

The continuously compounded risk-free rate is 0.25% per month.

Let S0 = $85.

Consider a European put option on this stock, with maturity in three months (i.e. at
time t = 3) and strike price $90.

(i) Calculate the price of this put option at time t = 0. [4]

(ii) Calculate the risk-neutral probability that the put option expires out-of-the-
money. [2]

(iii) Assess whether the probability calculated in part (ii) would be higher or lower
under the real-world probability measure. [No further calculation is required.]
[3]
[Total 9]

6 The market price St of a traded security satisfies the following stochastic differential
equation:

dSt = (μ − λσ) St dt + σSt dWt ,

where Wt is a standard Brownian motion under the probability measure P* .

(i) Determine the value of λ such that the discounted asset price process
St = e− rt St is a martingale under the given probability measure. [3]

(ii) Explain whether the probability measure P* is the real-world or risk-neutral

measure, for the value of λ obtained in part (i). [3]
[Total 6]

CT8 A2017–5 PLEASE TURN OVER

7 The current price of a non-dividend-paying share is £7 and its volatility is thought to
be 40% per annum. The continuously compounded risk-free interest rate is 5% per
annum.

A European call option on this share has a strike price of £6.50 and term to maturity
of one year.

(i) Calculate the price of this call option, assuming that the Black-Scholes model
applies. [4]

The market price for the option is actually £2.

(ii) Show that the volatility of the share implied by the true market price of the
option is 60% per annum, to the nearest 1% per annum. [6]
[Total 10]

8 (i) List the desirable characteristics of a term structure model. [3]

Let B (t , T ) be the price at time t > 0 of a zero-coupon bond which pays a value of 1
when it matures at time T.

Let F (t , S , T ) be the forward rate at time t for a deposit starting at time S > t and
expiring at time T > S.

Consider the following two investment strategies implemented at time t:

A At time t:

Purchase one zero-coupon bond maturing at time T.

Continue to hold the bond to time T.

B At time t:

Purchase α = e − F (t ,S ,T )(T − S ) zero-coupon bonds maturing at time S < T.

At time S:

Invest the redemption amount from the bond at the forward rate F (t , S , T ) and
continue to hold this deposit to time T.

(ii) Show that:

B(t ,T ) = e− F (t , S ,T )(T − S ) B(t , S ). [4]

(iii) Derive an expression for B (t , T ) in terms of the instantaneous forward rate,

using the result from part (ii). [3]
[Total 10]

CT8 A2017–6
9 Let Ri denote the return on security i in a two-factor model.

(i) Write down the return equation for this two-factor model, defining all
additional notation that you use. [2]

(ii) Describe the three main categories of multifactor models. [3]

[Total 5]

10 In a market in which the Capital Asset Pricing Model (CAPM) holds, there are two
securities with the following attributes (expressed per annum):

security A B
E(ri) 0.196 0.164
Cov(ri, rj) A 0.05 0.01
B 0.01 0.03

(i) Determine the composition of the market portfolio with expected return 18%
per annum. [2]

(ii) Calculate the beta of each security, under the assumption that the risk-free rate
of interest is 10% per annum. [2]

(iii) State the limitations of the CAPM. [3]

[Total 7]

11 (i) Describe the three main approaches to modelling credit risk. [5]

Consider the Merton model for credit risk. Let F(t) be the total value at time t of a
corporate entity which has issued zero-coupon debt with promised repayment amount
L due at time T.

(ii) State the condition under which the corporate entity is assumed to default in
this model. [1]

(iii) State the type of process that F(t) can be assumed to follow. [1]

(iv) Give an expression for the risk-neutral probability of default of the corporate
entity at time 0, defining any additional notation used. [2]
[Total 9]

END OF PAPER

CT8 A2017–7
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2017

Subject CT8 – Financial Economics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping candidates, both
those who are sitting the examination for the first time and using past papers as a revision aid and
also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The Examiners have
access to the Core Reading, which is designed to interpret the syllabus, and will generally base
questions around it but are not required to examine the content of Core Reading specifically or
exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in this
report; other valid approaches are given appropriate credit. For essay-style questions, particularly the
open-ended questions in the later subjects, the report may contain more points than the Examiners
will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that the
examination was set. Candidates should take into account the possibility that circumstances may
have changed if using these reports for revision.

Luke Hatter
Chair of the Board of Examiners
July 2017

 Institute and Faculty of Actuaries

 Subject CT8 (Financial Economics Core Technical) – April 2017 – Examiners’ Report

A. General comments on the aims of this subject and how it is marked

1. The aim of the Financial Economics subject is to develop the necessary skills to construct
asset liability models and to value financial derivatives. These skills are also required to
communicate with other financial professionals and to critically evaluate modern financial
theories.

2. The marking approach for CT8 is flexible in the sense that different answers to those
shown in the solution can earn marks if they are relevant and appropriate. Marks for the
methodology are also awarded.

B. General comments on student performance in this diet of the

examination

1. Students performed relatively well on bookwork questions, although many missed the
opportunity to be awarded full marks due to relatively superficial knowledge.

2. The majority of the students seemed to struggle on the application parts of the questions,
because they were not able to use and combine the information given to them in the
question. In a few instances, students did not know how to go from the lognormal
distribution to the Normal and then to the standard Normal. Further, there is often a lack
of knowledge of how to use the distribution tables to compute probabilities (in the specific
case of this exam paper, the normal distribution), and relative inaccuracy in getting the
details right.

C. Pass Mark

The Pass Mark for this exam was 60.

Solutions

Q1 (i) The expected utility theorem states that a function, U(w), can be constructed
representing an investor’s utility of wealth, w, at some future date. [1]

Decisions are made on the basis of maximising the expected value of utility
under the investor’s particular beliefs about the probability of different
outcomes. [1]

(ii) U’(w) = 1 + 2dw, and [½]

U’’(w) = 2d. [½]

Because the investor is risk averse, we must have U’’(w) < 0 (alternatively to
satisfy the condition of diminishing marginal utility of wealth (risk aversion))
[½]

Page 2
 Subject CT8 (Financial Economics Core Technical) – April 2017 – Examiners’ Report

So we must have d < 0. [½]

(iii) The condition of non-satiation requires U’(w) > 0. [½]

Hence 1 + 2dw > 0 and w < –1/(2d) [½]

So the quadratic utility function can only satisfy the condition of non-satiation
over a limited range of w:

Specifically –∞ < w < –1/(2d) [1]

(iv) 1,000 = –1/2d [½]

=> d = –1/2000 = –0.0005 [½]

(v) U(250) = 250 – 0.0005 × 2502 = 218.75 [1]

E[U(exchange)] = 0.5 × U(600) + 0.5 × U(0) [½]

= 0.5 × (600 – 0.0005 × 6002) = 210 [½]

So the investor should not accept the opportunity to exchange… [½]

… because the expected utility of the exchange opportunity is lower than that
of the prize. [½]
[Total 10]

Generally well answered. In part (i) many students covered the axioms on
which the theory is based rather than the theorem, as asked. In part (ii) some
candidates confused non satiation with risk aversion. A significant number of
candidates did not know how to reply to part (iv). In part (v) students
appeared to have difficulties distinguishing between utility of expected wealth
and expected utility of wealth.

Q2 Share prices are always positive, which is consistent with this model. [½]

The increments of share prices are proportional to the share price itself. [½]

However, estimates of σ vary widely according to what time period is considered. [1]

Examination of historic option prices suggests that volatility expectations fluctuate

markedly over time. [1]

One way of modelling this behaviour is to take volatility as a process in its own right.
This can explain why we have periods of high volatility and periods of low volatility.
[1]

Page 3
 Subject CT8 (Financial Economics Core Technical) – April 2017 – Examiners’ Report

One class of models with this feature is known as ARCH: autoregressive conditional
heteroscedasticity. [½]

A more contentious area relates to whether the drift parameter μ is constant over time.
[½]

There are good theoretical reasons to suppose that μ should vary over time. [½]

For example, if interest rates are high, we might expect the equity drift, μ, to be high
as well. [½]

One unsettled empirical question is whether markets are mean reverting, or not. [½]

There appears to be some evidence for this… [½]

… but the evidence rests heavily on the aftermath of a small number of dramatic
crashes. [½]

Furthermore, there also appears to be some evidence of momentum effects. [½]

A further strand of empirical research questions the use of the normality assumptions
in market returns. [½]

Actual returns tend to have many more extreme events, both on the upside and
downside, than is consistent with such a model. [1]

While the random walk produces continuous price paths, jumps or discontinuities
seem to be an important feature of real markets. [1]

Furthermore, days with no change, or very small change, also happen more often than
the normal distribution suggests. [1]

However, whilst a non-normal distribution can provide an improved description of the

actual returns observed, the improved fit to empirical data comes at the cost of losing
the tractability of working with normal (and lognormal) distributions. [1]

Market jumps are consistent with the arrival of information in packets rather than
continuously. [½]

After a crash, many investors may have lost a significant proportion of their total
wealth; it is not irrational for them to be more averse to the risk of losing what
remains. [½]

Page 4
 Subject CT8 (Financial Economics Core Technical) – April 2017 – Examiners’ Report

Many orthodox statistical tests are based around assumptions of normal distributions.
If we reject normality, we will also have to re-test various hypotheses. In particular,
the evidence for time-varying mean and volatility is greatly weakened. [1]
[Max 8]

Standard bookwork question. Overall most of the candidates described some key
points worth some marks, but not everyone covered all the necessary points to get
full marks. Most students focussed on the appropriateness of the normality
assumptions. A few students instead discussed Brownian motion rather than the
lognormal model.

Q3 (i) Using Ito’s Lemma:

dlogSt = 1/St dSt – 1/(2St2)(dSt)2 [½]

= (μ – σ2/2)dt + σdZt [1]

Integrating both sides gives

logSt = logS0 + (μ – σ2/2)t + σZt [½]

=> St = S0 exp((μ – σ2/2)t + σZt) [½]

As Zt is normal, [1]

then St is lognormal [½]

with parameters

(μ – σ2/2)t = 0.12875t [½]

and σ2t = 0.0625t [½]

[Max 4]

(ii) To find the initial investment we need the 25th percentile of logSt over 6 years,
i.e. with parameters 0.12875 × 6 = 0.7725 [½]

and 0.0625 × 6 = 0.375. [½]

25th percentile is calculated from:

P( (log S6– 0.7725) / √(0.375) < X) = 0.25 under a normal distribution [1]

 X = –0.6745 [½]

Page 5
 Subject CT8 (Financial Economics Core Technical) – April 2017 – Examiners’ Report

 log S6= -0.6745×√(0.375) + 0.7725 = 0.35945 [½]

 S6= 1.4325 [½]

So:

Initial investment required = £100,000 / 1.4325 = £69,806 [½]

(iii) (a) We need the 10th percentile of log S6, which is

P((log S6– 0.7725) / √(0.375) < X) = 0.1 [1]

 X = –1.2816 [½]

 log S6= -1.2816×√(0.375) + 0.7725 = –0.01232 [½]

 S6= 0.98776 [½]

So the VaR is £100,000 – (£50,000×0.98776) = £50,612 [½]

(b) E[S6] = exp(μ + σ2/2) = exp(0.7725 + 0.1875) = 2.61170 [1]

So expected value = 50,000 × 2.61170 = £130,585 [½]

Hence expected surplus of £30,585.

(iv) The investor has an expected surplus, and therefore expects to repay the
loan… [1]

… but there is also a chance of a very large shortfall. [1]

He therefore may wish to change the components of his portfolio, to reduce

the risk of not being able to pay off the loan. [1]
[Max 2]

[Note to markers: please award marks for any reasonable point which is
consistent with answers in 3(ii) and 3(iii) – even if those results were wrong.]

(v) The investor might move his investments to an asset with a lower expected
return but also lower variance. [1]

The investor might decide to diversify his portfolio between a large number of
different securities. [1]

The investor might decide to pay off some of the loan early. [1]

Page 6
 Subject CT8 (Financial Economics Core Technical) – April 2017 – Examiners’ Report

The investor might decide to buy an insurance product rather than using
securities. [1]
[Max 2]
[Total 17]

Large variety of answers on this question where well prepared candidates

scored full marks and less prepared candidates struggled. The main issues
seem to be the parts of questions requiring calculations. In part (iii) most
students struggled to calculate the VaR or calculated it at the 10% level rather
than 90%, as asked. For both part (iv) and (v) most of the candidates did not
manage to give valid points.

Q4 (i) Let f be the value of the derivative, S the price of the underlying, σ its
volatility, T maturity of the derivative and t current time.

f f
(a)   (t St ) [1]
s s

(b)   f [1]


f
(c) Either   or [1]
t

2 f
(d)  [1]
s 2

(ii) Change in value of option = 0.822×(–3) + 0.5 × 0.033 × (–3)2 – 0.855× 1 +

0.104 × (–0.05) = –3.178 [1]

So new value of option = 6.17 – 3.178 = €2.992 [1]

(iii) The delta for a call option is always positive because an increase in the share
price makes an option to buy the share for a set price more valuable. So as the
share price increases, the call option price also increases, hence the relative
change (the delta) is positive. [1]

Similarly, the delta for a put option is always negative because an increase in
the share price makes the option to sell the share for a set price less valuable.
So as the share price increases, the put option price reduces, hence the relative
change (the delta) is negative. [1]

Page 7
 Subject CT8 (Financial Economics Core Technical) – April 2017 – Examiners’ Report

(iv) The more volatile an asset is, the more valuable the choice offered by an
option. [1]
[Total 9]

Generally well answered by most candidates (especially part (i)). However

some candidates failed to calculate the correct figures in part (ii). In part (iii)
the majority of candidates assumed that Black Scholes applied which is why
full marks were not awarded.

Q5 (i)
Stock tree
time 0 1 2 3
85.00 100.30 118.35 139.66
72.25 85.26 100.60
61.41 72.47
52.20

The price C0 of the option is computed via risk-neutral valuation; let ̂ denote
the risk-neutral probability of an up movement, then:

e0.0025  0.85
pˆ   0.4621 [1]
1.18  0.85

And

3
 3
 
3 k 
C0  e  rT    pˆ k 1  pˆ  K  S0u k d 3k [2]
k
k 0  


 e 0.0075 17.53  3 pˆ 1  pˆ   37.80  1  pˆ 
2 3
  12.82 [1]
[Max 4]

The detailed working are provided below – in case attempts to answer this
question go through the whole tree [and it carries same marks as above].

PUT
time 0 1 2 3
12.82 5.05 0.00 0.00
19.55 9.41 0.00
28.36 17.53
37.80

Page 8
 Subject CT8 (Financial Economics Core Technical) – April 2017 – Examiners’ Report

(ii) Risk-neutral probability that the put option expires out-of-the-money =

P  S3  K  [1]

Hence P  S3  K   3 pˆ 2 1  pˆ   pˆ 3  0.4433 [1]

(iii) Under the risk-neutral probability the expected rate of return on the stock is
the risk-free rate of return, i.e. 0.25% per month. [1]

Under the real-world probability measure instead, the stock is expected to earn
a much higher rate of return… [1]

… in order to justify the higher risk it carries compared to the risk-free bond
[1]

Consequently we would expect the probability of the put option to expire out-
of-the-money to be higher than 0.4433. [1]
[Max 3]
[Total 9]

Generally well answered, although not as well answered as binomial tree

questions in past exams. A common mistake was failing to appreciate the
number of possible combinations comprising the probability in part (ii). There
were a lot of numerical slips; candidates struggled with the reasoning required
for part (iii).

Q6 (i) The SDE of St  e rt St is:

dSt     r    St dt  St dWˆt , [1]

For the martingale property to hold, set the drift to zero [1]

which implies  
  r  . [1]


(ii) By substitution of the value of λ in the given SDE we obtain

dSt  rSt dt  St dWt , [1]

In other words the expected rate of return on the stock is given by the risk-free
rate of interest [1]

Page 9
 Subject CT8 (Financial Economics Core Technical) – April 2017 – Examiners’ Report

Hence the probability measure P* is risk-neutral [1]

[Total 6]

Large variety of answers on this question: only well prepared candidates

scored well – some candidates did not answer. In particular, the main
difficulty was recognising that for the martingale property to hold, the drift
needed to be zero.

Q7 (i) Data: S0  7, K  6.50,   40% p.a., T  1 year, r  5%.

The Black-Scholes formula returns:

d1 = 0.5103 [½]

d2 = 0.1103 [½]

N(d1) = 0.6951 [½]

N(d2) = 0.5439 [½]

So C0  7  0.6951  6.50e 0.05  0.5439 [1]

= 1.50 [1]

(ii) 60% returns a call price of 1.995, following the same calculations as in part (i)
d1= 0.5068, [½]
d2 = -0.0932, [½]
N(d1) = 0.6939, [1]
N(d2) = 0.4629 [1]

We need to check that the volatility is closer to 60% than 61%, so we calculate
the call price with a volatility of 60.5%. We need this price to be larger than 2.
[1]

60.5% returns a call price of 2.0073

d1= 0.5076, [½]
d2 = –0.0974, [½]
N(d1) = 0.6941, [1]
N(d2) = 0.4612 [1]

Page 10
 Subject CT8 (Financial Economics Core Technical) – April 2017 – Examiners’ Report

Therefore, since the 60% result is smaller than 2 and the 60.5% result is larger
than 2, the implied volatility is 60% to the nearest 1%. [1]
[Max 6]
[Total 10]

Some struggled to get the d1 and d2 terms of the Black-Scholes formula

correctly. Many candidates just verified 60% as the volatility instead of
proving that this was the closest volatility to within 1%. Any meaningful values
used by candidates for verification purposed has been awarded accordingly

Q8 (i) The model should be arbitrage-free. [½]

Interest rates should ideally be positive. [½]

Interest rates should exhibit some element of mean reversion. [½]

The model should be computationally tractable / produce simple formulae for

bond and option prices. [½]

It should produce realistic dynamics. [½]

It should give a full range of possible yield curves. [½]

It should fit historical data. [½]

Can be calibrated easily to current market data. [½]

Flexible to cope with a range of derivatives. [½]

[Max 3]

(ii) Both strategies pay a value of 1 at time T [1]

By the no arbitrage principle… [1]

… if they have the same value at time T then they must have the same value at
time t [1]
Hence B(t,T) =  B(t,S) [1]

and so the requested relationship follows, with α = e–F(t,S,T)(T–S). [½]

[Max 4]

(iii) From the expression in part (ii), it follows that:

log B  t ,T   log B  t , S 
F t, S ,T    . [1]
T S

Page 11
 Subject CT8 (Financial Economics Core Technical) – April 2017 – Examiners’ Report

The instantaneous forward rate is defined as f  t ,T   lim F  t , S , T  , [½]

S T
i.e.

log B  t ,T   log B  t , S   log B  t ,T 

f  t ,T    lim  . [1]
S T T S T

Solving the last equality with respect to the ZCB price, we obtain:

T
  f  t , s ds
B  t ,T   e t [½]
[Total 10]

Large variety of answers and only well prepared candidates scored well. In
part (i) many candidates failed to list all the key points; in part (ii) a number of
candidates failed to use the given portfolio to obtain the required result and,
instead, used the result they had to show as given. In part (iii) candidates
struggled to recognise that they needed to define the instantaneous forward
rate.

Q9 (i) Ri  ai  bi,1 I1  bi,2 I 2  ci [½]

where ai and ci are the constant and random parts respectively of the
component of the return unique to security i [½]

I1 , I 2 are the changes in a set of the two indices [½]

bi,k is the sensitivity (factor beta) of security i to factor k [½]

(ii) Macroeconomic factor models

These use observable economic time series as the factors, such as the annual
rates of inflation and economic growth, short term interest rates, the yields on
long term government bonds, and the yield margin on corporate bonds over
government bonds. [1]

Fundamental factor models

These use company specific variables as the factors, e.g. the level of gearing,
the price earnings ratio, the level of research and development spending, the
industry group to which the company belongs. [1]

Page 12
 Subject CT8 (Financial Economics Core Technical) – April 2017 – Examiners’ Report

Statistical factor models

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

returns data. Instead a technique called principal components analysis can be
used to determine a set of indices which explain as much as possible of the
observed variance. [1]
[Total 5]

Well answered by most candidates. Generally candidates answered part (i)

correctly with some candidates failing to define correctly ci and some failing to
write down the equation correctly. Most of the candidates obtained marks in
part (ii), with some failing to give a proper definition of statistical models and
some failing to name the three main categories of multifactor models.

Q10 (i) The market portfolio is the weighted portfolio of the risky securities in the
market, consequently

ErM  18%  wA ErA  wB ErB [1]

As wA  wB  0.5 , then w A  wB  0.5 . [1]

(ii) From the security market line

Eri  r f
i 
ErM  r f

Therefore  A  1.2 and  B  0.8 . [1 each]

(iii) Empirical studies do not provide strong support for the model. [½]

The underlying assumptions are not realistic. [½]

Investors cannot necessarily borrow or lend unlimited amounts at the same

risk-free rate. [½]

The markets for risk assets may not be perfect. [½]

Investors may not have the same estimates of expected returns, standard
deviations and covariances of securities. There are basic problems in testing
the model since, in theory, account has to be taken of the entire investment
universe open to investors, not just capital markets. [½]

It does not account for taxes. [½]

Page 13
 Subject CT8 (Financial Economics Core Technical) – April 2017 – Examiners’ Report

It does not account for inflation. [Or: some investors may measure in real
terms and some in money terms.] [½]

It does not account for situations in which there is no riskless asset. [½]

The basic model does not allow for currency risk. [Or: investors may not
measure in the same currency.] [½]

It does not consider multiple time periods. [Or: investors do not all have the
same one-period time horizon.] [½]

It does not consider optimisation of consumption over time. [½]

[Max 3]
[Total 7]

Well answered by most candidates. However, in part (ii) there was some
evidence of students not being able to calculate the market portfolio correctly
instead calculating the minimum-variance portfolio under Mean-Variance
Portfolio Theory.

Q11 (i) Structural models [½]

Structural models aim to link default events explicitly to the fortunes of the
issuing corporate entity. [1]

An example of a structural model is the Merton model. [½]

Reduced form models [½]

Reduced form models use observed market statistics rather than specific data
relating to the issuing corporate entity. [1]

The market statistics most commonly used are the credit ratings… [½]

… issued by credit rating agencies such as Standard and Poor’s and Moody’s.
[½]

The output of such models is a distribution of the time to default. [½]

Intensity-based models [½]

An intensity-based model is a particular type of continuous-time reduced form

model. [1]

Page 14
Subject CT8 (Financial Economics Core Technical) – April 2017 – Examiners’ Report

It typically models the “jumps” between different states,… [½]

… which are usually credit ratings,… [½]
… using transition intensities. [½]
[Max 5]

(ii) Default occurs if the value of the assets is not enough to cover the face value
of the debt at maturity

Or alternatively: F(T) < L. [1]

(iii) F(t) follows a geometric Brownian motion (or continuous time lognormal
model). [1]

(iv) Hence, by risk-neutral valuation, the Merton model-based probability of

default is:

 F 0  2  
 ln r q   T 
 L  2 
P  F T   L   1  N   
T 
 
 
 

where P(.) is the probability under the risk-neutral measure, F (0) is the
current value of the firm, σ is its volatility, r is the risk-free rate and q
denotes any potential payout cashflow. [2]
[Total 9]

Candidates familiar with the study material scored well. Part (i) was often
answered correctly although some candidates failed to describe properly the
main approaches and some mixed the names of the approaches. In part (iii)
many candidates missed the “q”.

END OF EXAMINERS’ REPORT

Page 15
1
2 INSTITUTE AND FACULTY OF ACTUARIES
3
4
5
6
7 EXAMINATION
8
9
6 October 2016 (pm)
10
11
Subject CT8 – Financial Economics
12
Core Technical
13
14 Time allowed: Three hours
15
INSTRUCTIONS TO THE CANDIDATE
16
1. Enter all the candidate and examination details as requested on the front of your answer
17 booklet.
18
2. You must not start writing your answers in the booklet until instructed to do so by the
19 supervisor.
20
3. You have
Mark 15 minutes
allocations are of planning
shown and reading time before the start of this examination.
in brackets.
21 You may make separate notes or write on the exam paper but not in your answer
4. booklet. all
Attempt Calculators are beginning
10 questions, not to be used
yourduring
answerthetoreading time. You
each question on will
a newthen have
page.
22 three hours to complete the paper.
23 5. Candidates should show calculations where this is appropriate.
4. Mark allocations are shown in brackets.
24
5. Attempt all 10 questions, beginning
Graph paper your
is NOT answerfor
required to each question on a new page.
this paper.
25
26 6. Candidates should show calculations where this is appropriate.
AT THE END OF THE EXAMINATION
27 Graph paper is NOT required for this paper.
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
28 question paper.
29 AT THE END OF THE EXAMINATION
In addition to this paper you should have available the 2002 edition of the Formulae
30 Hand in BOTHand your answer
Tables and booklet,
your ownwith any additional
electronic calculatorsheets firmly
from the attached,
approved list. and this
question paper.
31
32 In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.
33
34
CT8 S2016  Institute and Faculty of Actuaries
35
1 Consider an asset whose return follows the probability density function f(x).

(i) Write down a formula for the Value at Risk for the asset, at confidence level p.
[1]

(ii) Write down a formula for the downside semi-variance of the return on the
asset, defining any additional notation you use. [1]

(iii) State the arguments for and against using semi-variance as a risk measure. [2]

A farmer has a small apple tree which produces one harvest of apples per year. The
number of apples the tree produces follows a Poisson distribution with a mean and
variance of 8.

(iv) Determine the 10% Value at Risk level for the number of apples produced. [3]

(v) Determine the expected shortfall below a harvest of 5 apples. [3]

[Total 10]

2 (i) State the main assumptions of mean-variance portfolio theory. [4]

Consider a mean-variance portfolio model with two securities, with respective returns
SA and SB, where the expected return E[SB] = 0.25E[SA] and the variance of return
V[SB] = 0.25V[SA].

Let the correlation between the returns on the two securities be ρ.

(ii) Determine, in terms of E[SA], the expected return on the minimum variance
portfolio if:

(a) ρ=0
(b) ρ=1
[4]

(iii) (a) Calculate the variance of the return on the minimum variance portfolio
for part (ii)(b).

(b) Comment on the risk in this portfolio.

[2]
[Total 10]

CT8 S2016–2
3 In a market where the assumptions of the Capital Asset Pricing Model hold, there are
two risky assets with the following attributes:

Security A B
Expected return (p.a.) 20% 16%

(i) Determine the composition of the market portfolio with expected return 18%
per annum. [2]

(ii) Calculate the beta of each security under the assumption that the risk-free rate
of interest is 10% per annum. [2]
[Total 4]

4 Let Ri denote the return on security i given by the following multifactor model:

Ri  ai  bi ,1 I1  bi ,2 I 2  bi , L I L  ci

where ai and ci are the constant and random parts respectively of the component of
the return unique to security i, I1 , , I L are the changes in a set of the L indices and
bi ,k is the sensitivity (factor beta) of security i to factor k.

(i) State the category of the above model where:

(a) index 1 is a price index, index 2 is the yield on government bonds and
index 3 is the annual rate of economic growth.

(b) index 1 is the level of Research and Development expenditure, index 2

is the price earnings ratio, index 3 is the level of gearing.
[2]

Consider the following two-factor model for the returns on three assets A, B and C:

Asset A B C
ai 0.03 0.05 0.1
bi,1 1 3 1.5
bi,2 4 2 1.5

(ii) Determine the equation for the expected return on a portfolio which:

(a) equally weights the three securities.

(b) has weights x A  0.5, xB  1.5, xC  0.
[4]

(iii) Construct a portfolio of securities A, B, C that has a factor beta of 2 on the first
factor and 1 on the second factor, i.e. the expected return on the portfolio is:

RP  aP  2 I1  I 2  cP . [3]
[Total 9]

CT8 S2016–3 PLEASE TURN OVER

5 (i) State the key arguments against modelling market returns using a Gaussian
random walk. [3]

(ii) Describe the difference in time series modelling between a cross-sectional

property and a longitudinal property, including their dependence on the initial
conditions imposed on the model. [4]
[Total 7]

6 Let pt denote the value at time t (measured in years) of a European put option on a
non-dividend-paying stock with price St . The option matures at time T and has a
strike price K. The continuously compounded risk-free rate of interest is r.

(i) Derive a lower bound for pt in terms of St and K. [4]

Consider a market with the following two non-dividend-paying stocks:

Stock Volatility Current price

S1 10% £10
S2 20% £10

The following options are available on those stocks:

Derivative Underlying Strike Time to Current

asset price expiry price

(a) European call option S1 £8 1 £2.50

(b) European call option S2 £8 1 £2.26
(c) European put option S1 £8 1 £1.55
(d) European put option S1 £12 1 £1.20
(e) American put option S1 £12 1 £1.13

The continuously compounded risk-free rate is 3% per annum.

(ii) Identify, with reasons, five discrepancies in these option prices. [5]
[Total 9]

CT8 S2016–4
7 Consider a binomial tree model for the stock price St. Let S0 = 50 and let the price
rise by 10% or fall by 5% each month for the next three months. Assume also that the
risk-free rate is 5% per annum continuously compounded.

(i) State the conditions under which the market is arbitrage free. [2]

(ii) Calculate the price at time t = 0 of a European call option on this stock, which
expires in three months and is struck at-the-money (i.e. strike price K = 50).
[4]

A special option, called a knock-out barrier option, goes out of existence (i.e. expires
without any payoff or value) if the underlying asset reaches a pre-specified barrier
b > 0 either from above (down-and-out) or from below (up-and-out).

The down-and-out call has the following payoff at time T:

max( ST  K , 0) if min St  b,
0t T

0 otherwise.

Assume this special option is written on the given stock, has the same strike price and
maturity as the European call option described in part (ii) and the barrier b is fixed
at 48.

(iii) Calculate the price of this contract using the binomial tree model and risk-
neutral valuation. [3]

(iv) Determine the price of the down-and-out contract when b = 40, without
performing any further calculations. [2]
[Total 11]

CT8 S2016–5 PLEASE TURN OVER

8 Consider a non-dividend-paying stock, with price St , and a European call option on
that stock, whose value can be modelled using the Black-Scholes model.

(i) Write down the formula for the delta of this option under this model. [1]

Suppose that the stock price at time 0 is S0 = $40 and the continuously compounded
risk-free rate is 2% per annum. The call option has strike price $45.91, term to
maturity 5 years and a delta of Δ = 0.6179.

(ii) Determine the implied volatility of the stock to the nearest 1%. [4]

A second stock with price Rt is currently priced at R0 = $30 and has volatility
σR = 15% per annum.

An exotic option pays an amount c at time T if S1/S0 < kS and R1/R0 < kR.

(iii) Give a formula for the value of the option at time 0 if the two stocks are
independent, defining any additional notation used. [2]

(iv) Explain how the structure of the option could be simplified if the assets were
perfectly correlated. [3]

Assume now that the stock prices are independent. The option has term T = 1 year,
payoff c = $50 and strike prices kS = 0.8 and kR = 0.6.

(v) Determine the value of the option at time 0. [5]

[Total 15]

CT8 S2016–6
9 (i) Write down the properties of the following two models for interest rates:

(a) the one-factor Vasicek model

(b) the Cox-Ingersoll-Ross model

[You are not required to give any formulae for the models.] [4]

The Vasicek term structure model is described by the following stochastic differential
equation:

drt  a (b  rt )dt  dWt ,

with initial value r0 and a, b, σ > 0.

(ii) Show, by solving the Vasicek stochastic differential equation, that:

t
 
rt  r0e  at  b 1  e  at   e   dWs .
a t s
[4]
0

(iii) Determine the expectation, the variance and the distribution of the short
rate rt . [3]
[Total 11]

CT8 S2016–7 PLEASE TURN OVER

10 A company has issued zero-coupon bonds payable in five years’ time for a nominal
amount of £100m. The company has also issued 1 million non-dividend-paying
shares. A Black-Scholes model for the value of the company is adopted.

(i) Derive an expression for the value of the debt at time 0 using the Merton
model, in terms of the total value of the company and the value of a call
option. [4]

The current total value of the company is £200m. The continuously compounded
risk-free interest rate is 1% per annum.

The current arbitrage-free prices of options on the company’s shares, with maturity in
five years’ time and a strike price of £100, are as follows:

 put option = £17.30

 call option = £27.55

(ii) Calculate, using put-call parity, the value of the zero-coupon bonds per £100
nominal. [3]

The volatility of the total value of the company is 17% per annum.

(iii) Determine the approximate change in the share price and the bond price that
would arise from a £1m increase in the total value of the company.
[Hint: consider the delta of an appropriate option.] [4]

(iv) Comment on the relative change in the share and bond prices in part (iii). [2]

(v) Comment, without carrying out any calculations, on how the relative change
in part (iii) would differ if the total value of the company was lower. [1]
[Total 14]

END OF PAPER

CT8 S2016–8
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2016

Subject CT8 – Financial Economics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping candidates, both
those who are sitting the examination for the first time and using past papers as a revision aid and
also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The Examiners have
access to the Core Reading, which is designed to interpret the syllabus, and will generally base
questions around it but are not required to examine the content of Core Reading specifically or
exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in this
report; other valid approaches are given appropriate credit. For essay-style questions, particularly the
open-ended questions in the later subjects, the report may contain more points than the Examiners
will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that the
examination was set. Candidates should take into account the possibility that circumstances may
have changed if using these reports for revision.

Luke Hatter
Chair of the Board of Examiners
December 2016

 Institute and Faculty of Actuaries

 Subject CT8 (Financial Economics Core Technical) – September 2016 – Examiners’ Report

A. General comments on the aims of this subject and how it is marked

1. The aim of the Financial Economics subject is to develop the necessary skills to construct
asset liability models and to value financial derivatives. These skills are also required to
communicate with other financial professionals and to critically evaluate modern financial
theories.

2. The marking approach for CT8 is flexible in the sense that different answers to those
shown in the solution can earn marks if they are relevant and appropriate. Marks for the
methodology are also awarded.

B. General comments on student performance in this diet of the

examination

1. Students performed relatively well on bookwork questions, although many missed the
opportunity to be awarded full marks due to relatively superficial knowledge.

2. The majority of the students seemed to struggle on the applications part of the questions,
because they were not able to use and combine the information given to them in the
question. In a few instances this resulted in students re-calculating given data from basic
principles and therefore running out of time. Further, there is often a lack of knowledge of
how to use the distribution tables to compute probabilities (in the specific case of this
exam paper, the normal distribution), and relative inaccuracy in getting the details right.

C. Pass Mark

The Pass Mark for this exam was 60.

Page 2
 Subject CT8 (Financial Economics Core Technical) – September 2016 – Examiners’ Report

Solutions

Q1 (i) VaR(X) = −t where P(X < t) = p. [1]

μ
 −∞ (μ − x)
2
(ii) f ( x)dx where μ is the mean return at the end of the chosen
period.
μ
 −∞ ( x − μ)
2
[Or equivalently f ( x)dx ] [1]

(iii) For:

Most investors do not dislike uncertainty of returns as such; rather they dislike
the possibility of low returns. One measure that seeks to quantify this view is
downside semi-variance. [1]

Against:

Semi-variance is not easy to handle mathematically. [½]

Semi-variance takes no account of variability above the mean. [½]

Furthermore if returns on assets are symmetrically distributed semi-variance is

proportional to variance, so it gives no extra information. [1]

Semi-variance measures downside relative to the mean rather than another

benchmark that might be more relevant to the investor. [½]
[Max 2]

(iv) P(X = 0) = (80e–8)/0! = 0.00034

P(X = 1) = (81e–8)/1! = 0.00268
P(X = 2) = (82e–8)/2! = 0.01073
P(X = 3) = (83e–8)/3! = 0.02863
P(X = 4) = (84e–8)/4! = 0.05725
So P(X ≤ 4) = 0.00034 + 0.00268 + 0.01073 + 0.02863 + 0.05725 = 0.09963

Alternatively, directly from the Formulae & Tables: P(X ≤ 4) = 0.09963 [1]

P(X = 5) = (84e–8)/5! = 0.09160

So P(X ≤ 5) = 0.191236 (or directly from the Formulae & Tables) [1]

So the 10% VaR level is 5 (or –5) apples. [1]

(v) P(X = 0) × (5 – 0) = 0.002

P(X = 1) × (5 – 1) = 0.011
P(X = 2) × (5 – 2) = 0.032
P(X = 3) × (5 – 3) = 0.057
P(X = 4) × (5 – 4) = 0.057 [2]

Page 3
 Subject CT8 (Financial Economics Core Technical) – September 2016 – Examiners’ Report

Summing the above, we get 0.159

So the expected shortfall below 5 apples is 0.159 apples [1]

[Total 10]

Well-prepared students scored well here, though some confused semi-

variance with expected shortfall. Many students calculated probabilities
though they are listed in the Formulae & Tables.

A common mistake was to calculate the VaR and Expected Shortfall using the
distribution function rather than the probability mass functions, i.e. P(X ≤ x)
rather than P(X = x).

Q2 (i) Investors select their portfolios on the basis of the expected return and the
variance of that return over a single time horizon. [1]

The expected returns, variance of returns and covariance of returns are known
for all assets and pairs of assets. [1]

Investors are never satiated. At a given level of risk, they will always prefer a
portfolio with a higher return to one with a lower return. [1]

Investors dislike risk. For a given level of return they will always prefer a
portfolio with lower variance to one with higher variance. [1]

(ii) We use the following notation for i=A,B:

E(Si)=Ei
V(Si)=Vi

and CAB is the covariance between the returns of Asset A and Asset B.

(a) From the Core Reading

VB − C AB
xA = .
VA − 2C AB + VB
[1]

So xA = (0.25VA – 0) / (VA – 0 + 0.25VA) = 0.2

and xB = 0.8. [½]

Hence expected return = 0.2 × EA + 0.8 × 0.25EA [½]

= 0.4EA . [½]

Page 4
Subject CT8 (Financial Economics Core Technical) – September 2016 – Examiners’ Report

(b) Now CAB = √(VA × 0.25 × VA) = 0.5VA . [1]

So xA = (0.25VA – 0.5VA) / (VA – 2 × 0.5VA + 0.25VA) = –1

and xB = 2. [½]

Hence expected return = –1 × EA + 2 × 0.25EA [½]

= –0.5EA . [½]
[Max 4]

(iii) (a) The variance of the return on the portfolio in (b) is:

(–1)2 × VA + 22 × VB + 2 × (–1) × 2 × 0.5VA [½]

= 0. [½]

(b) So we have created a risk-free portfolio. [1]

[Total 10]

In part (i) the majority of students stated all the assumptions of MVPT but
marks were only available for the main assumptions (as asked for in the
question).

Part (ii) was a straightforward calculation based on bookwork and most

students scored well. A proportion of students attempted to derive the
formula for the minimum variance portfolio from scratch rather than using the
formula given in the Core Reading – this was time-consuming and the number
of marks on offer should have been a good guide that this was not required.

Page 5
 Subject CT8 (Financial Economics Core Technical) – September 2016 – Examiners’ Report

Q3 (i) The market portfolio is the weighted portfolio of the risky securities in the
market, [½]
consequently ErM = 18% = w1Er1 + w2 Er2 . [½]

As w1 + w2 = 1 , then w1 = w2 = 0.5 . [1]

(ii) From the Security Market Line:

Eri − r f
βi = [1]
ErM − r f

therefore β A = 1.25 and βB = 0.75 . [1]

[Total 4]

A straightforward question and many students scored full marks. Part (i) was
well answered by all students but most students didn’t define the market
portfolio when deriving its composition.

Q4 (i) (a) Macroeconomic. [1]

(b) Fundamental. [1]

(ii) The results follow from the fact that the factor beta of a portfolio on a given
factor is the portfolio-weighted average of the individual securities’ betas on
that factor. This also applies to the constant and the random part. [1]

Working as follows:

Asset A B C

ai 0.03 0.05 0.1

bi,1 1 3 1.5
bi,2 –4 2 1.5

Weights
P1 0.33 0.33 0.33
P2 –0.5 1.5 0

P1 P2
aP 0.06 0.06
bP,1 1.83 4
bP,2 –0.17 5

Page 6
 Subject CT8 (Financial Economics Core Technical) – September 2016 – Examiners’ Report

Hence:

(a) = 0.06 + 1.83 − 0.17 + [1]

for cP = ( c A + cB + cC ) / 3 . [1]

(b) = 0.06 + 4 +5 + [1]

for cP = −0.5cA + 1.5cB . [1]
[Max 4]

(iii) The required portfolio has weights such that the portfolio-weighted averages
of the betas equal to the target beta. Hence, we need to solve the linear
system:

 xA 
 1 3 1.5    2 
 −4 2 1.5  xB  =  1  [1½]
  x   
 C

which returns solution x A = 1/ 8 , xB = 3 / 8 and xC = 1/ 2 (recall that the

weights sum up to 1). [½ each = 1½ total]
[Total 9]

Part (i) was well answered by almost all students. Part (ii) was also answered
well, but some students wrote the expected return on the portfolio in terms of
the return on the indices rather than the expected values of the indices.
Most students correctly derived the equations to solve in part (iii) with the
majority also solving the equations correctly.

Q5 (i)
• Market crashes appear more often than one would expect from a normal
distribution. (The real world distribution has “fat tails”.) [½]

• While the random walk produces continuous price paths, jumps or

discontinuities seem to be an important feature of real markets. [½]

• Days with no change, or very small change, also happen more often than
the normal distribution suggests. (The real world distribution is “more
peaked”.) [½]

• The assumption of independent increments is contradicted by empirical

evidence of mean reversion and momentum effects.
[½]
• The assumption of a constant volatility is contradicted by empirical
evidence. [½]

Page 7
 Subject CT8 (Financial Economics Core Technical) – September 2016 – Examiners’ Report

• It can be argued that expected returns on shares are likely to vary with
bond yields, which contradicts the assumption of a constant mean. [½]

• Random walks have a fractal dimension of 1½, (whereas) empirical

investigations of market returns often reveal a fractal dimension around
1.4. [½]

• Market returns are often (negatively) skewed [½]

[Max 3]

(ii)
• A cross-sectional property fixes a time horizon and looks at the
distribution over all the simulations. [1]

• For example, we might consider the distribution of inflation next year. [½]

• Implicitly, this is a distribution conditional on the past information which

is built into the initial conditions, and is, of course, common to all
simulations. [½]

• If those initial conditions change, then the implied cross-sectional

distribution will also change. [½]

• As a result, cross-sectional properties are difficult to validate from past

data, since each year of past history typically started from a different set of
conditions. [½]

• However, the prices of derivatives today should reflect market views of a

cross-sectional distribution. [½]

• Cross-sectional information can therefore sometimes be deduced from the

market prices of options and other derivatives. [½]

• A longitudinal property picks one simulation and looks at a statistic

sampled repeatedly from that simulation over a long period of time. [1]

• For example, we might consider one simulation and fit a distribution to the
sampled rates of inflation projected for the next 1,000 years. [½]

• For some models, this longitudinal distribution will converge to some

limiting distribution (ergodic distribution) as the time horizon lengthens.
[½]

• Furthermore this limiting distribution is common to all simulations. [½]

Page 8
 Subject CT8 (Financial Economics Core Technical) – September 2016 – Examiners’ Report

• Unlike cross-sectional properties, longitudinal properties do not reflect

market conditions at a particular date but, rather, an average over all likely
future economic conditions. [½]
[Max 4]
[Total 7]

Part (i) was standard bookwork which was answered well.

In part (ii), most students defined a cross-sectional and longitudinal property

correctly but failed to note their dependence on the initial condition and their
differences, as asked in the question. There were easy marks to be had by
giving an example of each, which few students did.

Q6 (i) Consider a portfolio, A, consisting of a European put on a non-dividend-

paying share and a share. [½]

At time T, portfolio A has a value of at least K, which is equal to that of the

cash alternative at time t of Ke–r(T–t). [½]

Thus by the principle of no arbitrage… [½]

pt + St ≥ Ke−r(T−t) . [1]

So pt ≥ Ke−r(T−t) − St . [1]

Moreover pt ≥0 as the payoff is always ≥0 so pt ≥ max(Ke−r(T−t) − St ,0) [1]

[Max 4]

(ii)
• (b) should be greater than (a) because the underlying asset is more volatile.
[1]

• (c) should be £0.26 by put/call parity (assuming that (a) is correct). [1]
[Alternatively, (a) should be £3.79 if (c) is correct, or both could be
incorrect.]

• (d) should be higher than (c) because the strike price is higher. [1]

• (d) is below the lower bound of £1.65. [1]

Page 9
 Subject CT8 (Financial Economics Core Technical) – September 2016 – Examiners’ Report

• (e) should be higher than (d) because an American option is always worth
at least as much as a European option. [1]
[Total 9]

Part (i) was largely well answered, though common mistakes included using
incorrect portfolios or trivial arguments that did not really constitute a proof.

Part (ii) was well answered by the majority of students, though few identified
all five differences. Some students calculated theoretical prices using the
Black-Scholes formula, but this was time-consuming and not necessary to
identify the discrepancies. Many students failed to check the lower bound for
the put option despite having proved it in part (i).

Q7 (i) The market is arbitrage free if and only if there exists a probability measure
under which discounted asset prices are martingales. [1]

In this case, the probability exists if and only if d < erΔt < u. [1]

Using the figures in the question, 0.95 < e0.25 × 0.05 < 1.1 [1]

er − d
Alternatively we need 0 < q < 1 where q = [1]
u−d
[Max 2]

(ii)
Stock price tree
Time 0 1 2 3
50.00 55.00 60.50 66.55
47.50 52.25 57.48
45.13 49.64
42.87

[1 mark for the final prices; the bottom one is not necessary]

The price C0 of the option is computed via risk-neutral valuation; let p̂ denote
the risk-neutral probability of an up movement, then:

pˆ = { exp ( 0.05 / 12 ) − 0.95} / {1.1 − 0.95}} = 0.3612 [1]

and

 k =0  k  pˆ k (1 − pˆ )3−k ( S0u k d 3−k − K )+

3 3
C0 = exp(–rT)

= exp(–rT) ( pˆ 3 × 16.55 + 3 × pˆ 2 (1 − pˆ ) × 7.48) = 2.62. [2]

Detailed workings:

Page 10
 Subject CT8 (Financial Economics Core Technical) – September 2016 – Examiners’ Report

CALL
Time 0 1 2 3
2.62 5.56 10.71 16.55
0.97 2.69 7.48
0.00 0.00
0.00

(iii) The only relevant trajectories, given the barrier set at 48, are the up-up-up, up-
up-down and up-down-up (i.e. the ones leading to a state in which the call
option is in the money). [1]

The price by risk-neutral valuation, therefore, is 2.0.

[1 for computation]
[1 for values of probabilities of the relevant trajectories – see table below]

Workings as follows:

K 50.0000
Split the stock tree DOC barrier b 48.0000
0 1 2 3 PATH min Payoff Probs Exp.
Value
50.0000 55.0000 60.5000 66.5500 uuu 55.0000 16.5500 0.0471 0.7797
50.0000 55.0000 60.5000 57.4750 uud 55.0000 7.4750 0.0833 0.6229
50.0000 55.0000 52.2500 57.4750 udu 52.2500 7.4750 0.0833 0.6229
50.0000 55.0000 52.2500 49.6375 udd 49.6375 0.0000 0.1474 0.0000
50.0000 47.5000 52.2500 57.4750 duu 47.5000 0.0000 0.0833 0.0000
50.0000 47.5000 52.2500 49.6375 dud 47.5000 0.0000 0.1474 0.0000
50.0000 47.5000 45.1250 49.6375 ddu 45.1250 0.0000 0.1474 0.0000
50.0000 47.5000 45.1250 42.8688 ddd 42.8688 0.0000 0.2607 0.0000

D0 2.0003

Alternative approach for the second and third marks:

Therefore option value = value of standard call option from part (ii) – the
value of the payoff under the duu path [1]

= 2.62 – 7.475 × .0833 × exp(–.05/4) = 2.00 [1]

Page 11
 Subject CT8 (Financial Economics Core Technical) – September 2016 – Examiners’ Report

(iv) If the barrier is at 40, the barrier option is equivalent to the vanilla call option
in part (ii), so the price is 2.62 [1]
as it is never knocked-out. [1]
[Total 11]

This was well-answered with the majority of students scoring full marks.
Some students simply defined arbitrage in part (i) rather than stating the
conditions for the market to be arbitrage free.

Common mistakes included using an incorrect formula for the risk-neutral

probability or failing to correctly apply the annual risk free rate to the required
monthly time steps. Some students tried to price the option using the Black-
Scholes formula without appreciating that the underlying Black-Scholes
assumptions may not hold.

Q8 (i) Delta = Δ = Φ(d1)

using standard Black-Scholes notation. [1]

(ii) Δ = Φ(d1) = 0.6179 means that d1 = 0.3 [1]

So 0.3 = (log(40/45.91) + (0.02 + 0.5σ2) × 5) / σ√5 [1]

So –0.0378 – 0.6708σ + 2.5σ2 = 0 [½]

Solving the quadratic gives σ = 0.3161 or σ = –0.0478 [1]

Rejecting the negative root gives σ = 32% (or may quote variance = 10%) [½]

(iii) Under the risk-neutral probability measure Q, the fair price of the option is
ce–rT Q(S1/S0 < kS) Q(R1/R0 < kR) [2]

(iv) Under the Black-Scholes model , if the stocks are perfectly correlated then
S1/S0 = R1/R0. [1]

So if kS < kR then the option only depends on stock S and has value
ce–rT Q(S1/S0 < kS) [1]

Similarly if kS > kR then the option only depends on stock R and has value
ce–r TQ(R1/R0 < kR) [½]

If kS = kR then the option can be defined in terms of the price of either stock as
ce–rT Q(S1/S0 < kS) = ce–rT Q(R1/R0 < kS) [½]

Page 12
 Subject CT8 (Financial Economics Core Technical) – September 2016 – Examiners’ Report

So overall the option can be defined in terms of the lower of kS and kR , and
either of the stock increases, i.e. has value
ce–rT Q(R1/R0 < min(kS,kR)) = ce–rT Q(S1/S0 < min(kS,kR)) [1]
[Max 3]

(v) ce–rT Q(ST/S0 < kS) Q(RT/R0 < kR)

= 50e–0.02 Q(ST/S0 < 0.8) Q(RT/R0 < 0.6)

= 50e–0.02 Q(S1 < 0.8 × 40) Q(R1 < 0.6 × 30) [1]

= 50e–0.02 (1 – Φ((log(S1/0.8S1) + (r – 0.5σS2))/σS)) (1– Φ((log(R1/0.6R1)

+ (r - 0.5σR2))/σR)) [1]

= 50e–0.02 (1 – Φ((log(1/0.8) + 0.02 – 0.5 × 0.322)/0.32) (1 – Φ((log(1/0.6)

+ 0.02 – 0.5 × 0.15)/√0.15) [½]

= 50e–0.02 (1 – (0.59982)) (1 – Φ(1.1769)) [½]

= 50e–0.02 (1 – 0.7257) (1 – 0.88039) [1]

= $1.61 (using σ = 0.32, or $1.59 using an exact σ = 0.3161) [1]

[Total 15]

Most students scored full marks in parts (i) and (ii). A number of students
used trial and error to find the volatility instead of simply solving the quadratic
equation.

Students struggled with parts (iv) and (v) with many only scoring low marks.
Most students calculated part (v) using the distribution of the share price
rather than Φ(d2) as an alternative solution. The best students showed their
workings so that some marks could be awarded even if the final answer was
not correct.

Q9 (i) (a) It incorporates mean reversion [½]

It is time homogenous, i.e. the future dynamics of r(t) only depend

upon the current value of r(t) rather than what the present time t
actually is. [1]

It is arbitrage free. [½]

It allows negative interest rates. [½]

Page 13
 Subject CT8 (Financial Economics Core Technical) – September 2016 – Examiners’ Report

It is easy to implement since the characteristic functions of all related

quantities are available. [1]
It has constant volatility [½]
[Max 2]

(b) It incorporates mean reversion…. [½]

… is arbitrage free… [½]
… and time homogenous. [½]

Volatility depends on the level of the rates: it is high/low when rates

are high/low. [1]

It does not allow negative interest rates. [½]

However it is more involving to implement than Vasicek model [½]

as it is linked to the chi-squared distribution. [½]

It is a one factor model [½]

[Max 2]

(ii) Use Itô’s lemma on the auxiliary process Xt = e at rt : [1]

dX d2X dX
= eat , 2 = 0, = aeat rt . [1]
dr dr dt

And so Itô gives:

dX t = [e at a (b − rt ) dt + ae at rt ]dt + e at σdWt . [1]

And hence:
dX t = deat rt = abeat dt + σeat dWt . [½]

By direct integration from 0 to t, it follows that:

t
at
( at
)
e rt = r0 + b e − 1 + σ  e as dWs [1]
0
t
and hence, as required, rt = r0e − at
(
+ b 1− e − at
) + σe − a( t − s )
dWs . [½]
0
[Max 4]

[Alternatively using an integrating factor of eat gives the same result.]

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 Subject CT8 (Financial Economics Core Technical) – September 2016 – Examiners’ Report

(iii) From Result 3.2 of the Core Reading, rt follows a Normal distribution [1]
with mean:

(
Ert = r0 e − at + b 1 − e − at ) [1]

and variance
 t 
2

= E   σ e ( ) dWs  
2 − −
Var ( rt ) = E ( rt − Ert )
a t s
[1]
  
  0  

t
−2 a( t − s )
= σ 2 e ds [1]
0

σ2
=
2a
(
1 − e −2 at . ) [½]
[Max 3]
[Total 11]

This was standard bookwork that was well-answered by the majority of

students, though some students gave formulae for the models despite being
told not to in the question.

Common mistakes in calculating the variance were to forget to square the

integrand or change the differential from dWs to ds.

Q10 (i) Under the Merton model the value at redemption is min(F(T), £100m), where
F(t) is the gross value of the company at time t. [1]

Thus the value at time 0 is:

e−5r E[min(F(5),100)] [1]

= e−5rE[F(5) − max(F(5) − 100,0)] [1]

(where the expectation is under the risk-neutral measure).

Thus the value at time 0 equals F(0) – C. [1]

where C is a call option on the total value of the company with strike £100m
and time to maturity five years. [1]
[Max 4]

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 Subject CT8 (Financial Economics Core Technical) – September 2016 – Examiners’ Report

Alternatively:

In the Merton model, assuming no other claims on the company’s assets:

F(0) = E(0) + B(0) [1]

So: B(0) = F(0) – E(0)

At time T, if:

• F(T) ≥ L, the shareholders will repay the debt and E(T) = F(T) – L [½]
• F(T) < L, the shareholders will default and E(T) = 0 [½]

i.e. the shares are equivalent to a European call option on the assets of the
company with maturity T and a strike price equal to the par value of the debt,
L, and a current price of C. [1]

So: B(0) = F(0) – C [1]

where C is a call option with a term of five years and a strike price of £100m.
[1]
[Max 4]

(ii) Put-call parity gives a share price of £105.37 (= 27.55 + 100e–0.05 – 17.3) [1]
hence the total value of all shares in issue is £105.37m. [½]

The total bond value is therefore £200m – £105.37m = £94.63m. [1]

This is £94.63 per £100 nominal. [½]

(iii) The sensitivity of the share price to a change in the company’s gross value is
dSt/dVt . [1]

If we regard St as a call option on the asset value Vt (current value £200m,

strike £100m) then this is the Greek delta. [1]

From the Black-Scholes formula and the volatility above we find that
d1 = 2.145 [1]
so delta = Φ(d1) = 0.984, [1]
so a £1m increase in asset value will give a £0.984m increase in the total share
value [½]
and a £0.016m increase in total bond value. [1]

This is an increase of £0.984 in the share price and an increase of £0.016 in the
bond price per £100 nominal. [½]
[Max 4]

(iv) The current value of the company is well in excess of the nominal value of the
bonds… [½]

Page 16
Subject CT8 (Financial Economics Core Technical) – September 2016 – Examiners’ Report

… so bondholders are highly likely to receive the full nominal amount on

maturity. [½]
The bond price is therefore not very sensitive to small changes in the value of
the company… [½]

… and the share price moves almost in line with the value of the company.
[½]

(v) If the company value was lower then the value received by the bondholders at
maturity would be more likely to fall short of the nominal amount. [½]

So any change in company value would impact the bond price more (and
hence impact the share price less). [½]
[Total 14]

Part (i) was standard bookwork with most students scoring well.

Students struggled with parts (ii) and (iii), but many picked up some marks by
showing all their working.

END OF EXAMINERS’ REPORT

Page 17
1
2 INSTITUTE AND FACULTY OF ACTUARIES
3
4
5
6
7 EXAMINATION
8
9
19 April 2016 (am)
10
11
Subject CT8 – Financial Economics
12
Core Technical
13
14 Time allowed: Three hours
15
INSTRUCTIONS TO THE CANDIDATE
16
1. Enter all the candidate and examination details as requested on the front of your answer
17 booklet.
18
2. You must not start writing your answers in the booklet until instructed to do so by the
19 supervisor.
20
3. Mark allocations are shown in brackets.
21
4. Attempt all 10 questions, beginning your answer to each question on a new page.
22
23 5. Candidates should show calculations where this is appropriate.

24
Graph paper is NOT required for this paper.
25
26
AT THE END OF THE EXAMINATION
27
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
28 question paper.
29
In addition to this paper you should have available the 2002 edition of the Formulae
30 and Tables and your own electronic calculator from the approved list.
31
32
33
34
CT8 A2016  Institute and Faculty of Actuaries
35
1 An investor measures the utility of her wealth using the utility function U(w) = ln(w)
for w > 0.

(i) Derive the absolute and relative risk aversions for this investor’s utility
function, and the first derivative of each. [4]

(ii) Comment on what this tells us about the proportion of her assets that this
investor will invest in risky assets. [2]

The investor has £100 available to invest in two possible assets, Asset A and Asset B.
The future value of Asset A depends on an uncertain future event.

 Every £1 invested in Asset A will be worth £1.30 with probability 0.75 and £0.40
with probability 0.25.

 Asset B is risk-free, so every £1 invested in Asset B will always be worth £1.

The investor does not discount future asset values when making investment decisions.
She decides to invest a proportion a of her wealth in Asset A and the remaining
proportion 1 – a in Asset B.

(iii) Express her expected utility of wealth in terms of a. [2]

(iv) Determine the amount that she should invest in each of Asset A and B to
maximise her expected utility, using your result from part (iii). [5]
[Total 13]

2 Consider an asset whose return follows the probability density function f(x).

(i) Write down a formula for the variance of the return on the asset, defining any
additional notation you use. [1]

(ii) Write down a formula for the shortfall probability for the return on the asset
below a level L. [1]

The returns on an asset follow a Normal distribution with mean µ = 6% per annum
and variance σ2 = 23% per annum. An investor buys €500 of the asset.

(iii) Determine the shortfall probability for the value of the asset in one year’s time
below a value of €480. [2]

(iv) Explain what can be deduced about an investor’s utility function if the investor
makes decisions based on:

(a) the variance of returns.

(b) the shortfall probability of returns.
[2]
[Total 6]

CT8 A2016–2
3 Consider a market with N securities. Let xi denote the weight of security i in a
portfolio, Vi the variance of the return on security i and Cij the covariance between the
returns on security i and security j.

(i) Write down an expression for V, the variance of the return on the portfolio. [1]

(ii) Describe how an efficient portfolio can be found under mean-variance

portfolio theory. [You do not have to include details of the partial derivatives
and their solutions.] [5]

(iii) Show that investors can diversify away specific risk by investing equal
amounts in an increasing number of independent securities. [3]

(iv) Show that the result in part (iii) still holds true when the securities are
correlated. [3]
[Total 12]

4 In a market where the assumptions of the Capital Asset Pricing Model (CAPM) hold,
there are a risk-free asset and two risky assets with the following attributes:

Rate of return (per annum)

State Probability Asset 1 Asset 2 Asset 3

1 0.2 5.0% 15.0% 26.0%

2 0.3 5.0% 22.0% 15.0%
3 0.1 5.0% 10.0% 24.0%
4 0.4 5.0% 28.0% 7.0%

Market capitalisation 30,000 70,000

(i) Determine the composition of the market portfolio. [1]

(ii) Determine the market price of risk. [5]

(iii) Calculate the beta of each risky asset. [2]

(iv) State the limitations of the CAPM. [3]

[Total 11]

5 (i) Define the three forms of the Efficient Markets Hypothesis. [3]

(ii) State two reasons why it is hard to test whether any of the three forms hold in
practice. [2]
[Total 5]

CT8 A2016–3 PLEASE TURN OVER

6 Suppose that at time t a portfolio (t , t) is held, where t represents the number of
units of a stock, with price St , held at time t and t is the number of units of a cash
bond, with price Bt , held at time t. The processes  and  are previsible.

Let V(t) = t St + t Bt be the value of the portfolio at time t.

(i) Explain what it means for this portfolio to be self-financing. [2]

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

Let Ct and Pt be the price at time t of a European call option and European put option
respectively, written on the stock S, each with strike price K and maturity T ≥ t.

The instantaneous risk-free rate is denoted by r.

(ii) Prove put-call parity in this context by constructing two self-financing

portfolios whose value must be equal by the principle of no arbitrage. [6]
[Total 8]

7 Consider a non-dividend-paying share with price St at time t (in years) in a market

with continuously compounded risk-free rate of interest r.

(i) Show that the fair price at t = 0 of a forward contract on the share maturing at
time T is K = S0erT. [5]

A share is currently worth S0 = €20. The continuously compounded risk-free rate of

interest is 1% per annum.

(ii) Calculate the fair price at t = 0 of a forward contract written on the share with
delivery at t = 2. [1]

(iii) Give an expression for the value to the investor of the forward contract in part
(ii) at time t  2, in terms of St , t and r. [2]

An investor enters into the above forward contract at time t = 0. At time t = 1 the
risk-free rate of interest has increased to 4% per annum. The share price has not
changed.

(iv) Calculate the value to the investor of the forward contract at t = 1. [1]

(v) Determine each of the following Greeks for the contract value at time t = 1:

 delta
 theta
 vega
[3]
[Total 12]

CT8 A2016–4
8 Consider a three-period binomial tree model for the stock price process St.

Let S0 = 100 and let the price rise by 10% or fall by 5% at each time step.

Assume also that the risk-free rate is 4% per time period, continuously compounded.

(i) (a) State the conditions under which the market is arbitrage free.

(b) Verify that there is no arbitrage in the given market.

[2]

(ii) Calculate the price of a European call option on this stock, with maturity at the
end of the third period and a strike price of 103. [4]

A special option, called a European “Paylater” call option, has the following payoff at
maturity T:

( ST  K  c) if ST  K

and zero otherwise. K is the strike price and c is the premium paid for the option.

The premium is paid at maturity, and is only paid if the option expires in-the-money.

Further, the option premium is set such that the value of the option at time t = 0 is
zero.

Assume that K = 103 and the maturity of the contract is at time t = 3.

(iii) Determine the premium c of this contract. [3]

[Total 9]

CT8 A2016–5 PLEASE TURN OVER

9 (i) Draw a diagram to illustrate the Jarrow-Lando-Turnbull model for credit
default, defining any notation used. [4]

Consider a three-state credit model for a company in discrete time. The states are
Healthy (H), Unhealthy (U) or Defaulted (D). Transition probabilities from state i to
state j, pij, are constant:

pHU = 0.1
pUH = 0.05
pHD = 0.02
pUD = 0.3
pDj = 0 for all j ≠ D

Denote the probability that the company is in state i at time t (years) as pi(t).

A company is in the Healthy state at time 0.

(ii) Calculate pD(2), i.e. the probability that the company is in the Default state at
time 2. [2]

The company issues a zero-coupon bond at time 0, with maturity at time 2 and
nominal value £100. The continuously compounded risk-free rate of interest is 4%
per annum.

Assume that the bond returns its nominal value at time 2 if the company is not in
default, or x% of its nominal value at time 2 if the company is in default.

The fair price of the bond at time 0 is £87.63.

(iii) Calculate the value of x, the assumed percentage recovery on default. [2]

(iv) Calculate the credit spread on the bond. [1]

(v) Comment on the impact on the current price of the bond if it returned x% of its
nominal value at the time of default rather than at time 2. [1]
[Total 10]

CT8 A2016–6
10 In the Vasicek model, the short rate of interest under the risk-neutral probability
measure is given by:
t
rt    e  kt (r0  )    e k (t u ) dWu
0

where k, ,  > 0 and W is a standard Brownian motion.

Consider the related process:

t
Rt  rs ds
0

where rt is the short rate defined above.

(i) Show that Rt has a Normal distribution with mean and variance given by:

1  e kt
E ( Rt )  t  (r0  ) and
k

 2  2(1  e  kt ) 1  e 2 kt 
Var(Rt )  t    . [6]
k 2  k 2k 

Let P(0,t) be the price at time 0 of a zero-coupon bond with redemption date t > 0.

(ii) Show that, under the Vasicek model:

Var  Rt 
 E  Rt 
P (0, t )  e 2 . [3]

(iii) Show, by using the results from parts (i) and (ii), that:

 B(t ) r0
P(0, t )  A(t )e

1  e kt
where B(t ) 
k

  2  2 
and A(t )  exp  ( B (t )  t )    2   B (t ) 2  . [4]
  2k  4k 


(iv) State the main drawback of the above model for the term structure of interest
rates. [1]
[Total 14]

END OF PAPER

CT8 A2016–7
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2016 (with mark allocations)

Subject CT8 – Financial Economics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping candidates, both
those who are sitting the examination for the first time and using past papers as a revision aid and
also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The Examiners have
access to the Core Reading, which is designed to interpret the syllabus, and will generally base
questions around it but are not required to examine the content of Core Reading specifically or
exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in this
report; other valid approaches are given appropriate credit. For essay-style questions, particularly the
open-ended questions in the later subjects, the report may contain more points than the Examiners
will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that the
examination was set. Candidates should take into account the possibility that circumstances may
have changed if using these reports for revision.

F Layton
Chairman of the Board of Examiners
June 2016

 Institute and Faculty of Actuaries

 Subject CT8 (Financial Economics Core Technical) – April 2016 – Examiners’ Report

A. General comments on the aims of this subject and how it is marked

1. The aim of the Financial Economics subject is to develop the necessary skills to construct
asset liability models and to value financial derivatives. These skills are also required to
communicate with other financial professionals and to critically evaluate modern financial
theories.

2. The marking approach for CT8 is flexible in the sense that different answers to those
shown in the solution can earn marks if they are relevant and appropriate. Marks for the
methodology are also awarded.

B. General comments on student performance in this diet of the

examination

1. Students performed relatively well on bookwork questions, although many missed the
opportunity to be awarded full marks for these due to relatively superficial knowledge.

2. The majority of the students though seemed to struggle on the applications part of the
questions, through not being able to put together the pieces of information given and use
them. In a few instances this resulted in students re-calculating given data from basic
principles and therefore running out of time. Further, there is often a lack of knowledge of
how to use the distribution tables to compute probabilities (in the specific case of this
exam paper, the normal distribution), and relative sloppiness in getting the details right.

C. Pass Mark

The Pass Mark for this exam was 60%.

Solutions

Q1 (i) U’(w) = 1/w [½]

U’’(w) = –1/w2 [½]

Absolute risk aversion = A(w) = – U’’(w)/U’(w) [½]

= 1/w [½]

A’(w) = –1/w2 [½]

Relative risk aversion = R(w) = – wU’’(w)/U’(w) [½]

=1 [½]

R’(w) = 0 [½]
[Total 4]

Page 2
Subject CT8 (Financial Economics Core Technical) – April 2016 – Examiners’ Report

(ii) R’(w) =0 thus the log utility function exhibits constant relative risk aversion.
[1]

This is consistent with an investor who keeps a constant proportion of wealth

invested in risky assets as she gets richer. [2]
[Max 2]

(iii) Wealth after the uncertain event will be either:

100 × (1.3a + (1 – a)) = 100 + 30a with probability 0.75 [½]

or:

100 × (0.4a + (1 – a)) = 100 – 60a with probability 0.25. [½]

Thus expected utility of wealth is:

0.75 × ln(100 + 30a) + 0.25 × ln(100 – 60a). [2]

[Max 2]

(iv) Differentiate with respect to a:

30 × 0.75/(100 + 30a) – 60 × 0.25/(100 – 60a). [2]

Set equal to zero:

30 × 0.75 / (100 + 30a) – 60 × 0.25 / (100 – 60a) = 0

30 × 0.75 / (100 + 30a) = 60 × 0.25 / (100 – 60a)
30 × 0.75 × (100 – 60a) = 60 × 0.25 × (100 + 30a)
22.5 × (100 – 60a) = 15 × (100 + 30a)
2250 – 1350a = 1500 + 450a
750 = 1800a
a = 0.4167 [2]

Check for maximum:

Differentiate with respect to a again:

– 302 × 0.75/(100 + 30a)2 – 602 × 0.25/(100 – 60a)2.

This must be negative because of the square terms, hence this is a local
maximum. [1]

Page 3
 Subject CT8 (Financial Economics Core Technical) – April 2016 – Examiners’ Report

So invest £41.67 in Asset Aand £58.33 in Asset B. [2]

[Max 5]
[TOTAL 13]

Early parts of this question were largely completed well, though some
students used the incorrect formulae despite them appearing in the tables
(sign problems mainly). The majority of the students were able to correctly
identify the nature of the utility function in terms of index of relative risk
aversion but failed to comment about the proportion of the assets that the
investor will invest in risky assets. The majority of students also failed to
express the expected utility of wealth, and calculated the utility of expected
wealth instead.

Q2 (i) Variance of return is defined as:

∞
 −∞ (μ − x)
2
f ( x)dx ,

where μ is the mean return at the end of the chosen period. [1]

L
(ii) Shortfall probability =  f ( x)dx . [1]
−∞

(iii) The shortfall probability required is the probability that the return is lower
than 480/500 – 1 = –4% i.e. P(N(6%, 23%) ≤ 4%) [1]
= P(Z≤ (–4% – 6%)/√(23%)) [½]
= P(Z ≤ –0.20851) [½]
= 0.417 [1]
[Max 2]

(iv) (a) This may imply that the investor has a quadratic utility function. [1]

(b) This corresponds to a utility function which has a discontinuity at the

minimum required return. [1]
[Total 2]
[TOTAL 6]

Well prepared students scored well on the bookwork parts of this question,
although some students failed to define in full the notation used in part (i).
Many students had problems in calculating the shortfall probability using the
distribution of the normal random variable, and in recognising that the
corresponding utility function has a discontinuity.

Page 4
 Subject CT8 (Financial Economics Core Technical) – April 2016 – Examiners’ Report

Q3 (i) V = Σi xi2 Vi + Σi Σj, j≠i xi .xj Cij . [Total 1]

(ii) The aim is to choose xi to minimise V … [1]

… subject to the constraints

Σi xi = 1 [1]

and expectation of return E = EP, say, in order to plot the minimum variance
curve. [1]

One way of solving such a minimisation problem is the method of Lagrangian

multipliers. [1]

The Lagrangian function is:

W = V − λ(E − EP) − μ(Σi xi − 1). [1]

To find the minimum we set the partial derivatives of W with respect to all the
xi and λ and μ equal to zero. [1]

The result is a set of linear equations that can be solved. [1]

The usual way of representing the results of the above calculations is by

plotting the minimum standard deviation for each value of EP as a curve in
expected return – standard deviation (E – σ) space. [1]

In this space, with expected return on the vertical axis, the efficient frontier is
the part of the curve lying above the point of the global minimum of standard
deviation. [1]
Any portfolio on this efficient frontier is an efficient portfolio. [1]
[Max 5]

(iii) Where all assets are independent, the covariance between them is zero and the
formula for variance becomes:

V = Σi xi2 Vi . [1]

If we assume that equal amounts are invested in each asset, then with N assets
the proportion invested in each is 1/N. Thus:

V = Σi (1/N)2 Vi [1]
= 1/N[Σi Vi/N] = 1/N [1]

where represents the average variance of the stocks in the portfolio.

Page 5
 Subject CT8 (Financial Economics Core Technical) – April 2016 – Examiners’ Report

As N gets larger and larger, the variance of the portfolio approaches zero. [1]
[Max 3]

(iv) With equal investment, the proportion invested in any one asset xi is 1/N and
the formula for the variance of the portfolio becomes:

V = Σi (1/N)2 Vi + Σi Σj (1/N)(1/N).Cij . [1]

Factoring out 1/N from the first summation and (N − 1)/N from the second
yields:

V = 1/N Σi Vi /N + (N − 1)/N Σi Σj Cij/N(N − 1). [1]

Replacing the summation by averages we have:

V = 1/N Vi + (N − 1)/N. ̅ . [1]

The contribution to the portfolio variance of the variances of the individual

securities goes to zero as N gets very large. [1]

This shows that the individual risk of securities can be diversified away. [1]

The contribution of the covariance terms approaches the average covariance as

N gets large. However, this does not represent specific risk i.e. risk relating to
individual securities. [1]
[Max 3]
[TOTAL 12]

Early parts of this question were largely completed well. The majority of the
students proceeded without problems although a few provided answers only
for the general case of dependent assets. Some students answered parts (iii)
and (iv) using the single index model despite the question being clear that
mean-variance portfolio theory was being examined.

Q4 (i) The composition of the market portfolio is as follows:

Market capitalisation 30,000 70,000

wi 0.3 0.7 [Total 1]

(ii) Mean returns: Asset 2: Asset 3:

21.8% 14.9% [1]

Page 6
Subject CT8 (Financial Economics Core Technical) – April 2016 – Examiners’ Report

Consequently:

3
ErM = wi Eri = 16.97% [1]
i =2

 3  
2
= E  wi ri   − ( ErM ) = 3.57% .
2
std. dev ( rM ) = σ M [2]

 i = 2 
  

( )
The market price of risk is given by ErM − r f / σ M [1]

And since the risk-free rate is 5.0%, this equates to:

(0.1697 – 0.05)/0.0357 = 3.35 [1]

[Max 5]

(iii) ( )(
From the Security Market Line it follows that βi = Eri − r f / ErM − r f . [1])
Hence β2 = 1.40 and β3 = 0.83 . [1 mark each]
[Max 2]

(iv) The assumptions made are unrealistic. [1]

Empirical studies do not provide strong support for the model. [1]
It does not account for taxes. [1]
Or inflation. [1]
Or situations in which there is no riskless asset. [1]
It does not consider multiple time periods. [1]
Or optimisation of consumption over time. [1]
Investors don’t always use the same “currency” [1]
Markets are not always perfect [1]
Investors don’t always have the same expectations [1]
Cannot lend/borrow unlimited amounts at the same risk-free rate [1]
Difficult to check as need to think about investment markets as well as capital
markets [1]
Unrealistic to invest in the market portfolio in practice as so many stocks [1]
[Max 3]
[TOTAL 11]

Many students answered all parts of this question correctly. A few either
made calculation mistakes, or did not cover a wide enough range of
limitations of the CAPM. Some students confused calculating the market
price of risk with the risk premium.

Page 7
 Subject CT8 (Financial Economics Core Technical) – April 2016 – Examiners’ Report

Q5 (i) The three forms are: Strong – market prices reflect all current information
relevant to the stock, including information which is not public. [1]

Semi-strong – market prices reflect all current, publicly available information

relevant to the stock. [1]

Weak – market prices reflect all information available in the past history of the
stock price. [1]
[Total 3]

(ii) Tests need to make assumptions (which may be invalid) such as normality of
returns or stationarity. [1]

Transaction costs may prevent the exploitation of anomalies, so that the EMH
might hold net of transaction costs. [1]

Allowance for risk: the EMH does not preclude higher returns as a reward for
risk; however the EMH does not tell us how to price such risks. [1]

Testing the strong form EMH is problematic as it requires access to

information that is not in the public domain. [1]

It can be difficult to define “public information” or to determine exactly when

information becomes public. [1]
It is impossible to test all of the possible trading rules that might be used by
technical analysts. [1]

The assumptions made about how security prices should react to new
information may be invalid. [1]
[Max 2]
[TOTAL 5]

Standard bookwork question which was largely well answered. Some

students referred to the investor knowing the information rather than the
security price reflecting the information or that the security price reflected
“only” the relevant information rather than “all” relevant information.

Q6 (i) This portfolio is described as self-financing if dV(t) is equal to φt dSt + ψt dBi.

That is, at t + dt, there is no inflow or outflow of money necessary to make the
value of the portfolio back up to V(t + dt). [Total 2]

(ii) Consider two self-financing portfolios:

• Portfolio A: holding the call (long position) and a sold put (short position)
at time t. [1]

Its value at time t is Ct – Pt [1]

Page 8
 Subject CT8 (Financial Economics Core Technical) – April 2016 – Examiners’ Report

and at time T, it is ST – K. [1]

• Portfolio B: holding a fraction e−δ(T–t) of the underlying asset for St e−δ(T−t)

and shorting (borrowing) cash of Ke–r(T–t) at time t. [1]

Its value at time t is then St e−δ(T−t) – Ke–r(T–t). [1]

Its value at maturity is then ST – K by taking into account the dividends

which are paid continuously at rate δ. [1]

By the principle of no arbitrage… [1]

… both portfolios must have the same value at all time t, since they have the
same value at time T. [1]

Hence: Ct – Pt = St e−δ(T−t) – Ke–r(T–t) [1]

[Max 6]
[TOTAL 8]

Standard bookwork question. The majority of the students answered correctly

although quite a few did not justify their argument on the basis of the no
arbitrage principle. Alternative valid approaches (including different portfolio
combinations) were of course acceptable.

Q7 (i) Let K be the forward price. Now compare the setting up of the following
portfolios at time 0:

A: one long forward contract. [1]

B: borrow Ke–rT cash and buy one share at S0. [1]

If we hold both of these portfolios up to time T then both have a value of

ST – K at T. [1]

By the principle of no arbitrage… [1]

… these portfolios must have the same value at all times before T. [1]

In particular, at time 0 both portfolios must have value zero (since the value of
a forward contract at t = 0 is zero). [1]

Since portfolio B has value S0 – Ke–rT at t = 0, this can only be zero if

K = S0erT. [1]
[Max 5]

(ii) K = €20 × e2×0.01 [1]

= €20.40 [1]
[Max 1]

Page 9
 Subject CT8 (Financial Economics Core Technical) – April 2016 – Examiners’ Report

(iii) Value = (Ster(2–t) – 20.40)e–r(2–t) = St – 20.40er(t–2). [Total 2]

(iv) Using (iii), we get value = €20 – €20.40e–0.04 [1]

= €0.40 at time 1 [1]
[Max 1]

(v) Using (iii):

delta = d/dSt(St – 20.40er(t–2)) [1]

[½ mark for the definition of the greek, ½ mark for the actual formula]
=1 [1]

theta = d/dt(St – 20.40er(t–2)) [1]

[½ mark for the definition of the greek, ½ mark for the actual formula]

= – 20.40 r t er(t–2) = –0.784 at t = 1 [1]

vega = 0 [1]
as the value does not depend directly on the volatility of the share [1]
[Max 3]
[TOTAL 12]

Early parts of this question were answered well. The majority of the students
though confused the forward price (i.e. the delivery price) with the value to the
investor of the forward contract in part (iii), and consequently struggled with
the remaining parts, even if the large majority knew the definition of each
Greek.

Q8 (i) (a) The market is arbitrage free if and only if there exists a probability
measure under which discounted asset prices are martingales. [1]

In this case, the probability exists if and only if d < er Δt < u. [1]

(b) d = 0.95 < e 0.04 < 1.1 = u hence the condition is verified. [1]
[Max 2]

(ii)
Stock tree
Time 0 1 2 3

100.00 110.00 121.00 133.10

95.00 104.50 114.95
90.25 99.28
85.74

[½ mark for each of the prices of the stock at time 3]

Page 10
Subject CT8 (Financial Economics Core Technical) – April 2016 – Examiners’ Report

The price C0 of the option is computed via risk-neutral valuation. [½]

Let p̂ denote the risk-neutral probability of an up movement, then:

pˆ = { exp ( 0.04 ) − 0.95} / {1.1 − 0.95}} = 0.6054 [1]

and
3
 3
( )
+
C0 = e − rT    pˆ k (1 − pˆ )
3− k
S0u k d 3− k − K
k
k =0  

( )
= e− rT pˆ 3 × 30.10 + 3 pˆ 2 (1 − pˆ ) ×11.95 = 10.52. [4]
[Max 4]

For information, the detailed tree-based workings are provided below:

CALL
Time 0 1 2 3

10.52 15.45 22.04 30.10

4.04 6.95 11.95
0.00 0.00
0.00

(iii) As the premium is set so that the option price is zero, by risk-neutral valuation
it follows that:

C0
c = erT [2]
ˆ
P( ST > K )

C0
= e rT [2]
pˆ + 3 pˆ 2 (1 − pˆ )
3

= 18.09 [1]
[Max 3]

Page 11
 Subject CT8 (Financial Economics Core Technical) – April 2016 – Examiners’ Report

Alternatively for the above:

From the figures in part (ii), must have:

[(30.1 – c) × p̂ 3 + (11.95 – c) × 3 p̂ 2 (1 – p̂ )] × exp-(3 × 0.04) = 0 [2]

c = [30.1 × p̂ 3 + 11.95 × 3 p̂ 2 (1 – p̂ )] / [ p̂ 3 + 3 p̂ 2 (1 – p̂ )] [2]

= 18.09 [1]
[Max 3]
[TOTAL 9]

Generally well answered, although some made calculation mistakes in

obtaining the prices of the given option contracts. In particular, too many
students simply used 1.04 for exp(0.04), which is of course not correct – a
simple check with the calculator would have shown this. The majority of
students adopted the correct approach to solve part (iii).

Q9 (i)

λ2j(t) j
2 λj2(t)
λj,n-1(t)
λn-1,j(t)
λ12(t)
λ21(t)

1 n-1

λ2n(t)
λ1n(t) λn-1,n(t)

[3 marks for diagram]

The n states represent n – 1 credit ratings plus default. [1]

λij(t) are the deterministic transition intensities from state i to state j at time t
under the real world measure P. [1]
[Max 4]
[1½ marks for diagram applied to specific example – 3 states model]

Page 12
 Subject CT8 (Financial Economics Core Technical) – April 2016 – Examiners’ Report

(ii) pD(2) = pHD + pHH × pHD + pHU × pUD [1]

= 0.02 + (1 – 0.1 – 0.02) × 0.02 + 0.1 × 0.3 [1]
= 0.0676 [1]
[Max 2]

(iii) £87.63 = e–2×0.04 (( 1 – pD(2)) × 100 + pD(2) × 100x) [1]

= e–2×0.04 ((1 – 0.0676) × 100 + 0.0676 × 100x) [1]
so x = 25% [1]
[Max 2]

(iv) 87.63 = 100e–2×(r+c) where c is the credit spread. [1]

So c = 2.6%. [1]
[Max 1]

(v) The impact on cashflows would be that the bond might return the x% of its
nominal value earlier than time 2, so the value of the bond would increase.
[Total 1]
[TOTAL 10]

Generally, students answered this question correctly, although in the first part
quite a few considered only the particular case of the three states given in the
rest of the question (but which had not yet been introduced for part (i)). A few
students used the Merton formula for default to solve part (iii) of the question,
which was not appropriate for this model.

Q10 (i) By substitution and direct integration between 0 and t:

Rt = θ t . [1]

+ ( r −θ )
(1 − e ) − kt
[2]
0
k

t
+
σ
k
0
 (
1 − e ( ) dWs
−k t −s
) [3]

In virtue of the properties of the stochastic integral, Rt follows a Normal

distribution [1]
with the given mean (as the integral has zero mean) [1]
and the given variance – see Result 3.2 in Core Reading (Ito isometry). [1]
[Max 6]

Page 13
 Subject CT8 (Financial Economics Core Technical) – April 2016 – Examiners’ Report

(ii) From risk-neutral valuation, the price of a bond is given by:

 − t r ds 
 s 
P ( 0, t ) = E  e 0  [2]
 
 

= E e− Rt ( ) [1]

which is the first moment of exp( − Rt ). [1]

As − Rt is normally distributed, the moment generating function gives the first

moment of − Rt as required:

Var( Rt )
− E ( Rt )+
=e 2 . [2]

Equivalently, use the results regarding the mean of the lognormal random
variable as per the Formulae & Tables.
[Max 3]

(iii) Notice that the variance can be written as:

σ2  1 − e− kt 1 − e −2 kt 
Var ( Rt ) =  t − B ( t ) − +  [2]
k 2  k 2k 

σ2 σ 2  1 − e − kt 1 − e −2 kt 
= − 2 ( B (t ) − t ) +  −2 + 
k 2k  k2 k2 

σ2 σ 2

2 ( ( )
B t −t) −
2
=− B (t ) .
k 2k

The result follows by substitution. [2]

[Max 4]

Page 14
Subject CT8 (Financial Economics Core Technical) – April 2016 – Examiners’ Report

(iv) The main drawback of the Vasicek model is that the short rate can take
negative values with positive probability. [1]
[TOTAL 14]

There was a wide range of quality of answers for this question. Generally,
students answered correctly the first and last parts of this question. Many
students managed to get through a few steps for part (ii), though often with
algebra issues; whilst in part (iii) there were relatively few comprehensive
attempts.

END OF EXAMINERS’ REPORT

Page 15
1
2 INSTITUTE AND FACULTY OF ACTUARIES
3
4
5
6
7 EXAMINATION
8
9
7 October 2015 (am)
10

Subject CT8 – Financial Economics

11
12
Core Technical
13
14 Time allowed: Three hours
15
INSTRUCTIONS TO THE CANDIDATE
16
1. Enter all the candidate and examination details as requested on the front of your answer
17 booklet.
18
2. You must not start writing your answers in the booklet until instructed to do so by the
19 supervisor.
20
3. Mark allocations are shown in brackets.
21
4. Attempt all 10 questions, beginning your answer to each question on a new page.
22
23 5. Candidates should show calculations where this is appropriate.

24
Graph paper is NOT required for this paper.
25
26
AT THE END OF THE EXAMINATION
27
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
28 question paper.
29
In addition to this paper you should have available the 2002 edition of the Formulae
30 and Tables and your own electronic calculator from the approved list.
31
32
33
34
35 CT8 S2015 © Institute and Faculty of Actuaries
1 Describe the definitions, assumptions and key results of consumer choice theory. [8]

2 An investor makes decisions using a quadratic utility function, U(w) = a + bw + cw2.

(i) Write down the absolute and relative risk aversion for this utility function. [2]

The investor currently has wealth of £100, and using her utility function
U(100) = 610.

The investor is offered a gamble with a profit of £20 with probability p, and a loss of
£20 with probability (1  p). She will accept this gamble only if p ≥ 0.55.

(ii) Explain what this implies about the investor’s risk aversion. [1]

The investor accepts the gamble and wins. She now has wealth of £120.

The investor is offered the same gamble again, with a profit of £20 with probability p,
and a loss of £20 with probability (1  p). Based on her new wealth, she will now
accept this gamble only if p ≥ 0.5625.

(iii) Determine a, b and c. [4]

(iv) Determine the maximum wealth for which the function U(w) satisfies the
requirement of non-satiation. [2]
[Total 9]

3 (i) Define an “efficient portfolio” in the context of mean-variance portfolio

theory. [1]

(ii) State the assumptions required for the existence of efficient portfolios. [2]

Suppose an investor invests his wealth in N securities, i = 1, ..., N, with xi denoting the
proportion of wealth invested in security i.

(iii) Write down a formula for the expected return on this portfolio. [1]

(iv) Write down a formula for the variance of the return on this portfolio. [1]

Now suppose the investor invests in only two securities, A and B.

(v) Derive the proportion xA that should be invested in security A to minimise the
portfolio variance. [4]
[Total 9]

CT8 S2015–2
4 (i) Describe the Arbitrage Pricing Theory (APT) using a two-index model for
illustration. [5]

A two-index APT model has been built, using a market (traded) index, IM, and a
currency index, IC . The model for expected returns is:

Ei = λ0 + bi,M M + bi,C λC,

where:

 Ei is the expected return on traded security i.

 λM and λC are the expected returns on the market and currency indices
respectively.

 bi,M and bi,C are the sensitivities of the returns of security i with respect to the
market and currency indices respectively.

(ii) Justify why λ0 must be 0. [3]

Suppose that a traded security has return R and the market has the following
characteristics:

 Cov(R,IM) = 0.02.
 Var(IM) = 0.04.
 Var(IC) = 0.01.
 The correlation between IM and IC is Corr(IM,IC) =  0.4.
 The expected return on the security is ER = 0.09.
 λM = 0.07 and λC = 0.02.

(iii) Calculate bi,M and bi,C. [4]

(iv) Determine Cov(R,IC). [3]

[Total 15]

CT8 S2015–3 PLEASE TURN OVER

5 An actuary plans to retire in five years’ time, and hopes to celebrate retirement with a
round-the-world cruise. The cruise will cost €20,000. The actuary chooses to save
for the cruise by buying non-dividend paying shares with price St governed by the
Stochastic Differential Equation:

dSt = St(μdt + σdZt)

where:

• Zt is a standard Brownian motion.

• μ = 10%.
• σ = 20%.
• t is the time from now measured in years; and
• S0 = 1.

The instantaneous, constant, continuously compounded risk-free rate of interest is

4% p.a.

(i) Derive the distribution of St. [2]

(ii) Calculate the amount, A, that the actuary will need to invest in the shares to
give a 40% probability of having savings of at least €20,000 in five years’
time. [3]

(iii) Calculate the following risk measures at t = 5 applied to the difference

between the value of the share holding and €20,000, if the actuary invests
€10,000 at t = 0:

(a) standard deviation

(b) 95% Value at Risk relative to €20,000
[4]
[Total 9]

6 Consider a non-dividend paying share with price St at time t in a market with

continuously compounded risk-free rate of interest r.

(i) Show that the fair price of a forward contract on the share maturing at time T
is K = S0erT. [4]

A share is currently worth S0 = £5. The continuously compounded risk-free rate of

interest is 3% p.a. for 0 ≤ t < 1, 5% p.a. for 1 ≤ t < 2 and 2% p.a. for 2 ≤ t ≤ 4.

(ii) Calculate the fair price at t = 0 of a forward contract written on the share with
delivery at t = 4. [1]

An investor enters into the above forward contract at time t = 0. At time t = 1 the
share price has increased to £6.

(iii) Calculate the value to the investor of the forward contract at t = 1. [2]
[Total 7]

CT8 S2015–4
7 A non-dividend paying share currently trades at S0 = $10. An investor is considering
buying a European call option on the share with a strike price of $12 and expiry in
five years. The continuously compounded risk-free rate of interest is 4% p.a.

(i) Determine lower and upper bounds for the price of the call option at time 0.
[2]

The call option is currently priced at $1.50. The assumptions of the Black-Scholes
model apply.

(ii) Calculate the implied volatility of the share. [4]

(iii) Determine the corresponding hedging portfolio in shares and cash for 100 call
options. [2]
[Total 8]

8 Let X be a continuous random variable with distribution function F. Define Y = F(X).

(i) Prove that Y is a U(0,1) random variable i.e. P(Y < y) = y for 0 ≤ y ≤ 1. [2]

Suppose that St is the price at time t (in years) of a share in a Black-Scholes market
with S0 = £1.11, the continuously compounded risk-free rate of interest r = 2% p.a.
and the volatility σ = 22% p.a.

(ii) Determine the values of a and b such that Φ((ln S2 − a)/b) is a U(0,1) random
variable under the risk-neutral measure, where Φ is the cumulative
distribution function of the standard normal distribution. [3]

Suppose that a derivative pays D2 = £100[Φ ((ln S2 − a)/b)]2 at maturity t = 2, where a

and b take the values calculated in part (ii).
(iii) Determine the fair price of this derivative. [3]

Suppose that another derivative security pays the amount D2 at time t = 2, but only if
D2 is at least £25.
(iv) Determine the fair price of this derivative. [3]
[Total 11]

CT8 S2015–5 PLEASE TURN OVER

9 (i) Describe the Merton model for credit risk. [5]

A company is about to issue a zero-coupon bond which will redeem in T = 5 years at

£12.3 billion. The value of current issued share capital is £12.5092 billion and the
company has no other debt. The continuously compounded risk-free rate of interest is
5% p.a. and the volatility of the company’s gross asset value is assumed to be
30% p.a.

Assume that the share price will not change on issue and that the assumptions of the
Black-Scholes model apply.

(ii) Write down the relationship between the current equity value of the company
and FT, the final gross value of the company’s assets. [1]

(iii) Estimate F0+, the gross value of the company’s assets just after the bond issue,
using the Black-Scholes formula and interpolation. [7]

(iv) Determine the corresponding credit spread on the loan. [2]

[Total 15]

10 Consider a market with the following properties:

t F(t  1,t) B(0,t) R(0,t) C(t)

0 - - - £100.00
1 2% (b) 2.0% £102.02
2 4% £94.18 (c) £106.18
3 3% £91.39 3.0% (d)
4 (a) £86.94 3.5% £115.03

where:

• t is time.

• F(s,t) is the forward rate at time 0 from time s to time t.

• B(s,t) is the price of a zero coupon bond at time s maturing at time t with a
nominal value of £100.

• R(s,t) is the spot rate of interest at time s for the period s to t.

• C(t) is the value of a cash account at time t.

(i) Calculate the values of (a), (b), (c) and (d) in the table above. [4]

CT8 S2015–6
 At time 0 an investor buys £1,000 nominal of zero coupon bonds maturing at time 2,
and £2,000 nominal of zero coupon bonds maturing at time 4. At time 1 interest rate
expectations have changed as set out below.

t F(t  1,t)
1 -
2 5%
3 4%
4 6%

(ii) Calculate the loss the investor will make if she sells the bonds at time 1. [3]

The investor decides to keep the bonds rather than selling them at time 1.

(iii) Comment on whether the investor can restructure her portfolio to recover her
loss if interest rates remain unchanged. [2]
[Total 9]

END OF PAPER

CT8 S2015–7
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2015

Subject CT8 – Financial Economics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping candidates, both
those who are sitting the examination for the first time and using past papers as a revision aid and
also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The Examiners have
access to the Core Reading, which is designed to interpret the syllabus, and will generally base
questions around it but are not required to examine the content of Core Reading specifically or
exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in this
report; other valid approaches are given appropriate credit. For essay-style questions, particularly the
open-ended questions in the later subjects, the report may contain more points than the Examiners
will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that the
examination was set. Candidates should take into account the possibility that circumstances may
have changed if using these reports for revision.

F Layton
Chairman of the Board of Examiners
December 2015

 Institute and Faculty of Actuaries

 Subject CT8 (Financial Economics Core Technical) – September 2015 – Examiners’ Report

A. General comments on the aims of this subject and how it is marked

1. The aim of the Financial Economics subject is to develop the necessary skills to construct
asset liability models and to value financial derivatives. These skills are also required to
communicate with other financial professionals and to critically evaluate modern financial
theories.

2. The marking approach for CT8 is flexible in the sense that different answers to those
shown in the solution can earn marks if they are relevant and appropriate. Marks for the
methodology are also awarded.

B. General comments on student performance in this diet of the

examination

The general performance was good. Candidates found some questions challenging, but well-
prepared candidates scored consistently across the whole paper. As in previous diets,
questions that required an element of application of the core reading to situations that were
not immediately familiar proved more challenging to most candidates. A significant number of
candidates failed to read some questions carefully enough to identify the relevant section of
the course being examined.

C. Comparative pass rates for the past 3 years for this diet of examination

Year %
September 2015 50
April 2015 60
September 2014 56
April 2014 55
September 2013 51
April 2013 51

Reasons for any significant change in pass rates in current diet to those in the
past:

The pass rates are comparable with standard pass rates for CT8, even if slightly lower than
recent diets. The paper was standard but candidates struggled with some questions.

Page 2
 Subject CT8 (Financial Economics Core Technical) – September 2015 – Examiners’ Report

Solutions

Q1 From the core reading:

1.1 The consumer’s preferences

1.1.1 Definitions

“Utility” is the satisfaction that a consumer obtains from a particular course of action.
The amount of one good that a consumer is prepared to swap for one extra unit of
another good is known as the “marginal rate of substitution”.

An “indifference curve” joins all the consumption bundles of equal utility. The slope
of a consumer’s indifference curves will depend on his or her individual preferences
and is equal to the marginal rate of substitution.

A given combination of goods (e.g. two apples and five bananas) is called a
“consumption bundle”.

1.1.2 Assumptions and results

(i) A consumer can rank any two bundles.

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

(ii) Consumers prefer more of a good to less of it.

Therefore indifference curves slope downwards from left to right and

indifference curves further from the origin give higher utility.

(iii) Consumer preferences exhibit diminishing marginal rates of substitution.

This means that if it takes, say, n extra apples to persuade a consumer to give
up one banana, it will take more than another n extra apples to persuade her to
give up yet another banana. Indifference curves are “convex to the origin”.

1.2 The budget constraint

1.2.1 The assumptions

(i) The prices of the goods are fixed.

(ii) The consumer’s income is fixed.

These two assumptions determine which consumption bundles are affordable. The
budget line joins all points that a consumer can afford, assuming that all income is
spent.

Page 3
 Subject CT8 (Financial Economics Core Technical) – September 2015 – Examiners’ Report

1.3 How consumers choose

Economists assume that consumers’ choices exhibit rational behaviour. A rational

consumer will choose the consumption bundle that maximises his own utility. This is
the concept of utility maximisation.

1.4 Implications

Combining the budget line with indifference curves, we can determine the
consumption bundle which a consumer will choose. A rational consumer will choose
a consumption bundle such that the marginal rate of substitution is equal to the slope
of the budget line – that is, where the ratios of marginal utilities equal the ratios of
prices.

Well prepared students scored well on this bookwork question. Some

students confused consumer choice theory with expected utility theory but still
managed to score some marks. Several students wrote about efficient
portfolios and scored nothing.

Q2 (i) A(w) = U’‘(w) / U’(w) = 2c / (b+2cw)

R(w) = wU’‘(w) / U’(w) = 2cw/(b + 2cw)

(ii) For a gamble with an equal size gain or loss, the requirement that p ≥ 0.55
implies that the investor is risk averse. (Alternatively, they have increasing
absolute and relative risk aversion.)

(iii) With w =100, the (certain) utility if the gamble is rejected is:

(1) 610 = a + 100b + 10,000c

whereas the expected utility if the gamble is accepted with p = 0.55 is:

U(100) = 0.55 * U(120) + 0.45 * U(80)

=> 610 = 0.55 * (a + 120b + 14,400c) + 0.45 * (a + 80b + 6,400c)
(2) => 610 = a + 102b + 10,800c

With w =120, the (certain) utility if the gamble is rejected is:

(3) U(120) = a + 120b + 14,400c

whereas the expected utility if the gamble is accepted with p = 0.5625 is:

U(120) = 0.5625 * U(140) + 0.4375 * U(100)

=> U(120) = 0.5625 * (a + 140b + 19,600c) + 0.4375 * (a + 100b + 10,000c)
(4) => U(120) = 0.4375 * U(100) + 0.5625 * U(140) = a + 122.5b + 15,400c

Page 4
 Subject CT8 (Financial Economics Core Technical) – September 2015 – Examiners’ Report

Solving these gives:

a = (17,080 – 25 * U(120)) / 3
b = (U(120) – 610) / 9
c = (U(120) – 610) / 3,600

(iv) U’(w) = b + 2cw

U’(w) = 0 => w = b / 2c
b =  400c (from above) => w = £200

Early parts of this question were largely completed well, though some
students used the incorrect formulae despite them appearing in the
tables. Many students identified the simultaneous equations to solve, but only
the best students proceeded to solve them.

Q3 (i) A portfolio is efficient if the investor cannot find a better one in the sense that
it has a higher expected return with the same variance, or a lower variance
with the same expected return.

(ii) The assumptions are:

Investors are never satiated.

Investors dislike risk.

Investors select assets based on mean and variance of return only.

Mean return, variance (or standard deviation) and co-variances are known for
all assets.

(iii) E  xi Ei where Ei is the expected return on security i.

i

(iv) V  xi x j Cij where Cij is the covariance of the returns on securities i and j
i j
and we write Cii = Vi.

(v) With only two securities the variance is

V  xA2VA  (1  xA )2VB  2 xA (1  xA )C AB

Page 5
 Subject CT8 (Financial Economics Core Technical) – September 2015 – Examiners’ Report

Differentiating wrt xA gives

dV
 2 x AVA  2(VB  x AVB )  2(1  2 x A )C AB
dx A

 (2VA  2VB  4C AB ) xA  2VB  2CAB

Setting this to zero gives

VB  C AB
xA 
V A  VB  2C AB

Checking the second derivative shows that this is a minimum:

d 2V
 2VA  2VB  4C AB  0
dx A2

Generally well answered, though not all students stated the requirements for
an efficient portfolio in both directions.

Q4 (i) Arbitrage pricing theory (APT) is an equilibrium market model that does not
rely on the strong assumptions of the capital asset pricing model (CAPM).

APT requires that the returns on any stock be linearly related to a set of factor
indices as shown below

Ri = ai + bi,1 I1 + bi,2 I2 + ... + bi,L IL + ci (*)

where Ri is the return on security i, ai and ci are the constant and random parts
respectively of the component of return unique to security i, I1 ... IL are the
returns on a set of L indices,

bi,k is the sensitivity of security i to index k.

We have

E[ci] = 0,
E[cicj] = 0 for all i, j where i ≠ j,
and Cov(ci,I) = 0 for all stocks and indices.

Page 6
Subject CT8 (Financial Economics Core Technical) – September 2015 – Examiners’ Report

This is exactly the same as the multi-index model for returns on individual
securities. The contribution of APT is to describe how we can go from a
multi-index model for individual security returns to a equilibrium market
model. Non-mathematically, the argument can be made as follows. Consider a
two index model. The return on the ith security is given by
Ri = ai + bi,1 I1 + bi,2 I2 + ci .

For investors who hold well-diversified portfolios the specific risk of each
security, represented by ci can be diversified away so an investor need only be
concerned with expected return, bi,1 and bi,2 in choosing his portfolio.

Suppose we hypothesize the existence of three widely diversified portfolios,

represented by the points (Ei , bi,1, bi,2) in E  b1  b2 space where i = 1, 2, 3.
These three portfolios define a plane in E  b1  b2 space with equation
E[Ri] = λ0 + λ1 bi,1 + λ2bi,2 .

A portfolio having any combination of b1 and b2 can be formed by combining

portfolios 1, 2 and 3 in the correct proportions. For example the portfolio P,
obtained by taking one third each of each of 1, 2 and 3 would have:

bP,1 = (b1,1 + b2,1 + b3,1)/3,

bP,2 = (b1,2 + b2,2 + b3,2)/3,
and E[RP] = λ0 + λ1 bP,1 + λ2bP,2 . (**)

Now, consider what would happen if another portfolio Q existed, with exactly
the same values of b1 and b2 but a higher expected return. Both portfolios
would have the same degree of systematic risk but Q would have a higher
expected return than P. Rational investors would therefore sell P and buy Q,
and this would continue until the forces of supply and demand had brought
portfolio Q onto the same plane as portfolios 1, 2 and 3.

Thus, in equilibrium, all securities and portfolios must lie on a plane in

E  b1  b2 space.

(ii) Since IM is a traded index it must satisfy the formula (**). But the portfolio
consisting of just the index has bM,M = 1 and bM,C = 0
and has expected return λM
so we must have λ0 = 0.

(iii) We must have

R = bi,MIM + bi,C IC + ci, where ci is independent of IM and IC.

So,

Cov(R, IM) = bi,MVar(IM) + bi,C Cov(IM,IC) = 0.04bi,M  0.4 * 0.01 bi,C

= 0.02,

Page 7
 Subject CT8 (Financial Economics Core Technical) – September 2015 – Examiners’ Report

while Ei = bi,M λM + bi,C λC = 0.07 bi,M + 0.02bi,C = 0.09

so bi,M = 0.8235 and bi,C = 1.6176.

(iv) Cov(R, IC) = bi,M Cov(IM,IC) + bi,C Var(IC) = 0.8235 * -0.008 + 1.6176 * 0.01
= 0.0096.

Well prepared students scored well here. Many made mistakes in the
calculations or tried to apply formulae for the single-index case to the two-
factor model.

Q5 (i) Using Ito’s Lemma:

dlogSt = 1/StdSt – 1/(2 * St2)(dSt)2 = (µ – σ2/2)dt + σdZt

Integrating both sides gives

logSt = logS0 + (µ – σ2/2)t + σZt

=> St = S0 exp((µ – σ2/2)t + σZt)

So St is lognormal with parameters

(µ – σ2/2)t = 0.08t and σ2t = 0.04t

(ii) To find the initial investment we need the 60th percentile of logSt, which is:

P((logSt – 0.4) / √(0.2) < X) = 0.6

 X = 0.253
 logSt = 0.253 * √(0.2) + 0.4 = 0.51315
 St = 1.6705

So:

A = €20,000 / 1.6705 = €11,972

(iii) (a) Var(St) = exp(2µt)(exp(σ2t) – 1)

=> Var(10,000St) = (10,000)2exp(2µt)(exp(σ2t) – 1)
= (10,000)2 * exp(2 * 0.5)(exp(0.2)  1) = €2 60,183,509
=> SD = €7,758

Page 8
 Subject CT8 (Financial Economics Core Technical) – September 2015 – Examiners’ Report

(b) We need the 5th percentile of logSt, which is:

P((logSt – 0.4) / √(0.2) < X) = 0.05

 X = 1.645
 logSt = 1.645*√(0.2) + 0.4 = 0.335666
 St =0 .71486
So the VaR is €20,000 – (€10,000*0.71486) = € 12,851
Credit was also given for calculation of the 95th percentile of logSt,
which is:

P((logSt – 0.4) / √(0.2) < X) = 0.95

 X = 1.645
 logSt = 1.645*√(0.2) + 0.4 = 1.135666
 St = 3.11325
So the VaR is €20,000 – (€10,000*3.11325) = –€ 11,132

This question was surprisingly poorly answered. Many students derived the
correct distribution but few calculated the parameter values using the
numbers in the question. Many students struggled to calculate the Value at
Risk correctly.

Q6 (i) Let K be the forward price. Now compare the setting up of the following
portfolios at time 0:

A: one long forward contract.

B: borrow KerT cash and buy one share at S0.

If we hold both of these portfolios up to time T then both have a value of

ST  K at T.

By the principle of no arbitrage these portfolios must have the same value at
all times before T.

In particular, at time 0, portfolio B has value S0 – KerT which must equal the
value of the forward contract.

This can only be zero (the value of the forward contract at t = 0) if K = S0erT.

(ii) K = £5*e0.03+0.05+2*0.02 = £5.64

(iii) Consider at time t = 1 portfolio A = the forward and 5.64e0.09 cash, portfolio
B = one share.

These have equal value at t = 4, so must be equal at t = 1 by the principle of no

arbitrage.

Page 9
 Subject CT8 (Financial Economics Core Technical) – September 2015 – Examiners’ Report

So value of existing contract = 6 – 5.64e0.09 = £0.85

Part (i) was a standard proof that was largely well answered. In part (iii) some
students applied the risk-free rate to the share price or simply calculated the
value of a forward contract at time 1 using the £6 share price.

Q7 (i) Lower bound = max{0, S0 – KerT }= 10 – 12e0.04*5 = 0.175 = $0.18

Upper bound = S0 = $10

(ii) Trial and error gives volatility of 16%.

Sample values:

Volatility Option value

10% $0.97
15% $1.41
20% $1.84
25% $2.27
30% $2.69
35% $3.11
40% $3.51

(iii) (d1) = 0.59 so the hedge is 100 * 0.59 = 59 shares

and 100 * 1.5 – 59 * 10 = $440 short in cash.

Largely well-answered, though some students produced a negative lower

bound for the option price. Most students attempted to find sigma through
trial and interpolation, but some were let down by failing to interpolate
correctly.

Q8 (i) P(Y ≤ y) = P(F(X) ≤ y) = P(X ≤ F1(y)) = F(F1(y)) = y whenever 0 ≤ y ≤ 1.

(ii) St = S0 exp(σBt+ (r  ½σ2)t), where B is a standard Brownian motion under Q.

Hence Bt has a N(0,t) distribution under Q and so ln(St) has a

N(lnS0+ (r  ½σ2)t, σ2t) distribution under Q.

Page 10
 Subject CT8 (Financial Economics Core Technical) – September 2015 – Examiners’ Report

It follows that, using the values for the parameters given, ln(S2) has a
N(0.09596,0.0968) distribution under Q
and so a = 0.09596, b = 0.31113.

(iii) The fair price is V0: = EQ[e2rD2]

= E[100e.04U2]
where U is a U(0,1) random variable. Thus V0 = 100e.04  10 u 2 du
= 100e.04/3 = £32.03.

(iv) Now the fair price is V1: = EQ[e2rD21(U>0.5)]

= E[100e.04U21(U>0.5)]
where U is a U(0,1) random variable. Thus V1 = 100e .04  10.5 u 2 du
= 100e.04(1  0.125) / 3 = £28.02.

Few students managed to score more than a few marks here, and some
didn’t attempt the question or scored zero. Many students managed part (ii).

Q9 (i) The Merton model is a structural model for credit risk.

It assumes that the shareholders are entitled to net assets of the company after
redemption of the loan.

Gross assets are modelled as the share price in a Black-Scholes market

Thus, if Lt is the loan value at time t, Ft is the gross asset value, Et is the equity
value at time t and the loan matures at time T , then LT = min(L,FT), where L is
the nominal amount of loan.

It follows that Et is the value of a call option on the gross assets with strike L
and Ft = Et + Lt.

(ii) We know from (i) that E0 = EQerT(FT  L)+, where Q is the equivalent
martingale measure.

(iii) We know E0, L, r, T and σ so we only lack F0, the initial price in the Black-
Scholes formula for a call: E0 = F0Φ(d1)  LerTΦ(d2).

Answers will vary depending on the initial trial values chosen.

Trying F0 =15 gives E0 = 6.595

Trying F0 = 30 gives E0 = 20.619

Page 11
 Subject CT8 (Financial Economics Core Technical) – September 2015 – Examiners’ Report

Interpolating gives a value for F0 of 21.3258 which gives E0 = 12.272

Eventually we get F0 = 21.58

(iv) From (iii) we get that L0 = F0  E0 = 9.0696.

This implies a yield of ln(12.3/9.0696)/5 = 6.09%, which gives a credit spread

of 1.09%

Standard bookwork which was largely well answered. Some students

confused the Merton and Jarrow-Lando-Turnbull models. Many students
struggled to apply the bookwork to part (iii). The most common mistake was
to confuse the value of E0 and F0. Again some students failed to interpolate
between two values correctly.

Q10 (i)
t F(t  1,t) B(0,t) R(0,t) C(t)

0 - - - £100.00
1 2% £98.02 2.0% £102.02
2 4% £94.18 3.0% £106.18
3 3% £91.39 3.0% £109.42
4 5% £86.94 3.5% £115.03

i.e. (a) = 5%
(b) = £98.02
(c) = 3.0%
(d) = £109.42

(ii)
t F(t  1,t) B(0,t)

0 - -
1 - -
2 5% 95.12
3 4% 91.39
4 6% 86.07

The investor bought 10 bonds maturing at t = 2 and 20 bonds maturing at

t = 4, at a total cost of 10 * 94.18 + 20 * 86.94 = £2,680.60.

The bonds are now worth 10 * 95.12 + 20 * 86.07 = £2,672.60.

Profit is 2,672.60 – 2,680.60 = £8.00 (i.e. a loss of £8.00).

Page 12
Subject CT8 (Financial Economics Core Technical) – September 2015 – Examiners’ Report

(iii) Any portfolio consisting only of risk-free assets will return the risk-free rate of
interest if rates remain unchanged.

The investor would therefore need to invest in other risky assets, or assets
linked to another interest rate, in order to recoup her loss.

Well-prepared students scored full marks here, but a surprising number failed
to find all four values in part (i). Some students assumed interest was
compounded annually, which cannot be possible given the values in the table.

END OF EXAMINERS’ REPORT

Page 13
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

24 April 2015 (pm)

Subject CT8 – Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. Mark allocations are shown in brackets.

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

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT8 A2015 © Institute and Faculty of Actuaries

1 (i) State in words the four axioms of the Expected Utility Theorem. [4]

(ii) State the conditions for an investor to be non-satiated and risk neutral in terms
of their utility function, U(w). [2]

An investor makes investment decisions using utility function U(w) = (wg − 1) / g.

(iii) Derive the relative risk aversion function for U(w). [2]

(iv) Describe how the relative risk aversion of U(w) changes with w. [1]
[Total 9]

2 Consider an asset the annual return, X, on which has probability density function f(x).

(i) Define the 5% Value at Risk for this asset. [1]

(ii) Define the expected shortfall of the return on this asset below 2%. [2]

Assume X has a Normal distribution with mean µ = 5% and variance σ2 = 100%%.

(iii) Calculate the 5% Value at Risk. [2]

(iv) Discuss the limitations of using Value at Risk to measure the downside risk in
an investment portfolio. [2]
[Total 7]

3 A share is currently priced at 640p. A writer of 100,000 units of a one year European
put option with an exercise price of 630p has delta-hedged the option with a portfolio
which holds cash and is short 24,830 shares. The continuously compounded risk-free
rate of interest is 3% p.a. and no dividends are payable during the life of the option.

The assumptions of the Black-Scholes model apply.

(i) (a) Write down an expression for the delta of the option.

(b) Calculate its value in this case. [4]

(ii) Prove that the volatility of the share implied by the delta is 7.1% p.a.
(assuming it is less than 100%). [5]

(iii) (a) Calculate the price of the option.

(b) Determine the value of the cash holding in the hedging portfolio. [4]
[Total 13]

CT8 A2015–2
4 Suppose that X is an AR(1) process given by the equation:

Xt+1 = 0.75Xt + 0.25et+1

where the en are independent, identically distributed N(0,1) random variables

independent of X0.

(i) (a) State the distribution of Xt+1 conditional on the value of Xt .

(b) Show that the distribution of Xt+s conditional on the distribution of Xs

is N(0.75tXs, 0.252 + 0.254 +…+ 0.252t). [3]

(ii) (a) Show that the distribution of Xt converges to a stationary distribution.

(b) State this distribution. [2]

The process ln(Yt), with Yt the multiplicative increase in a retail price index in year t,
is believed to be an AR(1) process with the same parameters as X above.

(iii) Determine E[Y3|Y0 = 1.21]. [3]

(iv) Determine the long-run mean annual increase in the retail price index. [3]
[Total 11]

5 Let (Xt; t ≥ 0) be a stochastic process satisfying dXt = μtdt + st dWt where Wt is a

standard Brownian motion.

Let f(t,x) be a function, twice partially differentiable with respect to x, once with
respect to t.

(i) State the stochastic differential equation for f(t, Xt). [2]

Let dXt = lXtdt + sdWt .

(ii) Solve this differential equation, by considering Xt = Utelt or otherwise. [6]

[Total 8]

CT8 A2015–3 PLEASE TURN OVER

6 Consider a non-dividend paying share with price St at time t.

(i) State and prove the put-call parity relationship for this share. [5]

Two options written on this share have the following characteristics:

1. a European call option maturing in two years, strike price $10.15, option price
$3.87

2. a European put option maturing in two years, strike price $10.15, option price
$0.44

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

(ii) Calculate the share price implied by the option prices. [2]

(iii) Determine the implied volatility of the share to the nearest 1%. [5]
[Total 12]

7 (i) Define delta, gamma and vega for an individual derivative. [3]

A bank is considering selling a European call option on a share, and wants to hedge
some of its risk. The share is non-dividend paying and has the following properties:

Strike price = $50

Option price = $17.91
Underlying share price = $60
Volatility = 25% p.a.
Time to expiry = 3 years

The continuously compounded risk-free rate of interest is 3% p.a. and the vega for
this option is $29.00.

(ii) Calculate delta for this option. [1]

(iii) Identify a delta-hedged replicating portfolio using the share and the risk-free
asset. [2]

Assume that the volatility has instantaneously increased to 27% p.a., with everything
else except the option price remaining the same.

(iv) Estimate the new option price. [2]

[Total 8]

CT8 A2015–4
8 (i) State the main assumptions of mean-variance portfolio theory. [3]

There are only three assets available on a stock exchange:

Asset 1, expected return 2%, standard deviation 4%

Asset 2, expected return 4%, standard deviation 12%
Asset 3, expected return 3%, standard deviation 8%

The correlation between the returns on assets 1 and 3 is 0.75. The return on asset 2 is
uncorrelated with the returns on the other two assets.

An investor in this market wants to minimise the variance of his portfolio.

(ii) Determine the Lagrangian function that can be used to find the minimum
variance portfolio for a given expected return. [3]

Let xi denote the weight of asset i (i = 1, 2, 3) in the minimum variance portfolio with
an expected return of 4%.

(iii) Show, by taking partial derivatives of the Lagrangian function in part (ii), that:

x1 = –0.45, x2 = 0.55, x3 = 0.9. [4]

(iv) Comment on how the portfolio would change if short-selling was not allowed.
[1]
[Total 11]

9 (i) Outline the three types of credit risk model. [3]

(ii) Describe how the Merton model can be used to estimate the risk-neutral
probability of default. [2]

Let r be the constant continuously compounded risk-free rate and d be the constant
recovery rate for a defaultable zero-coupon bond in a two state model for credit rating
with a deterministic transition intensity.

(iii) State the formula for the bond price. [1]

(iv) Determine the risk-neutral default intensity if the zero-coupon bond price is
given by:

B(t,T) = e−r(T−t) [1 − (1 − d)(1 − exp{−(T3 − t3)/6})]. [2]

(v) Calculate the fair price of an insurance contract which pays £1,200,000
after two years if the bond defaults in the first year and the continuously
compounded risk-free rate is 2% p.a. [3]
[Total 11]

CT8 A2015–5 PLEASE TURN OVER

10 There are two risk-free zero coupon bonds trading in a market, Bond X and Bond Y.

The short-rate of interest, rt, follows a Vasicek model:

drt = a(m − rt)dt + sdWt

where Wt is a standard Brownian motion.

(i) Write down the formula for the price of a risk-free zero coupon bond at time t,
with bond maturity at time T, under the Vasicek model. [3]

In this market the parameters for the Vasicek model are a = 0.5, µ = 4% and s = 10%.
The short-rate at time 0, r(0), is 2% p.a. Bond X matures at time 1, and Bond Y
matures at time 3. Both bonds are for a nominal value of $100.

(ii) Calculate the fair price of Bond X. [3]

Bond Y has a fair price at time 0 of $90.

(iii) Derive the market-implied risk-free spot rate of interest with maturity 3 years.
[2]

(iv) Derive the market-implied risk-free forward rate of interest from time 1 to
time 3. [2]
[Total 10]

END OF PAPER

CT8 A2015–6
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2015 examinations

Subject CT8 – Financial Economics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context at the date the
examination was set. Candidates should take into account the possibility that circumstances
may have changed if using these reports for revision.

F Layton
Chairman of the Board of Examiners

June 2015

 Institute and Faculty of Actuaries

 Subject CT8 (Financial Economics Core Technical) – April 2015 – Examiners’ Report

1 (i) 1. Comparability

An investor can state a preference between all available certain outcomes.

2. Transitivity

If A is preferred to B and B is preferred to C, then A is preferred to C.

3. Independence

If an investor is indifferent between two certain outcomes, A and B, then

he is also indifferent between the following two gambles:

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

(ii) B with probability p and C with probability (1  p).

4. Certainty equivalence

Suppose that A is preferred to B and B is preferred to C. Then there is a

unique probability, p, such that the investor is indifferent between B and a
gamble giving A with probability p and C with probability (1  p). B is
known as the certainty equivalent of the above gamble.

(ii) Non-satiated: U ( w)  0
Risk neutral: U ( w)  0

(iii) R(w) =  wU ( w) / U ( w)

=1ɣ

(iv) R( w) = 0 so the relative risk aversion is constant; “iso-elastic” is also

acceptable.

This question was generally well-answered.

2 (i) VaR = t where P(X < t) = 5%

(ii) Expected shortfall = E[max(2%  X, 0)]

2%
=  (2%  x) f ( x)dx


(iii) P(X < t) = 5% where x ~ N(5, 100)

 P(Z  (t  5) / 10) = 5%
 (t  5) / 10 = 1.645
 t = 11.45%

Therefore the 5% VaR is t = 11.45%.

Page 2
 Subject CT8 (Financial Economics Core Technical) – April 2015 – Examiners’ Report

(iv) VaR does not illustrate the size of the loss in the tail of the distribution, only
the likelihood.

The usefulness of VaR may be limited by a lack of data to determine the tail of
the distribution.

This question was relatively poorly answered for such a standard. Many candidates confused
the 5th and 95th percentiles. In part (iv) some students mentioned that VaR calculations often
assume a normal distribution, which was not relevant in the context of downside risk and
gained no marks.

3 (i) (a) Let f denote the price of a put option,

then d1 = (ln(S0/K) + (r + ½2)T)/ T
and then  =  ( d1) =  (d1)  1.

(b) In this case, we must have 100,000= 24,830 and so  = 0.25

(ii)  = .2483 and so d1 = 0.68. It follows (rearranging the expression for d1)
that (.01575 + .03 + 0.52) = 0.68. Solving the quadratic equation we obtain
 = 0.68  0.3709 = 0.07098 = 7.1% (choosing the root less than 1).

(iii) We need to calculate K erT(d2) = er(d1 + T )

= 630e0.03 (0.609)p = 630e0.03 * 0.2712 = 165.806p.

Clearly the option price is 165.806  24830 * 640/100,000 = 6.894p.

and the value of the cash holding is 100,000 * 165.806p = £165,806

This question was relatively poorly answered for such a standard question. Few candidates
scored on part (i)(a) or seemed to realise that the delta of a put must be negative.

4 Regrettably, there was a mistake on the paper, giving an incorrect formula for the
variance of Xt. Candidates were not penalised for this as they were credited with the
greater of their actual score on this question and their average mark for the other
questions on the paper.

The calculations are given both for the incorrect formula and the correct one.

The formula for the distribution of Xt+s should be:

N(0.75tXs, (0.752(t1) + 0.752(t2)…+1).252)

Since this is in the question the answers are given following through the mistake and
the correct answers afterwards in italics (except for (i)(b) itself).

Page 3
 Subject CT8 (Financial Economics Core Technical) – April 2015 – Examiners’ Report

(i) (a) Conditional on Xt, Xt+1 is normal, and has mean 0.75Xt and variance
0.252Var(et+1)= 0.252

(b) CORRECT ANSWER: By induction: true for t = 1, then if the statement

is true for t = n (and all s) then Xn+1+s is N(0.75nXs+1, (0.752(n1) +
0.752(n2)…+ 1).252), conditional on Xs+1 and Xs+1 is N(0.75Xs, 0.252)
conditional on Xs, so Xn+1+s is N(0.75n+1Xs, 0.252 + 0.752 (0.752(n1) +
0.752(n2)…+ 1).252) conditional on Xs, establishing the inductive step.

(ii) (a) Taking the answer from part (i)(b), we see that the mean converges
and so does the variance, so the distribution converges to a Normal.

(b) The mean tends to 0 and the variance tends to (.25)2/(1  (.25)2)
= 1/15, so the limiting distribution is N(0,1/15).

CORRECT ANSWER … the variance tends to (.25)2/(1  (.75)2) = 1/7,

so the limiting distribution is N(0,1/7)

(iii) Conditional on Y0, logY3 is N(0.753logY0, 0.252 +…+0.252*3) = N(0.08042,

.06665)

So E[logY3|Y0 = 1.21] = 0.753log 1.21 = 0.08042 and

Var(logY3|Y0 = 1.21) =.06665.

Thus E[Y3|Y0 = 1.21] = exp(0.08042 + ½ * 0.06665) = 1.12047.

CORRECT ANSWER
Conditional on Y0, logY3 is N(0.753log Y0, (0.754+0.752+1).252))=N(0.08042,
0.11743)
So E[logY3|Y0 = 1.21] = 0.253log1.21 = 0.08042 and Var(logY3|Y0 = 1.21) =
0.11743.
Thus E[Y3|Y0 = 1.21] = exp(0.08042 + ½ * 0.11743) = 1.14928.

(iv) The long-run distribution is logNormal(0, 0.252/(1  0.252)) =

logNormal(0, 0.06667), so the long-run mean annual increase is e½*0.06667
= 1.033895 or 3.3895%.

CORRECT ANSWER
The long-run distribution is logNormal(0, 0.252/(1  0.752))
= logNormal(0, 0.14285), so the long-run mean annual increase is
e½*142851=1.07404 or 7.404%.

Page 4
 Subject CT8 (Financial Economics Core Technical) – April 2015 – Examiners’ Report

5 (i)

This is actually from Taylor’s formula and the last line alone would have
scored full marks. Versions involving the integrals would also have scored full
marks.

(ii) Consider Xt = Uteλt.

Then dUt = d(eλtXt)

= λeλtXtdt + eλtdXt

= λeλtXtdt + eλt(λXtdt + σdWt) = σeλtdWt

t
So U t  U 0   e λs dWs
0
t
So X t  e U t  e X 0   e   dWs
λt λt λ t s

This question was generally well-answered. However many candidates showed an eccentric
use of stochastic calculus in part (ii).

6 (i) Consider two portfolios:

A: one call plus cash of Ker(Tt).

B: one put plus one share.

Both portfolios have a payoff at the time of expiry of the options of

max{K, ST}.

Page 5
 Subject CT8 (Financial Economics Core Technical) – April 2015 – Examiners’ Report

Since they have the same value at expiry and since the options cannot be
exercised before then they should have the same value at any time t < T, by
no-arbitrage: that is

ct + Ker(Tt) = pt + St

(ii) Put call parity implies a security price of $12.80.

(iii) Trial and error yields a volatility of 26%.

Sample values:

Volatility Call value

10% $3.44
15% $3.50
20% $3.64
25% $3.83
30% $4.05
35% $4.29
40% $4.54

This question was generally well-answered. However it is a cause for concern that many
candidates were unable to calculate the implied volatility.

7 (i) Denote the individual derivative by f and assume this is written on an

underlying security S

Delta = f/S
Gamma = 2f/S2
Vega = f/σ

(ii) Delta = 0.801

(iii) The hedge is delta = 0.801 shares = and 17.91 – 0.801 * 60 = $30.15 short in
cash.

(iv) Using the approximation f(S, σ + δ) ≈ f(S, σ) + δdf/dσ, we obtain an option

price ≈ 17.91 + 29.00 * 0.02 = $18.49.

This question was generally well-answered. Very few candidates seemed to be able to use the
Vega to perform the approximation in part (iv) and instead opted to recalculate the option
price using the Black-Scholes formula. This still scored full marks if done correctly, but was
time-consuming and unnecessary.

Page 6
 Subject CT8 (Financial Economics Core Technical) – April 2015 – Examiners’ Report

8 (i) Investors select their portfolios on the basis of the expected return and the
variance of that return over a single time horizon.

The expected returns, variance of returns and covariance of returns are known
for all assets and pairs of assets.

Investors are never satiated. At a given level of risk, they will always prefer a
portfolio with a higher return to one with a lower return.

(ii) Let the proportion invested in asset i, be xi, with expected return Ei, variance
Vi and correlation ρ12. Let E be the return on the portfolio of the three assets
and let λ and μ be Lagrange multipliers.

Then, the Lagrangian function W satisfies:

3
W  xi 2Vi  21313 x1x3  ( E1x1  E2 x2  E3 x3  E )  ( x1  x2  x3  1)
i 1

 16 x12  144 x2 2  64 x32  48 x1 x3  (2 x1  4 x2  3 x3  E )  ( x1  x2  x3  1)

W W
(iii)  32 x1  48 x3  2     0  288 x2  4     0
x1 x2

W
 128 x3  48 x1  3    0
x3

Substituting the values given for xi, we obtain three equations for λ and μ,
solving these gives λ =64.8 and μ = 100.8 and we can check that these
values satisfy the constraints.

(iv) Without short selling, the only way to get an expected return of 4% is to invest
wholly in asset 2.

This question was generally answered quite well. Well answered on part (i) but many
students listed all assumptions rather than the main ones. Part (ii) was well answered but
some students did not know the formula for the Lagrangian function or the variance for the
portfolio of three assets. Many students took the “show” instruction in part (iii) to mean
prove by solving the equations rather than “verify” and spent a considerable amount of time.
Few scored on part (iv) with many making vague comments about the variance changing.

Page 7
 Subject CT8 (Financial Economics Core Technical) – April 2015 – Examiners’ Report

9 (i) The three types of credit risk model are:

 structural models: these are explicit models of a corporate entity issuing

both debt and equity. They aim to link default events explicitly to the
fortunes of the issuer.

 reduced-form models: these are statistical models which use market

statistics (such as credit ratings) rather than specific data relating to the
issuer, and give statistical models for their movement.

 intensity-based models: these model the factors influencing the credit

events which lead to default and typically do not consider what triggers
these events.

(ii) In the Merton model, the company is modelled as having a fixed debt, L and
variable assets Ft. This means the equity holders can be regarded as holding a
European call on the assets with a strike of L. It follows from the Black-
Scholes model that we can deduce the (risk-neutral) default probability from
the share price.

(A correct quantitative answer was also rewarded.)

(iii) In the two state model for credit rating with deterministic transition intensity,
the formula for the zero coupon bond price is

B(t,T) = er(Tt) (1  (1  δ) (1  exp(   Tt  ( s ) ds ))).

(iv) It follows that the risk-neutral default intensity is given by λ(s) = s2/2.

(v) The fair price is

1.2exp(2r) (1  exp(   10  ( s )ds )) = 1.2e.04(1  e1/6) = £176,998.

There has been an average performance on this question. Many candidates seem unfamiliar
with this standard material. Many candidates did not know the formula for the bond price
with deterministic, but varying, transition intensity. Some candidates only listed the three
forms of credit model and others struggled with part (iv). Some also ended up with answers
for (v) in terms of delta, and/or (T  t), demonstrating a lack of competence with simple
differentiation.

Page 8
 Suubject CT8 (Financial
(F Ecconomics Coore Technical) – April 20
015 – Exam
miners’ Repo
ort

10 (i)

(ii) τ =1

b(τ)) = (1 – exp(0.5
e * 11)) / 0.5 = 0.7869
0

a(τ)) = (0.7869 – 1) * (00.04 – 0.12/((2 * 0.52)) – 0.12/ (4 * 00.5) * 0.786

692
= 0.00
074

B(0,1) = 100 * exp(0.00 74 – 0.7869

9 * 0.02) = 100 * 0.97772 = $97.72
2

1
(iii) R(t , T )  n B(t , T ) for t  T
ln
T t

R(0,3) = 1/(3  0) * ln(0..9) = 3.51%

%

1 B(t , T )
(iv) F (t , T , S )  ln for t  T  s
S  T B(t , S )

F(0,1,3) = 1/(3  1) * ln(997.72/90) = 4.11%

Candiddates perform med very po oorly indeedd on this qu

uestion. Many people trried to derive the
formulaa from first principles
p for
f part (i) pproducing many
m pages of workingg for no cred
dit.
Since thhere is a verrsion of the formula
f in the tables, this is even more wasteeful. A reassonable
numberr of candidaates scored the t easy maarks in part (iii). Less realised
r the opportunityy in part
(iv).

END
D OF EXA
AMINER
RS’ REPORT

Page 9
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

30 September 2014 (am)

Subject CT8 – Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. Mark allocations are shown in brackets.

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

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT8 S2014 © Institute and Faculty of Actuaries

CT8 exam paper September 2014

Please note, regarding Question 9: The five marks for part (v) of
Question 9 should have been split as two marks for part (iv) and
three marks for part (v).
1 Outline consumer choice theory. [9]

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

manufacturing company M. The investor believes that returns on shares in S have
mean 10% and variance 16%% while returns on shares in M have mean 8% and
variance 25%%. The correlation between the two companies is 0.3.

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

theory.

(i) Explain which company’s share she would prefer. [2]

Assume the investor’s preferences are described by a standard quadratic utility

function.

(ii) State which assumption of the mean-variance portfolio theory can be relaxed.
[1]

(iii) Calculate the expected return and the standard deviation of a portfolio which is
invested three quarters in S and one quarter in M. [2]

(iv) Calculate the minimum variance portfolio. [2]

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

(v) Describe the effect this will have on portfolios composed of M and S,
including the minimum-variance portfolio. [3]
[Total 10]

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

(i) Calculate the probability of the event that Z1 > 0 and Z 2 < 0. [5]

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

distributed N(0,1) random variables.

(ii) State the model for geometric Brownian motion. [1]

(iii) Explain why the standard Brownian motion is less suitable than the geometric
Brownian motion as a model of stock prices. [2]
[Total 8]

CT8 S2014–2
4 A non-dividend paying stock currently trades at $65. Every two years the stock price
either increases by a multiplicative factor 1.3, or decreases by a multiplicative factor
0.8. The effective risk-free rate is 4% p.a.

Calculate the price of an American put option written on the stock with strike price
$70 and maturity four years, using a two period binomial model. [9]

5 Let S be the price of a non-dividend paying share, and let r be the continuously
compounded risk-free rate.

(i) Derive the forward price at time zero for the forward contract on S with
maturity T. [4]

Assume that, at time zero, the share price is 500, and that the forward contract has
maturity two years. The share pays a dividend of 5% of the share price every six
months with the next dividend due in two months, and the continuously compounded
risk-free rate is 3% p.a.

(ii) Determine the forward price for this contract. [4]

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

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

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

arbitrage-free model. [2]

Consider a specific bond with maturity T1, suppose its price satisfies the following
Stochastic Differential Equation (SDE) under the real-world probability measure P:

dB(t,T1) = B(t,T1)[m(t,T1)dt + S(t,T1)dW(t)]

where W is a standard Brownian Motion, m(t, T1) is the drift and S(t, T1) is the
volatility.

(ii) (a) State the market price of risk.

(b) Explain what it represents.

(c) Show how it can be used in transforming the SDE above from the real-
world probability measure P to a risk-neutral probability measure Q.
[4]

(iii) Show how the above results would be used in calculating zero-coupon bond
prices. [3]

(iv) Explain how this is typically done in practice. [2]

[Total 11]

CT8 S2014–3 PLEASE TURN OVER

7 Let B be a standard Brownian motion.

(i) Derive the probability density function of max0≤s≤t (Bs+ μs), where μ is a
constant, using the formula in section 7.2 of the Actuarial Formulae and
Tables. [3]

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

(ii) Give the expression for the fair price at time t of a derivative written on S
paying an amount DT at time T, defining any terms you use. [3]

Suppose that S has an initial price of S0 = £1.20 and a volatility σ = 30% p.a. and that
the continuously compounded risk-free rate is r = 3% p.a.

(iii) Calculate the fair-price at time zero of the derivative paying £10 at time T = 2
if and only if max0≤s≤T (Bs + μs) > £1.44. [4]
[Total 10]

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

(i) Define delta. [1]

Suppose that the stock price at time zero is S0 = $100, the continuously compounded
risk-free rate is 3% and that a European call option written on S with strike price
$109.42 and maturity t = 1 year has a delta of Δ = 0.42074.

(ii) Find the implied volatility of the stock to the nearest 1%. [3]

An exotic option written on S with strike prices K1 and K2 and exercise times τ and T
is defined as follows:

• The option may be exercised at time τ in which case the holder receives $100 if
and only if the price of the underlying, Sτ is at least K1.

• If the option is not exercised at time τ, then the holder will receive an amount c if
and only if the price at expiry T, ST, satisfies ST / Sτ ≥ K2.

(iii) Explain why, if c ≤ $100, the option will always be exercised at time τ when
Sτ is at least K1. [2]

(iv) Give a formula for the value of the option just after the first exercise time τ
(i.e. just after the first exercise option has expired). [2]

(v) Explain why this value does not depend on the stock price at time τ. [2]

Suppose that K1 = $10, K2 = e−0.09, τ = 1 year, T = 2 years and c = $200.

(vi) Determine the fair price of the exotic option just after time one and hence at
time one and at time zero. [3]
[Total 13]

CT8 S2014–4
9 A company has issued a loan in the form of a zero-coupon bond which redeems in one
year from now. The bond is priced at £92.78 per £100 nominal and the recovery rate
in the event of a default is assumed to be 50%. The continuously compounded risk-
free rate for one year is 3% p.a.

(i) Write down the formula for the bond price under the two-state model, defining
all the terms used. [2]

(ii) Calculate the risk-neutral probability that the bond defaults. [3]

Assume that the Merton model holds and that the annual volatility of the company’s
total assets is 13%.

(iii) Give an expression for the risk-neutral probability that the company defaults,
defining any other terms you use. [3]

(iv) Calculate the ratio of nominal loan to total asset value, assuming that the risk-
neutral default probability is the same as calculated in (ii).

(v) Calculate the ratio of loan value to total asset value and hence determine the
percentage of total assets represented by equity value at time zero. [5]
[Total 13]

10 (i) (a) Describe the lognormal model for securities prices including the
definition of the parameters used.

(b) State the corresponding mean and variance for the security price. [4]

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

S0 = €200. The expected price at time 1 (in years) is E(S1) = 200e0.4 and the variance
is Var(S1) = 40000e−0.4.

(ii) Determine the parameter values for the corresponding lognormal model. [3]
[Total 7]

END OF PAPER

CT8 S2014–5
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2014 examinations

Subject CT8 – Financial Economics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context at the date the
examination was set. Candidates should take into account the possibility that circumstances
may have changed if using these reports for revision.

F Layton
Chairman of the Board of Examiners

November 2014

 Institute and Faculty of Actuaries

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

General comments on Subject CT8

Subject CT8 introduces the main concepts and principles of financial economics. These are
developed in later subjects in the ST series of exams. This subject combines various types of
skills. In particular, along with CT7, it is one of the first where candidates are expected to
write lengthy passages of reasoned thought, rather than just complete calculations. This is a
skill that will be new to many, and candidates are advised to pay particular attention to the
answers to this type of question by studying many past papers.

Comments on the September 2014 paper

The general performance was good. Candidates found some questions challenging, but well-
prepared candidates scored consistently across the whole paper. As in previous diets,
questions that required an element of application of the core reading to situations that were
not immediately familiar proved more challenging to most candidates. A significant number
of candidates failed to read some questions carefully enough to identify the relevant section
of the course being examined.

Page 2
 Subject CT8 (Financial Economics Core Technical) – September 2014 – Examiners’ Report

1 The traditional theory of consumer choice has three main elements:

(i) the consumer’s preferences

(ii) the budget constraint
(iii) how the consumer decides which consumption bundle to choose

(i) The consumer’s preferences

Definitions

“Utility” is the satisfaction that a consumer obtains from a particular course of

action.

The amount of one good that a consumer is prepared to swap for one extra unit
of another good is known as the “marginal rate of substitution”.

An “indifference curve” joins all the consumption bundles of equal utility.

The slope of a consumer’s indifference curves will depend on his or her
individual preferences and is equal to the marginal rate of substitution.

A given combination of goods (e.g. two apples and five bananas) is called a
“consumption bundle”.

Assumptions and results

(a) A consumer can rank any two bundles.

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

(b) Consumers prefer more of a good to less of it.

Therefore indifference curves slope downwards from left to right and

indifference curves further from the origin give higher utility.

(c) Consumer preferences exhibit diminishing marginal rates of

substitution.

(ii) The budget constraint

The assumptions

(a) The prices of the goods are fixed.

(b) The consumer’s income is fixed.

These two assumptions determine which consumption bundles are affordable.

The budget line joins all points that a consumer can afford, assuming that all
income is spent.

Page 3
 Subject CT8 (Financial Economics Core Technical) – September 2014 – Examiners’ Report

(iii) How consumers choose

Economists assume that consumers’ choices exhibit rational behaviour. A

rational consumer will choose the consumption bundle that maximises his own
utility. This is the concept of utility maximisation.

Implications

Combining the budget line with indifference curves, we can determine the
consumption bundle which a consumer will choose. A rational consumer will
choose a consumption bundle such that the marginal rate of substitution is
equal to the slope of the budget line – that is, where the ratios of marginal
utilities equal the ratios of prices.
[9]

This question was generally well answered by candidates who knew the bookwork on
consumer choice theory. A significant minority of candidates wrote about behavioural
finance (sometimes many pages) and scored few, if any, marks.

2 (i) S has a higher return and a lower variance so is preferable in a mean-variance

framework. [2]

(ii) You can relax the assumption that investors solely select their portfolios on the
basis of the expected return and variance of that return. [1]

(iii) E[P] = 0.75 × E[S] + 0.25 × E[M] = 9.5%

Var(P) = 0.752 Var(S) + 0.252 Var(M) + 2 × 0.75 × 0.25 × 4 × 5 × 0.3

= 12.8125%%

So standard deviation (P) = (12.8125) = 3.57945% [2]

(iv) The amount invested in S, xS , will be,

VM  CSM 25  4 5  0.3
xS    0.655173
VS  2CSM  VM 16  2  4  5  0.3  25

invested in S, and so 0.344828 invested in M. [2]

(v) The study suggests that the correlation between M and S will increase.

This means that portfolios containing positive amounts of M and S will have a
higher variance.

Page 4
 Subject CT8 (Financial Economics Core Technical) – September 2014 – Examiners’ Report

If the correlation increases, then the minimum variance portfolio will contain
relatively higher amounts of S and relatively lower amounts of M. [3]
[Total 10]

Generally well answered. A surprising number of candidates went about deriving the
proportion of assets in the minimum variance portfolio from first principles. A number of
candidates also weren’t able to calculate the variance of a linear combination of correlated
random variables. Part (v) required thinking beyond the core reading, and the better
candidates scored here.

3 (i) One possible answer is as follows (other acceptable proofs could score full
marks):

We need:

W 0 ,
W  X  0  X  0 and abs( X )  abs(W )

The probability of each of these inequalities is 0.5,

and they are all independent.

Therefore the overall probability is 1/8. [5]

(ii) St  e At  Zt

Where A,  and  are constants and Z t is the standard Brownian motion. [1]

(iii) However successful the Brownian motion model may be for describing the
movement of market indices in the short run, it is useless in the long run, if
only for the reason that a standard Brownian motion is certain to become
negative eventually.

It could also be pointed out that the Brownian model predicts that daily
movements of size 100 or more would occur just as frequently when the
process is at level 100 as when it is at level 10,000. [2]
[Total 8]

Many candidates found part (i) challenging, and skipped to other questions without having a
go at parts (ii) and (iii), which presented an opportunity for some relatively easy marks.

4 As the option is an American put, it may be optimal to exercise early and we have to
test at each node on the binomial tree.

First let us calculate the value of the European put option at each node starting from
expiry (the value of the American option is then the maximum of the value of the
European option and the intrinsic value at any node).

Page 5
 Subject CT8 (Financial Economics Core Technical) – September 2014 – Examiners’ Report

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

1.042  0.8
q  0.5632 .
1.3  0.8

The value of the option payoff for the European options at t = 4 is given by:

Stock price Option payoff

SUU = 65 ×1.032 = 109.85 0

SUD = SDU = 65 × 1.03 * 0.8 = 67.6 $2.40
SDD = 65 × 0.82 = 41.6 $28.40

The value of the European option, and hence American options at time t = 2 are then:

Stock price American option payoff Value of European option at

at t = 2 t=2

SU = 65*1.03 = 84.5 0 $0.97

SD = 65* 0.8 = 52 $18 $12.71

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

Finally, the value at time zero is

Max($5, (0.5632 × $0.97 + (1  0.5632) × $18)/1.042) = $7.77

[9]

Generally well answered. Most candidates realised that you can exercise an American
option early, but few managed to adjust the option price appropriately to allow for
this. Some candidates also slipped up over the two-year time steps.

5 (i) One possible answer is as follows (other acceptable proofs could score full
marks):

Let K be the forward price. Now compare the setting up of the following
portfolios at time 0:

A: one long forward contract.

B: borrow K exp(rT) cash and buy one share at S0.

If we hold both of these portfolios up to time T then both have a value of

ST − K at T.

Page 6
 Subject CT8 (Financial Economics Core Technical) – September 2014 – Examiners’ Report

By the principle of no-arbitrage these portfolios must have the same value at
all times before T.
In particular, at time 0, portfolio B has value S0 – K exp(−rT) which must
equal the value of the forward contract.

This can only be zero (the value of the forward contract at t = 0) if

K = S0 exp(rT). [4]

(ii) Similarly consider two portfolios:

A: one long forward contract

B: long 1.054 units of the share and short K * exp(0.06) in cash

Following similar logic to part (i), with the dividend being reinvested in the
share at each dividend date we find that no arbitrage implies that the fair
forward price K = 500 exp(0.06) 1.054 = 436.79. [4]

(iii) This does not provide an arbitrage opportunity since the dividend is not risk-
free (and if the share price dropped significantly so would the dividend
amount, even if the yield remained the same). [2]
[Total 10]

Part (i) was well answered. In part (ii) many candidates made a decent attempt at allowing
for dividends, but few got to the right answer. A surprising number of candidates thought
that a high dividend yield presented an arbitrage opportunity, failing to appreciate that
dividends are not risk-free.

6 (i) We have started off with a process for r(t) which is not a tradable asset. An
arbitrage opportunity must relate to trading an asset, therefore arbitrage-free
models must allow for trading. [2]

(ii) (a) The market price of risk is defined as:

m(t , T1 )  r (t )
 (t , T1 )  .
S (t , T1 )

(b) γ(t,T1) represents the excess expected return over the risk-free rate per
unit of volatility in return for an investor taking on this volatility.

(c) With this identity we find that for all t < T

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

= B(t,T)[(r(t) + (t)S(t,T))dt + S(t,T)dW(t)]

= B(t,T)[r(t)dt + S(t,T)(dW(t) + (t)dt)]

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

= B(t,T)  r (t ) dt  S (t , T )dW (t ) 
where dW (t ) = dW(t) + (t)dt is the standard Brownian motion
under Q. [4]

(iii) For a one-factor model we have seen above the broad principal which
transforms from P to Q. In order to say more about the basic price processes
we must look at the effect of this transformation on r(t).

Thus

dr(t) = a(t,r(t))dt + b(t,r(t))dW(t) under P

= a(t,r(t))dt + b(t,r(t))  dW (t )   (t ) dt 

= (a(t,r(t))  (t)b(t,r(t)))dt + b(t,r(t)) dW (t )

= a(t , r (t ))dt  b(t , r (t ))dW (t )

where a(t , r (t )) = a(t,r(t))  (t)b(t,r(t)).

The final two lines give us the dynamics of r(t) under the artificial measure Q.

We then use this to determine:

 
B(t,T) = EQ exp    r (u )du  t 
T

  t  

for specific models. [3]

(iv) When modellers use this approach to pricing, from the practical point of view
they normally start by specifying the dynamics of r(t) under Q in order to
calculate bond prices. Second, they specify the market price of risk as a
component of the model, and this allows us to determine the dynamics of r(t)
under P. [2]
[Total 11]

Part (i) was generally well answered, but very few candidates managed parts (iii) and (iv)
which were largely bookwork. Quite a few candidates tried solving the SDE for the log of the
ZCB price with no mention of transforming to the risk neutral probability measure.

Page 8
 Subject CT8 (Financial Economics Core Technical) – September 2014 – Examiners’ Report

7 (i) Let M = max0≤s≤t (Bs+ μs), then

P(M > y) = Φ((μt  y)/√t) + e2μy Φ((y μt)/√t).

It follows that M has density f given by

f(y) = ∂f/∂y

= φ((μt  y)/√t)/√t  2μ e2μy Φ((y  μt)/√t) + e2μy φ((μt  y)/√t)/√t,

where φ is the standard normal density: it follows after a little algebra that

f(y) = 2φ((μt  y)/√t)/√t  2μ e2μy Φ((y  μt)/√t). [3]

(ii) The fair price is er(Tt) EQ [Dt t ] ,

where Q is the unique risk-neutral (or equivalent martingale) measure, r is the

risk-free rate and  is the filtration. [3]

(iii) Under the EMM, Q, we have:

St /S0  log N(r  0.5σ2)t,σ2t)

and St /S0= exp((r  0.5σ2)t + σBt)

The value of the derivative is contingent on:

P  max( Bs  s )  1.44 
 0 st 

Comparing the Bs + s part of this expression with the expression inside the
share price formula, we might take:

r  0.52
= = 0.5


(although the value of  was not given in the question so we award full marks
to any student who has derived the correct answer in terms of )

= 10e0.06P[max0s2(Bs + s) > 1.44]

  1.44  2  21.44  1.44  2  

  e  
  2   2 
= 10e0.06

Page 9
 Subject CT8 (Financial Economics Core Technical) – September 2014 – Examiners’ Report

[4]
[Total 10]

Many candidates found this question tough and scored few marks. A number of candidates
were seemingly put off by part (i) and didn’t attempt the potentially easier marks available in
later parts.

8 (i) Δ is the first partial derivative of the option price with respect to the
underlying asset price. [1]

(ii) Using the formula for the Δ, we see that Φ(d1) = 0.42074 and hence d1 =  0.2.

Thus 0.2 σ = 0.0600 + ½σ2 or ½σ2 + 0.2σ  0.06 = 0.

Solving the quadratic gives σ = 20% or 60% and rejecting the negative value
gives σ = 20%. [3]

(iii) When Sτ is at least K1 then the holder is presented with a choice between $100
now and the possibility of $c later. Clearly if c ≤ 100, the holder will always
choose to exercise immediately. [2]

(iv) Just after τ, the optional element has expired and the holder is entitled to $c at
time T if and only if (ST/Sτ ≥ K2). And so the fair price after time τ is

cer(Tτ) Q(ST/Sτ ≥ K2|Fτ),

where Q is the EMM. [2]

(v) Since, under

Q, ST/Sτ = exp(σ (BT  Bτ) + (r  ½σ2)(T  τ)),

where B is a Brownian motion under Q, and since BM has independent

increments, ST/Sτ is independent of Fτ and so the value of the option just after
time τ does not depend on Sτ. [2]

(vi) Inserting the parameter values, the value after time 1 is

200e0.03(1  Φ(0.5)) = $134.20.

Since this is greater than $100, the holder will never exercise the option at
time 1 and so

V0 = e0.03V1 = $130.24. [3]

[Total 13]

Page 10
 Subject CT8 (Financial Economics Core Technical) – September 2014 – Examiners’ Report

Reasonably well answered. Many candidates tried to find the volatility by trial and error,
which was time-consuming compared to deriving and solving the quadratic equation. Some
candidates derived the quadratic equation then still solved it by trial and error. Several
candidates tried to determine the price of the exotic option as a call option for part (vi).

9 (i) B(t,T) = er(Tt)[1  (1  δ) (1  exp  Tt  s ds ))] ,

where B is the bond price, λ is the risk-neutral default rate, δ is the recovery
rate, and r is the risk-free rate. [2]

(ii) Using the formula,

0.9278 = e0.03[1  0.5 (1  exp(  10  s ds )]

= e0.03[1  0.5p],

where p is the default probability.

Hence p = 0.08789. [3]

(iii) Under the Merton model, Q(default) = Q(FT < L), where L is the nominal loan
amount, and Ft is the gross asset value of the company at time t and Q is the
EMM.

Hence

Q(default) = Q(F0 exp(σ BT + (r  ½σ2)T) < L)

= Q(BT < (ln(L/F0)  (r  ½σ2)T)/σ)

= Φ(ln(L/F0)  (r  ½σ2)T)/σ√T) [3]

(iv) Thus

Φ([ln(L/F0)  0.02155]/0.13) = 0.08789

so

ln(L/F0) = 0.13Φ1(0.08789) + 0.02155 = 0.154457

and so

L/F0 = 0.85688. [2]

Page 11
 Subject CT8 (Financial Economics Core Technical) – September 2014 – Examiners’ Report

(v) Thus,

L0/F0 = 0.9278*0.85688 = 0.79501

and so

E0/F0 = 1  0.79501 = 20.5%,

where Et is the net equity value at time t and Lt is the loan value at time t. [5]
[Total 15]

Candidates scored well on parts (i), (ii) and (iii). Well prepared candidates scored full
marks but many did not attempt parts (iv) and (v). Many candidates thought that lambda was
the probability of default (rather than the integral of lambda) and tried to find lambda
without success.

10 (i) (a) The lognormal model has independent, stationary normal increments
for the log of the asset price.

Thus, if Su denotes the stock price at time u, then

log(St/Ss) ~ N(µ(t  s),σ2(t  s))

where µ is the drift and σ is the volatility parameter.

(b) It follows that

E(St) = S0exp(μt+½ σ2t)

and the variance is

Var(St) = S02 exp(2μt + σ2t)(exp(σ2t)  1).

[Alternative: if students use Geometric BM as the foundation for the

lognormal model then they will model

log(St/Ss) ~ N(µ(t  s)  ½σ2(t  s),σ2(t  s)).

The formulae for mean and variance will then change to:

E(St) = S0exp(μt)

and

Var(St) = S02 exp(2μt)(exp(σ2t) 1).] [4]

Page 12
 Subject CT8 (Financial Economics Core Technical) – September 2014 – Examiners’ Report

(ii) From (i), we see that

exp(μ+½σ2) = e0.4 and exp(2μ + σ2)(exp(σ2)  1) = e0.4,

so that exp(σ2)  1 = e1.2.

It follows that

σ2 = log (1 + e1.2) = 0.2633

and

μ = log(e0.4)  ½ log (1 + e1.2) = 0.2684.

[Alternative: if students use Geometric BM then they should obtain

exp(μ) = e0.4 and exp(2μ)(exp(σ2)  1) = e0.4,

so that exp(σ2)  1 = e1.2.

It follows that

σ2 = log(1 + e1.2) = 0.2633, as before, and μ = log(e0.4) = 0.4.]

[3]
[Total 7]

Generally very well answered, with most students recalling and applying the bookwork
correctly.

END OF EXAMINERS’ REPORT

Page 13
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

24 April 2014 (am)

Subject CT8 – Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. Mark allocations are shown in brackets.

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

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT8 A2014 Institute and Faculty of Actuaries

1 Outline the key findings in behavioural finance. [10]

2 (i) State the expression for the return on a security, i, in the single-index model,
defining all terms used. [2]

(ii) Explain the difference between the single-index model and the Capital Asset
Pricing Model. [1]

Suppose the market has expected return 6% and standard deviation 10%. Two
securities have expected returns 8% and 10%, and standard deviations 15% and 20%.
The correlation between these two securities and the market is 0.25 and 0.4
respectively. Assume the single-index model described in (i) holds.

(iii) Calculate the constant parameters in the expression for the return of these two
securities. [5]

(iv) Explain how a multi-index model would be expected to perform relative to the
single-index model in terms of fitting data and predicting future security price
moves. [2]
[Total 10]

3 Let W be a standard Brownian motion.

(i) State the continuous-time log-normal model of a security price S, defining all
the terms used. [2]

Let f be a function of t and Wt2 .

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

Hint: E (Wt2⏐Fs ) = Ws2 + t − s for all t ≥ s.

(b) Use Ito’s lemma to show that f (t , Wt2 ) is a process with zero drift.
[4]

Let X be the process defined as X t = t αWt β .

(iii) Derive the values of α and β for which X t defines a standard Brownian
motion. [6]
[Total 12]

CT8 A2014–2
4 Consider the following long position in European and American call options written
on a stock, with strikes and times to expiry as set out in the table below.

Option European/American Strike price Time to expiry

A American 400 3 years

B American 400 2 years
C American 420 3 years
D European 400 3 years
E European 400 2 years

Rank these options in order of value to the extent that this is possible. [5]

5 Consider the following model for the short-rate r:

drt = μrt dt + σdZt

where μ and σ are fixed parameters and Z is a standard Brownian motion.

(i) Comment on the suitability of this model for the short-rate. [4]

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

drt = a (μ − rt )dt + σdZt .

(ii) Derive an expression for ∫ Tt r (u )du . [6]

(iii) State the distribution of ∫ Tt r (u )du . [1]

[Total 11]

6 (i) State the equation for the capital market line in the Capital Asset Pricing
Model (CAPM), defining all the terms used. [3]

In a market where the CAPM is assumed to hold, the expected annual return on the
market portfolio is 12%, the variance is 4%% and the effective risk-free annual rate is
4%. An Agent wants an expected annual return of 18% on a portfolio worth
£1,200,000.

(ii) Calculate the standard deviation of the return on the corresponding efficient
portfolio. [2]

(iii) Calculate the amount of money invested in each component of the Agent’s
portfolio. [3]
[Total 8]

CT8 A2014–3 PLEASE TURN OVER

7 In a Black-Scholes market, let S be the price of a stock and D be the price of a
derivative written on S, with maturity T, where Dt = g(t, St) for any t < T and
g(T, x) = f(x).

(i) Write down the partial differential equation (PDE) that g must satisfy,
including the boundary condition for time T. [3]

Suppose that the derivative pays STn / S0n−1 at time T, where n is an integer greater
than 1.

(ii) Show, using (i), that the price of the derivative at time t is given by
Dt = (Stn / S0n−1)eμ(T−t) for some μ which you should determine. [6]
[Total 9]

8 (i) State and prove the put-call parity for a stock paying no dividends. [5]

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

strike price $120 and expiry T = 1 year is priced at $10.09. The continuously
compounded risk-free rate is 2% p.a. and the stock is currently priced at $110.

(ii) Estimate the implied volatility of the stock to the nearest 1%. [4]

A European put option on the same stock has strike price $121 and the same maturity.
An investor holds a portfolio which is long one call and short one put.

(iii) Sketch a graph of the payoff at maturity of the portfolio against the stock price
[2]

(iv) (a) Determine an upper and a lower bound on the value of the portfolio at
maturity.

(b) Deduce bounds for the current put price. [3]

(v) Determine the fair price of the put. [2]

[Total 16]

9 Outline the evidence against normality assumptions in models of market returns. [8]

CT8 A2014–4
10 A company has two zero-coupon bonds in issue. Bond A redeems in 1 year and the
current price of £100 nominal is £92.50. Bond C redeems in 2 years and the current
price of £100 nominal is £74.72.

The continuously compounded risk-free rate is 2.5% p.a. for the next two years.

(i) Write down the formula for the general zero-coupon bond price in the two-
state model for credit ratings, defining all the terms used. [2]

(ii) Determine the implied risk-neutral probability of default for bond A, assuming
this model holds, and a recovery rate of 50% for bond A. [3]

If bond A defaults then bond C automatically defaults with a recovery rate of zero,
whereas if bond A does not default then bond C may still default in the second year,
but with a recovery rate of 50%.

(iii) Modify your answer to (i) to give a formula for the current price of bond C.
[3]

(iv) Calculate the risk-neutral probability of default for bond C. [3]

[Total 11]

END OF PAPER

CT8 A2014–5
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2014 examinations

Subject CT8 – Financial Economics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that
the examination was set. Candidates should take into account the possibility that
circumstances may have changed if using these reports for revision.

D C Bowie
Chairman of the Board of Examiners

June 2014

© Institute and Faculty of Actuaries

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

General comments on Subject CT8

Subject CT8 introduces the main concepts and principles of financial economics. These are
developed in later subjects in the ST series of exams. This subject combines various types of
skills. In particular, along with CT7, it is one of the first where candidates are expected to
write lengthy passages of reasoned thought, rather than just complete calculations. This is a
skill that will be new to many, and candidates are advised to pay particular attention to the
answers to this type of question by studying many past papers.

Comments on the April 2014 paper

The general performance was good. Candidates generally found this paper challenging, but
well-prepared candidates scored well across the whole paper and the best candidates scored
close to full marks. As in previous diets, questions that required an element of application of
the core reading to situations that were not immediately familiar proved more challenging to
most candidates.

Page 2
 Subject CT8 (Financial Economics Core Technical) – April 2014 – Examiners’ Report

1 Anchoring and adjustment

Anchoring is a term used to explain how people will produce estimates. They then
adjust away from this initial anchor to arrive at their final judgement.

Prospect theory

A theory of how people make decisions when faced with risk and uncertainty. It
replaces the conventional risk averse / risk seeking decreasing marginal utility theory.

Prospect theory is associated with the concept of:

Framing (and question wording)

The way a choice is presented (“framed”) and, particularly, the wording of a question
in terms of gains and losses, can have an enormous impact on the answer given or the
decision made.

Myopic loss aversion

This is similar to prospect theory, but considers repeated choices rather than a single
“gamble”.

Estimating probabilities

Issues (other than anchoring) which might affect probability estimates include:

• Dislike of “negative” events – the “valence” of an outcome (the degree to which it

is considered as negative or positive) has an enormous influence on the probability
estimates of its likely occurrence.

• Representative Heuristics – people find more probable that which they find easier
to imagine. As the amount of detail increases, its apparent likelihood may
increase (although the true probability can only decrease steadily).

• Availability – people are influenced by the ease with which something can be
brought to mind. This can lead to biased judgements when examples of one event
are inherently more difficult to imagine than examples of another.

Overconfidence

People tend to overestimate their own abilities, knowledge and skills. This may be a
result of:

• Hindsight bias – events that happen will be thought of as having been predictable
prior to the event, events that do not happen will be thought of as having been
unlikely prior to the event.

• Confirmation bias – people will tend to look for evidence that confirms their point
of view (and will tend to dismiss evidence that does not justify it).

Page 3
 Subject CT8 (Financial Economics Core Technical) – April 2014 – Examiners’ Report

Mental accounting

People show a tendency to separate related events and decisions and find it difficult
to aggregate events.

Effect of options

Other issues include:

• Primary effect – people are more likely to choose the first option presented, but

• Recency effect – in some instances, the final option that is discussed may be
preferred! (The gap in time between the presentation of the options and the
decision may influence this dichotomy.)

• Other research suggests that people are more likely to choose an intermediate
option than one at either end!

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

hand, a higher probability is attributed to options explicitly stated than when
included in a broader category.

• Status Quo bias – people have a marked preference for keeping things as they are.

• Regret aversion – by retaining the existing arrangements, people minimise the

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

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

This question was generally well answered by candidates who knew the 8 key findings of
behavioural finance. A surprising number of candidates confused this question with the
Efficient Market Hypothesis. Some candidates discussed the shortcomings of assuming that
consumers are rational.

2 (i) The single-index model expresses the return on a security as

Ri= αi + βiRM+ εi

where Ri is the return on security i,

αi and βi are constants,

RM is the return on the market,

εi is a random variable representing the component of Ri not related to

the market.

Page 4
 Subject CT8 (Financial Economics Core Technical) – April 2014 – Examiners’ Report

(ii) The single-index model is purely empirical and is not based on any theoretical
relationships between βi and the other variables, which are assumed in CAPM.

(iii) The βi are the ratio of the covariances of the securities with the market divided
by the variance of the market.

15 ×0.25 ×10 20 ×0.4 × 10

So, β1 = = 0.375 and β 2 = = 0.8.
100 100

Hence, α1 = 8 − 0.375 × 6 = 5.75 and α 2 = 10 − 0.8 × 6 = 5.2.

(iv) As you are fitting more parameters, in-sample results should give a better fit
(although not necessary a higher information criterion).

In terms of prediction, adding additional indices are unlikely to improve

predictions, assuming the market is reasonably efficient.

Part (i) was well answered by most candidates. Part (ii) was poorly answered by most
candidates. Part (iii) was well answered by most candidates. Some candidates failed to
derive both alpha and beta, but instead only provided a single set of parameters. Part (iv)
was well answered by most candidates. Several candidates failed to answer both parts of the
question (i.e. fitting the data and predicting future security prices). A number of candidates
also concluded that the multi-factor model would be better at predicting future security
prices.

3 St = S0 exp(μt + σWt)

Where μ is the drift

and σ is the volatility

( )
Using the hint, we see that E Wt2 − t | Fs = Ws2 − s for all s < t.

(and E(|( Wt2 − t ) | ) < ∞) .

Then using Ito’s lemma we can see that

d (Wt2 − t ) = 2Wt dWt ,

so indeed the process has zero drift and is a martingale.

For X to be a Brownian Motion we need

( )
t = Var(Xt) = t 2α Var Wt β = t 2α+β ⇒ 2α + β = 1

Page 5
 Subject CT8 (Financial Economics Core Technical) – April 2014 – Examiners’ Report

We can then consider the increment in the process from t = 1(when the value of Xt is
simplified). So suppose that t > 1:

( ) ( )
E ( t αWt β −W1 )2 = t 2α+β + 1 − 2t α min t β ,1 .

But for Xt to be a standard Brownian motion we must also have:

( )
E ( t αWtβ −W1 )2 = t − 1

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

This is not the only solution.

If β < 0 then t αt β = 1and so α + β = 0 and thus α = 1 and β = −1 also works.

You may recognise the second solution to this problem as the time inversion property
of standard Brownian motion.

Alternatively:

The law of any Gaussian stochastic process is completely determined by its

expectation and its covariance function.

For Xt to be standard Brownian motion, we require:

E Xt = 0 and cov (Xs, Xt ) min(s, t).

Now Cov(Xs , Xt) = Cov(sαXsβ, tαXtβ) = sα tαmin(sβ, tβ)

Setting this equal to min(s, t) gives the two pairs of solutions required: α = 0, β = 1
and α = 1, β = −1.

Part (i) was well answered by most candidates. Part (ii) was well answered by most
candidates. Part (iii) was very poorly answered in general. Few if any considered the finite
moment condition. Only a few students managed to score more than a couple of marks in
part (iii) because they didn’t try to check the relevant Gaussian parameters.

Page 6
 Subject CT8 (Financial Economics Core Technical) – April 2014 – Examiners’ Report

4 Call options with lower strike prices are more valuable, so A > C.

American call options are more valuable than European call options so A > D and
B > E.

American call options with longer time to expiry are more valuable so A > B.

So, A is the most valuable, B is more valuable than E, and we cannot pass comment
on the relative value of other pairs with the information available.

Most managed this quite well, though a lot of students who found the correct inequalities also
derived some spurious ones as well. The most common mistake seemed to be not
understanding American options and not noticing that dividends might be payable.

5 (i) Interest rates may not be positive.

Interest rates do not display mean reversion.

This model is computationally tractable.

This model won’t give a realistic range of yield curves.

It won’t fit historical data well.

It cannot be calibrated to current market data.

It is not very flexible (single factor model).

It is arbitrage-free.

(ii) Since the Vasicek model is an Ornstein-Uhlenbeck process we can solve the
SDE for the short rate to get:

( ) + σe
u
− a ( u −t ) − a( u −t )
r (u ) = r (t ) e ∫e
− au as
+ μ 1− e dZ s .
t

Hence

T T T T u
− a ( u −t )
du + μ ∫ ⎡⎢1 − e ( ) ⎤⎥ du + σ ∫ e− au ∫ eas dZ s du
− a u −t
∫ r ( u ) du = r ( t ) ∫ e ⎣ ⎦
t t t t t

Page 7
 Subject CT8 (Financial Economics Core Technical) – April 2014 – Examiners’ Report

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

1− e ( ) 1− e ( )
T − a T −t T − a T −s

∫ r ( u ) du = μ ( t − t ) + ⎡⎣r ( t ) − μ ⎤⎦ a
+ σ∫
a
dZ s
t t

T
So, ∫ r ( u ) du is a Gaussian random variable.
t

Students scored well on part (i) which was standard bookwork. In part (ii) many students
only solved the Vasicek SDE rather than deriving an expression for the integral as asked.

6 (i) The capital market line is given by

rP − r0 = σP / σM(rM − r0),

where

rP is the expected return on an efficient portfolio, P;

rM is the expected return on the market portfolio;
r0 is the risk-free rate;
σP is the standard deviation of the return on the portfolio, P;
σM is the standard deviation of the return on the market portfolio.

(ii) rP is 18% and so

14 = 8σP / 2, thus σP = 0.035 = 3.5%.

(iii) The efficient portfolio is a mix of the market portfolio and the risk-free asset.
If the weights (which sum to 1) are wM and w0 then the expected return is
12wM + 4 w0 so 8 wM = 14 and wM = 1.75, wM = −0.75.

Thus the efficient portfolio has £2,100,000 in the market portfolio and is short
£900,000 in cash.

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

Some weaker students confused the variance with the standard deviation when applying the
formula for CAPM. Others lost marks for minor calculation errors.

Page 8
 Subject CT8 (Financial Economics Core Technical) – April 2014 – Examiners’ Report

7 (i) The PDE is the Black-Scholes PDE:

½σ2x2gxx+ (r −q)xgx – rg + gt = 0

with boundary condition as above: g(T, x) = f(x).

(ii) The proposed solution implies that for this derivative the function g is given
by g(t, x) = (xn / S0n−1)eμ(T−t), where n is an integer great than 1.

This gives xgx = ng, x2gxx = n(n − 1)g and gt = −μg.

Thus, to solve the PDE we need μ = ½σ2n(n − 1) + (n − 1)r − nq.

A quick check shows that g satisfies the boundary condition:

g(T, x) = xn/S0n−1.

Not generally well-answered. Most students managed part (i) but few got any marks for part
(ii). A surprising number of students answered part (i) correctly but failed to try the obvious
route of substituting the equation from part (ii) into the formula from part (i).

Students were not penalised if they took the dividend rate q to be 0.

8 (i) Consider the portfolio which is long one call plus cash of Ke−r(T−t) and short
one put.

The portfolio has a payoff at the time of expiry of ST.

Since this is the value of the stock at time T, the stock price should be the
value at any time t < T: that is

Ct + Ke−r(T−t) − Pt = St.

(ii) This relationship is known as put-call parity.

The Black-Scholes formula gives us that S0 Φ(d1) Ke−rT Φ(d2),

with

S0 = 110, K = 120, r = .02, T = 1

so that

d1 = (log(S0 / K) + r + ½σ2T) / σ √T = (log(11/12) + .02 + ½σ2) / σ,

d2 = d1 − σ.

Guessing and repeated interpolation gives σ = 30%.

Page 9
 Subject CT8 (Financial Economics Core Technical) – April 2014 – Examiners’ Report

(iii)

(iv) (a) The payoff from the portfolio, D, satisfies

S1 −121 ≤ D ≤ S1 −120.

It follows that the initial price, V, of the portfolio should satisfy

S0 − 121e−r≤ V ≤ S0 −120 e−r,

i.e. −8.604 ≤ V ≤ −7.624.

(b) And this implies that 17.714 ≤ P0 ≤ 18.694.

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

Most students scored highly with the proof of the put-call parity.

Part (ii): a lot of students checked two trial values, and then interpolated to get something at
or near 30%. They didn't always check that their answer gave the right answer.

Part (iii): few students managed to sketch the graph correctly. There was often confusion
over the payoff profile between 120$ and 121$.

Part (iv): few students understood the question, mainly because they hadn’t sketched the
graph in part (iii).

Part (v): a common mistake was using put-call parity to work out the value of the put and not
spotting that it had a different strike.

Page 10
 Subject CT8 (Financial Economics Core Technical) – April 2014 – Examiners’ Report

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

market returns. In particular,

• market crashes appear more often than one would expect from a normal
distribution. While the random walk produces continuous price paths, jumps or
discontinuities seem to be an important feature of real markets.

• Furthermore, days with no change, or very small change, also happen more often
than the normal distribution suggests. This would seem to justify the consideration
of Levy processes.

• Q-Q plots of the observed changes in the FTSE All Share index against those
which would be expected if the returns were lognormally distributed show
substantial differences. This demonstrates that the actual returns have many more
extreme events, both on the upside and downside, than is consistent with the
lognormal model.

• a quintic polynomial distribution whose parameters have been chosen to give the
best fit to the data, clearly provides an improved description of the returns
observed, in particular more extreme events are observed than is the case with the
lognormal model. The rolling volatilities of a simulation from the non-normal
distribution show significant differences over different periods. This volatility
process has the same characteristics as the observed volatility from the equity
market.

This question was very poorly answered by most candidates, with very few candidates
scoring more than 4/8. Several candidates scored zero marks for providing a discussion on
the normal distribution itself, as opposed to the assumption of normality in market returns.
Candidates were generally able to generate the first two points (market crashes occur more
often than expected, jumps, etc. and that there are a larger number of days with little or no
movement). Almost no one discussed the use of Q-Q plots or a quintic polynomial. Again,
some candidates noted the points highlighted by Anna Bishop around the Hausdorff fractal
dimension.

10 (i) B(t,T) = e−r(T−t)[1 − (1 − δ)(1 − exp(− ∫ Tt λ s ds))] , where B is the bond price, λ
is the risk-neutral default rate, δ is the recovery rate, and r is the risk-free rate.

(ii) Using the formula, 0.925 = e−0.025[1 − 0.5(1 − exp(− ∫ 10 λ s ds ))]

so that

Q(bond A defaults) = (1 − exp(− ∫ 10 λ s ds )) = 0.10317

(iii) Now bond C pays:

• nothing with probability (1 − exp(− ∫ 10 λ s ds ))

Page 11
 Subject CT8 (Financial Economics Core Technical) – April 2014 – Examiners’ Report

• 50% with probability (1 − exp(− ∫ 12 λ s ds )) exp(− ∫ 10 λ s ds)

• 100% with probability exp(− ∫ 02 λ s ds)

Thus

C0 = 0.7472 = e−0.05 [exp(− ∫ 02 λ s ds) + 0.5(1 − exp(− ∫ 12 λ s ds )) exp(− ∫ 10 λ s ds)]

= e−0.05[0.5 exp(− ∫ 02 λ s ds) + 0.5 exp(− ∫ 10 λ s ds)]

(iv) From the second expression in (iii) and the answer to (ii) we obtain

Q(bond C defaults) = 1 − exp(− ∫ 02 λ s ds)

= (1 − 2e0.05.7472 + (1 − .10317)) = 0.32581.

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

Most struggled on part (iii).

A small number of students managed to work out the non-conditional probability of C

defaulting with only a handful coming to the full answer.

END OF EXAMINERS’ REPORT

Page 12
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

25 September 2013 (pm)

Subject CT8 – Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. Mark allocations are shown in brackets.

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

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT8 S2013 © Institute and Faculty of Actuaries

1 (i) (a) State the expected utility theorem.
(b) State the four axioms from which it can be derived.
[5]

(ii) Explain of the concepts of non-satiation and risk aversion, showing how they
can be expressed in terms of a utility function. [2]

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

absolute risk aversion at a value of wealth of one unit is 0.25

(iii) Calculate the value of b and the range over which U(.) satisfies the condition
of non-satiation. [3]
[Total 10]

2 (i) Describe the single-index model of security returns, defining any terms used.
[2]
The single-index model is to be used in a particular market.

(ii) Determine the following results:

(a) the expected return on a security

(b) the variance of returns on a security; and
(c) the covariance of returns between two securities

in the market, using the parameters described in part (i). [3]

(iii) Show that investors can diversify away specific risk in this model by holding
equal weights in an increasing number of securities. [4]

(iv) State the potential impact of adding additional indices to the model:

(a) in terms of explaining historic data.

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

3 (i) Outline the three forms of the Efficient Markets Hypothesis (EMH). [3]

(ii) Discuss the following two scenarios in the light of the EMH:

Scenario 1: Company A’s share price falls suddenly, immediately after news
of an earthquake in the capital city of one of its major markets.

Scenario 2: Company B’s share price falls suddenly, when a long-awaited and
publicly negotiated merger is completed.
[3]
[Total 6]

CT8 S2013–2
4 In the Wilkie model, the force of inflation in year t, I(t), is modelled as an AR(1)
process as follows:

I(t) = m + a(I(t − 1) − m) + Z(t),

where, for any t, all Z(t) are independent, identically distributed N(0, σ2) random
variables.

Let m = 0.03; a = 0.6 and σ2 = 2.5 ×10−5. The force of inflation was 3.3% in 2012.

(i) Calculate a 95% confidence interval for the force of inflation in 2013. [3]

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

(ii) Comment on the appropriateness of this assumption assuming that the Wilkie
model is correct. [2]
[Total 5]

5 The share price in Santa Insurance Co, St , is currently 97p and can be modelled by
the stochastic differential equation:

dSt = 0.4St dt + 0.5St dBt

where Bt is a standard Brownian motion.

(i) (a) Determine dlog St , using Ito’s Lemma.

(b) Calculate the expectation and variance of the Santa Insurance Co share
price in two years’ time. [6]

The share price in Rudolf Financial Services plc, Rt , is also currently at 97p and can
be modelled by the stochastic differential equation:

dRt = −0.4Rt dt + 0.5dBt

Let Ut = e0.4t Rt

(ii) (a) Calculate dUt.

(b) Calculate the expectation and variance of the Rudolf Financial

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

CT8 S2013–3 PLEASE TURN OVER

6 A non-dividend-paying stock has a current price of 300p. Over each of the next two
three-month periods its price will either go up by 30p or down by 30p. Price
movements for each period are independent of each other. An investment in a cash
account returns 2% per quarter. A European call option on the stock pays out in six
months based on a strike price of 290p. The price of the stock is to be modelled using
a binomial tree approach with three-month time steps.

(i) Calculate the value of the call option today using a risk-neutral pricing
approach. [3]

Assume that the real world probability of the stock price moving up in each of the
next three month periods is 0.7

(ii) (a) Calculate the values of the state price deflator after six months

(b) Calculate and the value of the call option today using your answers to
part (ii)(a).

(c) Compare this to your answer to part (i). [5]

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

(iii) (a) Explain, without performing any further calculations, how the state
price deflator would change in value.

(b) Comment on the impact that this would have on the option price. [2]
[Total 10]

7 The continuously compounded risk-free rate of interest is r, and a stock, with maturity
T, pays dividends continuously at rate q.

(i) Determine the forward price at time 0 for a forward contract on the stock. [3]

(ii) Show that there exists a portfolio that earns the risk free rate r, containing:

• the stock
• a European call option on the stock
• and a European put option on the stock [4]
[Total 7]

8 (i) Write down a stochastic differential equation for the short rate r in the Vasicek
model defining any notation used. [1]

(ii) List the desirable and undesirable features of this model for the term structure
of interest rates. [4]

(iii) (a) Solve the stochastic differential equation from your answer to part (i).
(b) Comment on the statistical properties of rT , T > t.
[7]
[Total 12]

CT8 S2013–4
9 A one-year European call option on a non-dividend paying stock in Company ABC
has a strike of $150.

The continuously compounded risk-free rate is 2% p.a. The current stock price is
$117.98. Assume that the market follows the assumptions of a Black-Scholes model.

An institutional investor holds a delta-hedged portfolio with 100,000 call options, no

cash and short 18,673 shares of Company ABC.

(i) Calculate the delta of the call option. [2]

(ii) Calculate the implied volatility for the underlying. [4]

(iii) Calculate the price of a one-year put on the same stock with a strike of $150.
[2]

The investor retains their holding of call options and trades in the put and the stock to
achieve a delta and gamma-hedged portfolio.

(iv) Calculate the investor’s new holdings of the put and the stock. [4]
[Total 12]

10 (i) Describe the Merton model for pricing a bond subject to default risk. [4]

A very highly geared company – XYZ plc – has issued zero-coupon bonds payable in
four years’ time. The debt is a nominal $120m.

(ii) Give expressions for the value of the debt in four years’ time and today,
adopting a Black-Scholes model for the value of XYZ plc. [4]

The current gross value of XYZ plc is $180m. The continuously compounded risk-
free interest rate is 2% p.a. and the continuously compounded credit spread on the
bond is 4.5% p.a.

(iii) Calculate the price of the bond today. [1]

(iv) Estimate to the nearest 1% the implied volatility of the value of XYZ. [3]

(v) Determine the implied risk-neutral probability of default. [3]

[Total 15]

END OF PAPER

CT8 S2013–5
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2013 examinations

Subject CT8 – Financial Economics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that
the examination was set. Candidates should take into account the possibility that
circumstances may have changed if using these reports for revision.

D C Bowie
Chairman of the Board of Examiners

December 2013

 Institute and Faculty of Actuaries

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

General comments on Subject CT8

Subject CT8 introduces the main concepts and principles of financial economics. These are
developed in later subjects in the ST series of exams. This subject combines various types of
skills. In particular, along with CT7, it is one of the first where candidates are expected to
write passages of reasoned thought, rather than just complete calculations. This is a
skill that will be new to many, and candidates are advised to pay particular attention to the
answers to this type of question by studying many past papers.

Comments on the September 2013 paper

The general performance was good and broadly in line with the previous session (April
2013). Candidates generally found this paper challenging, but well-prepared candidates
scored well across the whole paper and the best candidates scored close to full marks. As in
previous diets, questions that required an element of application of the core reading to
situations that were not immediately familiar proved more challenging to most candidates.
The comments that follow the questions concentrate on areas where candidates could have
improved their performance. Candidates approaching the subject for the first time are advised
to include in their revision these areas and the ability to apply the core reading to similar
situations.

Page 2
Subject CT8 (Financial Economics Core Technical) – September 2013 – Examiners’ Report

1 (i) (a) The expected utility theorem states that a function, U(w) can be
constructed representing an investor’s utility of wealth, w, at some
future date. Decisions are made on the basis of maximising the
expected value of utility under the investor’s particular beliefs about
the probability of different outcomes.

(b) The expected utility theorem can be derived formally from the
following four axioms.

1. Comparability

An investor can state a preference between all available certain outcomes.

2. Transitivity

If A is preferred to B and B is preferred to C, then A is preferred to C.

3. Independence

If an investor is indifferent between two certain outcomes, A and B, then he is

also indifferent between the following two gambles:

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

(b) B with probability p and C with probability (1 − p).

4. Certainty equivalence

Suppose that A is preferred to B and B is preferred to C. Then there is a

unique probability, p, such that the investor is indifferent between B and a
gamble giving A with probability p and C with probability (1 − p).

B is known as the certainty equivalent of the above gamble.

(ii) It is usually assumed that people prefer more wealth to less. This is known as
the principle of non-satiation and can be expressed as:
U′(w)>0 or U is strictly increasing.

Attitudes to risk can also be expressed in terms of the properties of utility

functions.

A risk averse investor values an incremental increase in wealth less highly

than an incremental decrease and will reject a fair gamble. The utility function
condition is U ( w) < 0 or U is strictly concave.

(iii) The absolute risk aversion A is given by:

U ( w)
A( w)  .
U ( w)

Page 3
 Subject CT8 (Financial Economics Core Technical) – September 2013 – Examiners’ Report

Which for the utility function given can be calculated by taking derivatives as,
2b
.
1  2bw

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

Non-satiation means U ( w) > 0 <=> 1+2bw > 0 <=>   w  5.

This bookwork question was largely well-answered although some candidates appeared to be
unaware that non-satiation and absolute risk aversion do not have identical meanings.

2 (i) The single-index model expresses the return on a security as:

Ri = αi + βiRM + εi

where: Ri is the return on security i

αi and βi are constants
RM is the return on the market

The εi are independent, zero-mean random variables, uncorrelated with RM,

representing the component of Ri not related to the market.

(ii) The expected return on security i is

Ei =   Ri     i  i RM  i   αi + βi .EM,

where EM is the expected return on the market.

The variance of returns on security i is Vi = Var  i  i RM  i  i2VM  Vi ,

where VM is the variance of returns on the market, Vi is the variance of the
random variable component of Ri not related to the market and the result holds
because under the model εi is uncorrelated with RM.

The covariance of returns between security i and security j is given by

   
Ci,j = Cov Ri , R j  Cov i  i RM  i ,  j   j RM   j  βi . βj .VM ,
since under the model εi is uncorrelated with RM and εi is independent of εj for
all i ≠ j.

Page 4
Subject CT8 (Financial Economics Core Technical) – September 2013 – Examiners’ Report

(iii) Using the results from (ii), the variance of portfolio returns on a portfolio of N
equally weighted securities is

N
1
V  N 2 Cov  Ri , R j 
i , j 1

N N
1 1

N2
 (i2VM  Vi )   βi . βj .VM
N 2 i , j 1, i  j
i 1

 1 N 2
=  i  VM plus terms which tend to zero as N  .
N 
 i 1 

In other words, the limiting portfolio variance depends on the average value of
the i s and the variance of the market but not the specific risk of any
individual security.

Alternative solution:

The single index model for a portfolio P of N assets held in proportions xi, …,
xN is:

RP = P + PRM + P

N N N
where P =  xi i , P =  xii and P =  xi i
i 1 i 1 i 1

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

VP = 2PVM  V P

2
 N   N 
=   xii  VM  var   xi i 
   
 i 1   i 1 

1
If xi = then:
N

2
1  N  1  N 
VP = 2   i  VM  2   Vi 
N  i 1  N  i 1 

1
=  2VM  V
N

Page 5
 Subject CT8 (Financial Economics Core Technical) – September 2013 – Examiners’ Report

Where  is the average of the individual i’s and V is the average of the
Vi ’s.

As N  , the second component, which represents the specific risk, tends

to 0.

(iv) More factors will always improve the fit of a regression to historic data, in
other words reduce the residual errors in relation to the data fitted, although
market correlation typically has the most explanatory power.

There is little evidence that multi-factor models are significantly better at

forecasting the future correlation structure.

Again this was a largely well-answered question, although some candidates didn’t define
notation despite the explicit instruction to do so. Surprisingly few candidates used the results
they had derived in part (ii) to prove part (iii). Some candidates confused this model with
CAPM.

3 (i) Strong form EMH: market prices incorporate all information, both publicly
available and also that available only to insiders.

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

information.

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

information contained in the price history of that investment.

(ii) Scenario 1: The first event tells us nothing about the EMH-assuming this
earthquake was not predictable, its happening could not have been discounted
in market prices.

A quick adjustment of prices in response to a news announcement suggests

evidence for the semi-strong form (and by implication the weak form) EMH.

However, although the price drop was quick, we have no idea how accurate it
was. It is possible that the market has over or under reacted to the bad news
and will correct itself later. If this is the case, then it suggests markets are not
efficient.

Some earthquake specialists (insiders) may have known about the earthquake
shortly in advance but there is no mention of price movements before the
earthquake, perhaps this suggests the market is also strong form efficient.

Scenario 2: The second event strongly contradicts the strong-form EMH.

Insiders are privy to all information about the merger talks and therefore there
shouldn’t be a sudden reaction.

Page 6
Subject CT8 (Financial Economics Core Technical) – September 2013 – Examiners’ Report

Indeed, given the public nature of the negotiations, this seems even to
contradict the semi-strong form (and by implication the strong form) of the
EMH although perhaps markets were pricing in a significant probability of the
merger failing or overreacting to the benefits and then correcting themselves.

This question was reasonably answered, although some candidates simply related the same
form of EMH to both scenarios. Many candidates missed the fact that the merger had already
been publicly negotiated and so wasn’t new information.

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

where N is a standard normal r.v. It follows that a 95% confidence interval is

(0.0318 ± 0.005  1.9600) = (0.0220, 0.0416)

(ii) Not at all appropriate, since 1% does not lie in the 95% confidence interval for
2013 and it was 3.3% in 2012!

However there may be compensating assumptions which make this divergence

unimportant, for example wage-inflation may also be underestimated.

The pension scheme may have a view that inflation will fall next year, e.g. due to
a forecast recession. The Wilkie model parameters are estimated as averages over
a historic time period (they are longitudinal estimates) and therefore may not
reflect future conditions.

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

reasonable statement about this assumption.

A surprising number of candidates were unable to calculate a confidence interval, and there
were many calculation slips. The majority of candidates struggled to interpret part (ii) of the
question.

5 (i) (a) Divide by St to separate variables:

dSt
 0.4dt  0.5dBt .
St

Use Itô’s Lemma to calculate d log St:

dSt 0.5
d log St   2 (dSt ) 2  0.275dt  0.5dBt .
St St

(b) Written in integral form, this reads:

log St = log S0 + 0.275t + 0.5Bt.

Page 7
 Subject CT8 (Financial Economics Core Technical) – September 2013 – Examiners’ Report

or, finally,

St  S0e0.275t  0.5 Bt .

St
So has a lognormal distribution with parameters 0.275t and 0.25t,
S0
or equivalently St is lognormally distributed with parameters log S 0
+ 0.275t and 0.25t.

The properties of the lognormal distribution give us the expectation

and variance of St:

  S2   97e0.8  215.877 p


Var  S2   97 2 (e0.55 ) 2 Var e0.5 B2 

= 97 2 (e0.55 ) 2 e0.5 e0.5  1 
=30,232.41p = (173.87)2 = (£173.87)2 = £2 3.0232
2

(ii) (a) We wish to solve the stochastic differential equation:

dRt  0.4 Rt dt  0.5dBt .

Consider U t  Rt e0.4t

dU t  0.4 Rt e0.4t dt  e0.4t dRt

 0.5e0.4t dBt

t
(b) so U t  U 0  0.5 e0.4 s dBs
0
and hence

t
Rt  R0e 0.4t
 0.5 e0.4( s t ) dBs .
0

Now since

 t 0.4 s t  
  0.5 e dBs 0,
 
 0 

E  R2   97 e 0.8 p  43.584 p  £0.43584

Page 8
Subject CT8 (Financial Economics Core Technical) – September 2013 – Examiners’ Report

and

 2  0.25
Var  R2   Var  0.5e0.4 s  2 dBs 
0.8
 
1  e 1.6  0.2494 p 2
 0 

 (0.499 p) 2  £ 2 0.00002494  (£0.00499) 2

Overall well-answered but some candidates did seem to struggle applying Ito’s Lemma and
with calculating the expectation and variance; Some candidates confused the Normal and
LogNormal distributions, while others simply stated the answer rather than deriving it.

6 (i) First we calculate the risk-neutral probability of an upwards movement in the

stock price from each state:

1.02  300  270

q  300    0.6
330  270

1.02  330  300

q  330    0.61
360  300

1.02  270  240

q  270    0.59.
300  240

Then the option price V is:

1
V =  q  300  q  330   70  q  300  1  q  330    10  1  q  300   q  270  10  0 
1.022  

= 29.143.

Alternatively, if the candidates misinterpret the question and use 2% as a force

of interest per quarter we get qs = (0.601007, 0.611107, 0.590906), and a
value for V of 29.21234. 2 marks can be awarded for this or any other answer
which has the right working but the wrong interpretation of the interest rate.

(ii) (a) Using the results from (i) we can calculate the values of the state-price
deflator:

q  300  q  330 
A  360    0.71793
 0.7 1.02  2

q  300  1  q  330    1  q  300   q  270 

A  300    1.07559
2  0.7  0.3 1.022

Page 9
 Subject CT8 (Financial Economics Core Technical) – September 2013 – Examiners’ Report

A  240  
1  q  300   1  q  270    1.75146.
(0.3 1.02) 2

Alternatively candidates may have calculated four deflators, one for

each path:

A(uu) = 0.71793, A(ud) = 1.071017, A(du) = 1.080171 ,

A(dd) = 1.75146.

If candidates have used 2% as a force of interest:

A(uu) = 0.72016, A(ud) = 1.069345, A(du) = 1.078681 ,

A(dd) = 1.742506.

Or if using three nodes the middle node is 1.074013.

(b) Then the option premium V can be calculated as:

V = EP (A2V2)

 
= 0.7 2 A  360   70   2  0.7  0.3  A  300   10 


 0.32  A  240   0 
= 29.143.

(c) This is the same answer as under part (i) as expected – under a given
model the option price should not vary depending on how we evaluate
the model.

(iii) (a) A(360) would rise as the denominator decreases; A(240) and A(300)
would shrink as the denominator rises.

(b) Overall the option price would remain unchanged as it does not depend
on real-world probabilities.

Generally reasonably answered, although some candidates only calculated one risk-neutral
probability instead of three and many struggled to calculate correct state price deflators or
more surprisingly confused real-world and risk-neutral probabilities.

Page 10
Subject CT8 (Financial Economics Core Technical) – September 2013 – Examiners’ Report

7 (i) Let K be the forward price and denote the stock price at time t by St . Now
compare the setting-up of the following two portfolios at time 0:

 A: one long forward contract.

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

Invest dividends in the stock.

At time T portfolio A is worth ST  K .

At time T portfolio B is worth ST  K .

By the principle of no-arbitrage these portfolios must have the same value at
all times before T.

In particular, at time 0, portfolio B has value e  qT S0  Ke rT which must equal

the value of the forward contract (which must be zero at time 0).

So K = e( r q )T S0 .

(ii) Consider a portfolio consisting of e qT units of stock, a European put option

and short a European call option both of which expire at time T at strike price
K, whose prices at time t are denoted by St , pt and ct respectively.

At expiry:

If ST  K , the put option expires worthless, the call option will be exercised
(or be worthless if ST  K ) and the stock will be delivered in return for K.
I.e. the value of the portfolio will be K.

If ST  K , the call option will not be exercised, and the stock can be sold via
the put option for K, so the value of the portfolio will be K.

Since the portfolio will be worth a known, fixed amount at time T, by the
principle of no-arbitrage it must earn the risk free rate up to time T.

This question differentiated between the stronger and weaker candidates. Candidates who
knew how to adjust the portfolio construction arguments to forward pricing scored well.

Page 11
 Subject CT8 (Financial Economics Core Technical) – September 2013 – Examiners’ Report

8 (i) The stochastic differential equation for the short rate r is:

drt = α(μ − rt) dt + σdBt.

where B is a standard Brownian motion, σ is the volatility, and α and μ are the
drift parameters. [1]

(ii) Desirable:

Arbitrage-free
Instantaneous and other rates mean reverting
Ease of computation/pricing of derivatives and bonds

Undesirable:

Short rate not necessarily positive

Does not generate realistic dynamics/yield curves
e.g. bonds of all durations perfectly correlated
e.g. constant volatility of the short rate
Does not provide good historical fit (even with suitable parameter values)
Is not easy to calibrate
Is not sufficiently flexible – e.g. cannot price derivatives whose value depends
on more than one interest rate

(iii) (a) We wish to solve the stochastic differential equation:

drt = α(μ − rt) dt + σdBt.

Consider ut  rt eαt

dut  αrt eαt dt  eαt drt

 αμeαt dt  σeαt dBt .

T
so uT  ut  μ(e αT
 e )  σ  eαs dBs
αt

   σ e
T
 α(T t )  α  T t   α(T  s )
and hence rT  rt e  μ 1 e dBs .
t

Page 12
Subject CT8 (Financial Economics Core Technical) – September 2013 – Examiners’ Report

(b) From this we see that under the risk-neutral measure rT follows a
Gaussian distribution

with mean


rt e    μ 1  e  
 α T t  α T t

and variance
σ2
2α 
1 e   .
2α T t

Largely, well-answered bookwork question, although the candidates found the later sections
of this question progressively more difficult.

9 (i) The Δ of the call holding must be minus the Δ of the shareholding, which, by
definition is – 18673, so the Δ of a call is ΔC = 0.18673.

(ii) ΔC for a call is Φ(d1), where d1 = (ln(S0/k) + r + ½σ2))/σ = (ln(1.1798/1.5)

+ 0.02 + ½σ2))/σ = 0.22/σ + ½σ.

Now Φ(d1) = 0.18673 so d1 = 0.89

which implies that

 0.22 + 0.89 σ + ½ σ2 = 0 so σ = -0.89 ± (0.892 + 0.44)½.

Rejecting the negative root gives a value of σ = 22%.

(iii) d2 = d1  σ√T =  1.11. Thus P = KerT Φ(d2)  S0 Φ(d1)

= 150er Φ(d2)  117.98Φ(d1) = 147.0298 Φ(d2)  117.98Φ( d1)
= 147.0298 0.8665  117.98  0.81327 = $31.4517

(iv) Using C to denote the call option, P the put option and S the stock we know
that:

ΔC  ΔP = ΔS =1
ΓC  Γ P and Γ S  0

So since we hold 100,000 call options, we must be short 100,000 put options
and 100,000 shares to get a gamma and delta neutral portfolio.

Alternative calculation approaches were awarded full marks if candidates

reached the right conclusions.

Candidates found this question difficult, especially the latter part which only the strongest
candidates answered well.

Page 13
 Subject CT8 (Financial Economics Core Technical) – September 2013 – Examiners’ Report

10 (i)
 Merton’s model assumes that a corporate entity has issued both equity and
debt such that its total value at time t is F(t). F(t) varies over time as a
result of actions by the corporate entity which does not pay dividends on
its equity or coupons on its bonds.

 Part of the corporate entity’s value is zero-coupon debt with a promised

repayment amount of L at a future time T. At time T the remainder of the
value of the corporate entity will be distributed amongst the equity holders
and the corporate entity will be wound up.

 The corporate entity will default if the total value of its assets, F(T) is less
than the promised debt repayment at time T i.e. F(T) < L. In this situation,
the bond holders will receive F(T) instead of L and the equity holders will
receive nothing.

 This can be regarded as treating the equity holders of the corporate entity
as having a European call option on the assets of the company with
maturity T and a strike price equal to L.

(ii) (a) Under the Merton model, the value at redemption is

min(F(4),120) = 120  max(120  F(4),0) = F(4) – max(F(4)
 120, 0), where F(t) is the gross value of the company at time t.

Thus the value at time 0 is

e4rE[min(F(4),120)] = e4rE[F(4)  max(F(4)  120,0)],

[Alternative expressions are fine, as per the first part of (ii) (a).]

where the expectation is under the risk-neutral measure, so equals F(0)

 C, where C is a call option on the gross value with strike 120.

[Alternatively = 120e4r – P, where P is a call option on the gross

value with strike 120. ]

(iii) The bond price is 120  e4(r+.045) = $92.5262m.

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

This leads to an estimated volatility of 40%.

Try a volatility of 20%. This gives an option price of $72.266.

A volatility of 50% gives a price of $92.293.

Interpolating gives a volatility of:

20 + (87.276  72.266 / (96.06  72.266)  30 = 39%.

Page 14
Subject CT8 (Financial Economics Core Technical) – September 2013 – Examiners’ Report

This gives a price of $86.413.

Interpolating again gives a volatility of 40%.

For reference when marking:

volatility = 30%, c = $78.985, vol = 40%, c = $87.275, vol = 45%,

c = $91.645

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

= 1  Φ(d2) = 1  Φ(0.206831)
= 1  0.58192 = 0.41808 = 42%

Candidates struggled to gain many marks on this question, and many seemed to be short of
time reflecting the importance of time management in these exams.

END OF EXAMINERS’ REPORT

Page 15
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

17 April 2013 (pm)

Subject CT8 – Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. Mark allocations are shown in brackets.

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

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT8 A2013 © Institute and Faculty of Actuaries

1 List the key advantages and disadvantages of the following measures of investment
risk in the context of a portfolio of bonds subject to credit risk:

• Variance of return
• Downside semi-variance of return
• Shortfall probability
• Value at Risk
• Tail Value at Risk
[10]

2 Consider a mean-variance portfolio model with two securities, SA and SB , where the
expected return and the variance of return for SB are twice the corresponding values
for SA . Suppose the correlation between the returns on the two securities is ρ.

(i) (a) Determine the values of ρ which allow the possibility of constructing a
zero-risk portfolio, by calculating the variance of the return on a
portfolio with weights xA and xB invested in the two assets.

(b) Calculate the portfolio weights that lead to the most efficient zero-risk
portfolio.

(c) Calculate the expected return on the portfolio in part (i)(b) in terms of
the expected return on SA .
[5]

(ii) Calculate the maximum expected return for an investor:

(a) if portfolio weights are unlimited.

(b) if the investor can short sell at most one unit of either security and the
total he has to invest is one unit.
[2]

(iii) Calculate the expected return on the minimum variance portfolio if the
covariance between the two securities is 60% of the variance of SA . [2]
[Total 9]

3 An analyst states that “It is common practice in actuarial modelling to use the same
data set to specify the model structure, to fit the parameters, and to validate the model
choice. A large number of possible model structures are tested, and testing stops
when a model is found which passes a suitable array of tests.”

Indicate, giving evidence and examples, why this procedure may be inappropriate.
[5]

CT8 A2013–2
4 In a market where the CAPM holds there are five assets with the following attributes.

Asset A B C D E Probability
of being in
state
Annual return in
State 1 3% 3% 3% 3% 3% 0.25
State 2 5% 7% 2% 8% 3% 0.5
State 3 7% 5% 8% 1% 3% 0.25
Market Capitalisation 10m 20m 40m 30m

(i) Calculate the expected annual return on the market portfolio and σM, the
standard deviation of the annual return on the market portfolio. [4]

(ii) Calculate the market price of risk under CAPM. [2]

(iii) Calculate the beta of each asset. [6]

(iv) Outline the limitations of the CAPM. [3]

[Total 15]

5 (i) State the five key features of a standard Brownian motion Bt . [5]

Consider a stochastic differential equation

dX t = Yt dBt + At dt ,

where At is a deterministic process and Yt is a process adapted to the natural

filtration of Bt .

(ii) Write down Ito’s lemma for f (t , X t ) , where f is a suitable function. [2]

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

[Total 9]

CT8 A2013–3 PLEASE TURN OVER

6 Suppose that at time t we hold the portfolio ( at , bt , ct ) where at, bt and ct represent
the number of units held at time t of securities with respective price processes At , Bt
and Ct . Assume ( at , bt , ct ) are previsible. Let Vt be the value of this portfolio at
time t.

(i) Explain what it means for (at , bt , ct ) to be previsible. [1]

(ii) Write down an equation for the instantaneous change in the value of the
portfolio, including cash inflows and outflows, at time t. [2]

(iii) Give the condition for this portfolio to be self-financing. [2]

(iv) Define a replicating strategy for a derivative with payoff X at a future time U,
contingent on the path taken by at , bt and ct . [2]

(v) Describe how the no-arbitrage condition and a self-financing strategy can be
used to value the derivative in (iv) at time 0. [2]

(vi) Give a condition for the market to be complete. [1]

[Total 10]

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

Over each of the next two years its price will either be multiplied by a factor of 1.2 or
divided by 1.2. The continuously compounded risk-free rate is 1% p.a. The value of
an option on the stock is 50p.

Denote by Puu the value of the payoff if both stock price moves are up, Pud for the
value of the payoff if one move is up and one is down (this is the same whichever
order the price moves occur), and Pdd for the value of the payoff if both stock price
moves are down. The price of the stock is to be modelled using a binomial tree
approach with annual time steps.

(i) Derive, and simplify an equation for Puu in terms of Pud and Pdd . [4]

(ii) Calculate, using your answer to part (i), or otherwise, the range of values that
Puu could take. [2]

(iii) Determine the value of the option in each of the two cases below, assuming
that Puu takes its maximum possible value:

(a) If the first stock price move is up.

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

CT8 A2013–4
8 (i) Describe three limitations of one-factor term structure models. [5]

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

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

2 years on an underlying (non-dividend bearing) stock with price process St. Its
payoff at maturity is $100Max(S2/S1 − 1;0) if and only if the stock price has not
exceeded $2 by time 1. The volatility of the stock is 25% p.a. and the continuously
compounded risk-free rate is 3% p.a. The initial stock price is $1.

(i) Calculate Q(Maxt<1St < 2), where Q is the EMM, using the formula in the
actuarial tables and the representation of a geometric Brownian Motion. [3]

(ii) (a) Write down an expression for the price of this option at time 1. You
should consider separately the two cases (Maxt<1St) < 2 and
(Maxt<1St) ≥ 2.

(b) Show that the value of this option at time 1 is $11.348 in the case
(Maxt<1 St )< 2.

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

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

10 (i) Describe the two-state model for credit defaults. [4]

Company A’s bonds are modelled according to a two-state model. Company A has
two zero-coupon bonds in issue, both with a recovery rate of δ = 60%. Bond 1
matures in one year, bond 2 in two years’ time. Bond 1 has a continuously
compounded credit spread of 4%, bond 2 has a continuously compounded credit
spread of 5%. The continuously compounded risk-free rate is 1.5% p.a.

(ii) (a) Calculate the price per $100 nominal of each bond in one year and in
two years’ time.

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

and in two years’ time.
[6]

(iii) Determine the implied values of the default intensities, assuming that they are
constant for each of the two years. [3]
[Total 13]

END OF PAPER

CT8 A2013–5
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2013 examinations

Subject CT8 – Financial Economics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that
the examination was set. Candidates should take into account the possibility that
circumstances may have changed if using these reports for revision.

D C Bowie
Chairman of the Board of Examiners

July 2013

© Institute and Faculty of Actuaries

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

General comments on Subject CT8

Subject CT8 introduces the main concepts and principles of financial economics. These are
developed in later subjects in the ST series of exams. This subject combines various types of
skills. In particular, along with CT7, it is one of the first where candidates are expected to
write lengthy passages of reasoned thought, rather than just complete calculations. This is a
skill that will be new to many, and candidates are advised to pay particular attention to the
answers to this type of question by studying many past papers.

Comments on the April 2013 paper

The general performance was good and better than on the previous session (September 2012).
Candidates generally found this paper challenging, but well-prepared candidates scored well
across the whole paper and the best candidates scored close to full marks. As in previous
diets, questions that required an element of application of the core reading to situations that
were not immediately familiar proved more challenging to most candidates. The comments
that follow the questions concentrate on areas where candidates could have improved their
performance.

Page 2
 Subject CT8 (Financial Economics Core Technical) – April 2013 – Examiners’ Report

1 Variance of return

Variance is mathematically tractable.

Variance fits neatly with a mean-variance portfolio construction framework.

Variance is a symmetric measure of risk. The problem of investors is really the

downside part of the distribution.

Credit risky bonds have an asymmetric return distribution and as defaults are often
co-dependent on economic downturns portfolios can have fat tails.

Neither skewness or kurtosis of returns is captured by a variance measure.

Downside semi-variance of return

Semi-variance is not easy to handle mathematically and it takes no account of

variability above the mean.

Furthermore if returns on assets are symmetrically distributed semi-variance is

proportional to variance.

As with variance of return, semi-variance does not capture skewness or kurtosis.

It takes into account the risk of lower returns.

It can be decomposed into systematic and non-systematic risk contributions.

Shortfall probability

The choice of benchmark level is arbitrary.

For a portfolio of bonds, the shortfall probability will not give any information on:

• upside returns above the benchmark level

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

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

It allows a manager to manage risk where returns are not normally distributed.

Value at Risk (VaR)

VaR generalises the likelihood of underperformance by providing a statistical

measure of downside risk.

Portfolios exposed to credit risk, systematic bias or derivatives may exhibit non-
normal distributions.

Page 3
 Subject CT8 (Financial Economics Core Technical) – April 2013 – Examiners’ Report

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

distributions of returns.

The further one gets out into the “tails” of the distributions, the more lacking the data
and, hence, the more arbitrary the choice of the underlying probability distribution
becomes.

Tail Value at Risk (TailVaR)

Relative to VaR, TailVaR provides much more information on how bad returns can be
when the benchmark level is exceeded.

It has the same modelling issues as VaR in terms of sparse data, but captures more
information on tail of the non-normal distribution.

In general, and given that this was a straightforward question, this was surprisingly poorly
answered with students losing marks for not knowing basic definitions.

2 Let the expected return on S A be E A and the variance of return be V A . Then the
expected return on S B is 2 E A and the variance of return is 2 V A .

(i) (a) The only zero risk portfolio can occur if the correlation is either 1 or
−1. By considering diversification, the most efficient portfolio will
occur when it is −1.

The overall portfolio variance is:

V = x 2AVA + 2 xB2VA + 2 2 x A xB ρVA = VA ( x A − 2 xB ) 2

+2 2 x A xB (1 + ρ)V A

Since −1 ≤ ρ ≤ 1 and VA > 0

this can only be 0 if ρ = −1 .

(b) Then, V = 0 ⇒ x A = 2 xB and the overall portfolio constrain

2 1
x A + xB = 1 yields x A = and xB = .
2 +1 2 +1

2+2
(c) So the expected return on the overall portfolio E = E A . .
2 +1

(ii) (a) In this case the maximum expected return is infinite (obtained by
selling unlimited amounts of security S A to purchase unlimited
amounts of security S B ).

Page 4
 Subject CT8 (Financial Economics Core Technical) – April 2013 – Examiners’ Report

(b) In this case the maximum expected return is obtained by selling one
unit of S A to purchase two units of S B . The maximum expected
return is then 3 E A .

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

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

11
And so the expected return is E A = 1.2222 E A .
9

This question was surprisingly poorly answered with most candidates missing the point of the
question, which was to test their understanding of basic ideas about correlated assets.

3 We may not be justified in accepting a model simply because it passes the tests. Many
of these tests (for example, tests of stationarity) have notoriously low power, and
therefore may not reject incorrect models.

Indeed, even if the “true” model was not in the class of models being fitted, we would
still end up with an apparently acceptable fit, because the rules say we keep
generalising until we find one.

This process of generalisation tends to lead to models which wrap themselves around
the data, resulting in an understatement of future risk, and optimism regarding the
accuracy of out-of-sample forecasts.

For example, Huber recently compared the out-of-sample forecasts of the Wilkie
model to a naïve “same as last time” forecast over a 10 year period. The naïve
forecasts proved more accurate.

May candidates had not studied basic material covered in this question and answered poorly.

4 (i) The market portfolio is in proportion to the market capitalisation since every
investor holds risky assets in proportion to that portfolio. Thus the market
portfolio is 0.1A + 0.2B + 0.4C + 0.3D (asset E is the risk-free asset).

Asset A B C D E Probability
of being in
state
Annual return in
State 1 3% 3% 3% 3% 3% 0.25
State 2 5% 7% 2% 8% 3% 0.5
State 3 7% 5% 8% 1% 3% 0.25
Market Capitalisation 10m 20m 40m 30m

Page 5
 Subject CT8 (Financial Economics Core Technical) – April 2013 – Examiners’ Report

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

and so EM = (10×5%+20×5.5%+40×3.75%+30×5%)/100 = 4.6%

Now σ2M = 0.25×(3−4.6)2+0.5×(5.1−4.6)2+0.25×(5.2−4.6)2 = 0.855%

and σM = 0.92466%

(ii) market price of risk is (EM−r)/σM = (4.6 − 3)/0.92466 = 173%

(iii) βi = Cov(Ri, RM)/Var(RM).

Now Cov(RA, RM) = 0.25×3×3+0.5×5×5.1+0.25×7×5.2−5×4.6 = 1.1%;

Cov(RB, RM) = 0.25×3×3+0.5×7×5.1+0.25×5×5.2−5.5×4.6 = 1.3%;
Cov(RC, RM) = 0.25×3×3+0.5×2×5.1+0.25×8×5.2−3.75×4.6 = 0.5%;
Cov(RD, RM) = 0.25×3×3+0.5×8×5.1+0.25×1×5.2−5×4.6 = 0.95%

It follows that βA = 1.1/0.855=1.2865, βB = 1.3/0.855 = 1.5205,

βC = 0.5/0.855 = 0.5848 and βD = 0.95/0.855 = 1.1111.
OR
Assets all lie on the securities market line, so Ei −r = βi(EM−r), so
βA = 2/1.6=1.25, βB = 2.5/1.6 = 1.5625
βC = 0.75/1.6 = 0.46875 and βD = 2/1.6 = 1.25.

(iv) Most of the assumptions of the basic model can be attacked as unrealistic.
Empirical studies do not provide strong support for the model. There are
basic problems in testing the model since, in theory, account has to be taken of
the entire investment universe open to investors, not just capital markets.

Regrettably, there was an inconsistency with the CAPM in the question data.
Accordingly candidates could obtain full marks to part (iii) by giving either of the two
answers above.
In general the question was answered well, with most candidates showing good familiarity
with the CAPM.

5 (i) Bt has independent increments, i.e. Bt − Bs is independent of {Br , r ≤ s}

whenever s < t.

Bt has stationary increments, i.e. the distribution of Bt − Bs depends only on

t − s.

Bt has Gaussian increments, i.e. the distribution of Bt − Bs is N(0, t − s).

Bt has continuous sample paths t → Bt.

B0 = 0.

Page 6
 Subject CT8 (Financial Economics Core Technical) – April 2013 – Examiners’ Report

∂f ⎡ ∂f ∂f 1 ∂2 f 2 ⎤
(ii) df ( t , X t ) = Yt dBt + ⎢ + At + Yt ⎥ dt
∂x ⎢⎣ ∂t ∂x 2 ∂x 2 ⎥⎦

(iii) Using Ito’s lemma above we have:

df ( t , X t ) = 2te 2tX t Yt dBt + 2e 2tX t ⎡ X t + tAt + t 2Yt 2 ⎤ dt

⎣ ⎦

This question was very well answered in general, with most candidates fully conversant with
the basic properties of Brownian Motion and with Ito’s Lemma.

6 (i) It means that at , bt and ct are known based on information up to but not
including time t.

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

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

(iii) The portfolio is self-financing if the instantaneous change in the value of the
portfolio is equal to the pure investment gain.

In other words, dVt = at dAt + bt dBt + ct dCt

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

0 ≤ t <U

(where U is the payment time for X) such that:

VU = aU AU + bU BU + cU CU = X .

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

self-financing portfolio strategy ( at , bt , ct ) , will reproduce the derivative
payment without risk. Hence, by no arbitrage the value of the derivative at
time 0 must be V0.

(vi) The market is complete if for any contingent claim X there is a replicating
strategy ( at , bt , ct ) .

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

portfolios and simple stochastic calculus seemed beyond most candidates.

Page 7
 Subject CT8 (Financial Economics Core Technical) – April 2013 – Examiners’ Report

7 (i) First we calculate the risk neutral probability of an up-jump q:

1
1.01 −
q= 1.2 = 0.481818
1
1.2 −
1.2

Then the equation of value for the option price is,

50 p =
1
1.01 2 (q P
2
uu + 2q(1 − q ) Pud + (1 − q)2 Pdd )
So

Puu = 219.70826 p − 2.15094 Pud −1.15664 Pdd .

(ii) Puu represents the payoff from an option so cannot be negative. Likewise, it
takes its maximum value when Pud and Pdd are zero. So
0 < Puu < 219.70826 p.

(iii) (a) If Puu takes its maximum value then Pud and Pdd are both zero.

If first stock price move is up then the new value of the option is:

qP
V = uu = 104.8113.
1.01

(b) As Pud and Pdd are both zero if the first stock price move is down then
the option will expire worthless.

Many candidates seemed uncomfortable with a basic binary tree calculation, despite these
being well-explained in the Core Reading. Those with some familiarity scored very well.

8 (i)
• Not perfect correlation across maturities.

Firstly, if we look at historical interest rate data we can see that changes in the
prices of bonds with different terms to maturity are not perfectly correlated as
one would expect to see if a one-factor model was correct. Sometimes we even
see, for example, that short-dated bonds fall in price while long-dated bonds
go up.

Recent research has suggested that around three factors, rather than one, are
required to capture most of the randomness in bonds of different durations.

Page 8
 Subject CT8 (Financial Economics Core Technical) – April 2013 – Examiners’ Report

• Different volatility phases.

Secondly, if we look at the long run of historical data we find that there have
been sustained periods of both high and low interest rates with periods of both
high and low volatility. Again these are features which are difficult to capture
without introducing more random factors into a model.

This issue is especially important for two types of problem in insurance: the
pricing and hedging of long-dated insurance contracts with interest-rate
guarantees; and asset-liability modelling and long-term risk-management.

• Pricing complex derivatives.

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

contracts which are more complex than, say, standard European call options.
For example, any contract which makes reference to more than one interest
rate should allow these rates to be less than perfectly correlated in order to
produce realistic pricing formulae.

(ii) This models two processes which satisfy the equations:

dr ( t ) = α r ( m ( t ) − r ( t ) ) dt + σ r1dW1 ( t ) + σ r 2 dW2 (t )
dm ( t ) = α m ( μ − m ( t ) ) dt + σ m1dW1 ( t )

where r(t) is the short rate, and m(t), the local mean-reversion level for r(t) and
W1 (t ) and W2 (t ) are independent, standard Brownian motions under the risk-
neutral measure Q.

Answers were mixed. Again, knowledge of basic Core Reading made all the difference to
candidates scores on this question.

9 (i) Q(Maxt<1St ≥ 2)
= Q(maxt<1σBt + (r − ½σ2)t ≥ ln 2)
= Q(maxt<1Bt + (r − ½σ2)t/σ ≥ ln 2/σ)
= Φ([−ln 2 + (r − ½ σ2)]/σ) + exp(2(r − ½σ2) ln 2/σ2) Φ(−[ln 2 + (r − ½σ2)]/σ)
= Φ(−2.7776) + 0.9727 × Φ(−2.7676)
= 0.00274 + 0.9727 × 0.00282
= 0.00548

So Q(Maxt<1St < 2) = 0.99452.

Page 9
 Subject CT8 (Financial Economics Core Technical) – April 2013 – Examiners’ Report

(ii) (a) Denoting by Q the EMM and by F1 the information available at time 1,
the risk neutral pricing formula gives the following price C1 for the
option at time 1:

• if the event {Maxt<1St < 2} occurs:

C1 = C1 (low) = e−rEQ[100.Max(S2/S1−1;0)|F1]

• if the event {Maxt<1St ≥ 2} occurs:

C1 = C1 (up) = 0

(b) In the case {(Maxt<1 St )< 2}, we need to compute the following
conditional expectation: C1 (low) = e−rEQ[100.Max(S2/S1−1;0)|F1]

Since S2/S1 is independent of the values of S up to time 1 under the

EMM Q, the conditional expectation is a simple expectation:

C1 (low) = e−rEQ[100.Max(S2/S1−1;0)] = e−r.100. EQ[Max(S2/S1−1;0)]

But S2/S1 = exp((r−σ2/2)+σ.(B2−B1)).

Hence, we simply need to compute the price of a standard European

option with strike and initial stock price both equal to 1 and maturity
1 year.

After some simple calculations, we have, in the case {(Maxt<1 St )<2}

C1 (low) = 100.[Φ(d1)−exp(−3%).Φ(d2)]
with d2 = [r–σ2/2]/σ and d1 = d2+σ.

Hence, C1 (low) = $11.348

(c) Thus, the fair price at time 0 of the option is C0 = E[e−r C11{Maxt<1St < 2}]
where 1{Maxt<1St < 2} is the indicator of the event {Maxt<1St < 2}, so takes
the value 1 if {Maxt<1St < 2} occurs and 0 otherwise.

So C0 = 0.99452e−r C1(low)
C0 = $10.952

This question was very poorly answered, with most candidates unable to cope with path-
dependent option, even though the steps to solution were laid out in the question. Familiarity
with the actuarial tables would also have been helpful.

Page 10
 Subject CT8 (Financial Economics Core Technical) – April 2013 – Examiners’ Report

10 (i) In the two state model, the company defaults at time-dependent rate λ(t) if it
has not previously defaulted. Once it defaults it remains permanently in the
default state. It is assumed that after default all bond payments will be reduced
by a known factor (1 − δ), where δ is the recovery rate. Now we need to
change to the risk neutral measure, which will change the default rate to λ′(t ) .
This rate is that implied by market prices.

(ii) The risk-neutral prices are given by

Pt = 100e−tR(t) = 100e−rt(1−(1 − δ)(1- exp(− ∫ t0 λ s ds )) )

= 100e−rt (δ + (1 − δ )Q(At)),

where R(t) is the effective rate for a ZCB with redemption at t, λs is the risk
neutral default rate at time s and At is the event that there has been no default
by time t.

So, P1 = 100e−(.015+.04) = $94.6485

and so Q(A1) = (er P1/100 – δ)/(1 − δ) = 0.90197

And P2 = 100e−2(.015+.05) = $87.8095

and so Q(A2) = (e2r P2/100 – δ)/(1 − δ ) = 0.76209

(iii) Thus ∫ 10 λ s ds = λ1 = −ln [Q(A1)] = 0.10317

and ∫ 02 λ s ds = λ1 + λ2 = −ln [Q(A2)] = 0.27169 and so λ2 = 0.16852.

This was a difficult question and many candidates clearly didn’t know the relevant material.
A smaller number did and consequently performed well.

END OF EXAMINERS’ REPORTS

Page 11
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

4 October 2012 (am)

Subject CT8 – Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. Mark allocations are shown in brackets.

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

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT8 S2012 © Institute and Faculty of Actuaries

1 The effective risk free interest rate is 4% p.a. Company AA has issued a one year
zero coupon bond with a yield of 6% p.a. and Company BB has issued a one year zero
coupon bond with a yield of 8% p.a. All rates are annually compounded.

Recovery rates on the bonds in the event of default are zero and there are no frictional
costs.

(i) Calculate the risk neutral implied default probability of each bond. [2]

(ii) Calculate the 95% VaR and 95% TailVaR at the end of the year for the
following portfolios, assuming defaults by AA and BB are independent:

(a) £100 invested in AA bonds.

(b) £100 invested in BB bonds.
(c) £50 invested in AA bonds and £50 invested in BB bonds.
[6]

(iii) Comment on your answers to (ii). [4]

[Total 12]

2 A non-dividend-paying stock has a current price of S0 = 400 p . Over each of the next
three years its price could increase by 20% (so St +1 = 1.2St ), or decrease by 20% (so
St +1 = St /1.2 ). The continuously compounded risk-free rate is 6% p.a. The stock
price move in each year is independent of the move in other years.

A non-standard derivative pays off S3 after three years, provided that at some point
over three years the stock price has moved up in one year and then immediately down
in the following year. Otherwise, the derivative pays zero.

Calculate the current price of this non-standard derivative. [8]

3 (i) State the three main assumptions of Modern Portfolio Theory. [3]

Assume Modern Portfolio Theory holds true.

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

(iii) Describe how an efficient portfolio can be found. [4]

[Total 10]

CT8 S2012–2
4 A non-dividend paying stock is currently priced at S0 = £80 . Over each of the next
two three-month periods it is expected to go up by 6% or down by 5% on each period.
The continuously compounded risk free interest rate is 5% p.a.

(i) Calculate the value of a six-month European call option with a strike price of
£82. [5]

(ii) Calculate the value of a six-month European put option with a strike price of
£82.

(a) Directly. [2]

(b) Using put-call parity. [3]

(iii) Explain whether, if the put option were American, it would ever be optimal to
exercise early. [4]
[Total 14]

5 State eight desirable characteristics of a term-structure model. [8]

6 (i) State the Stochastic Differential Equations for the short rate r(t) in the Vasicek
model and the Cox-Ingersoll-Ross model. [2]

(ii) Explain the impact of a movement in the short rate on the volatility term in
both models. [2]
[Total 4]

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

Widget Inc with a strike price of $1.30 has current price of $0.8557.

The continuously compounded risk free rate is 0.5% p.a. The current stock price is
$1.20. Assume all the Black-Scholes assumptions hold.

(i) Calculate the implied volatility for the underlying stock to within 1% p.a. [2]

It is known that in three months Universal Widget Inc will embark on a major
restructuring. It is anticipated that this will double the volatility of the stock price
thereafter.

(ii) Write down a formula in terms of the underlying Brownian motion, Z, for the
stock price in three months’ and in six months’ time. [3]

(iii) Derive the corresponding price of a six month European put on the Universal
Widget Inc stock with strike price $1.20
[6]
[Total 11]

CT8 S2012–3 PLEASE TURN OVER

8 (i) Describe the Merton model for pricing a defaultable bond. [4]

A very highly geared company, Risky plc, has issued zero coupon bonds payable in
three year time for a nominal amount of £3,200m.

A Black-Scholes model for the value of the company is adopted.

(ii) Derive an expression for the value of the debt. [3]

The current gross value of the company is £6,979m. The continuously compounded
risk-free interest rate is 2% p.a. and the price of £100 nominal of the bond is £92.603.

An insurance company is offering default insurance on Risky plc. They will charge a
premium of £55,000 for a contract which pays £1m at the end of three years if Risky
plc defaults.

(iii) Discuss whether there is an arbitrage opportunity. [4]

[Total 11]

9 Consider a market where there are two risky assets A and B and a risk free asset. Both
risky assets have the same market capitalisation.

Assume that all the assumptions of the CAPM hold.

(i) State the composition of the market portfolio. [1]

(ii) Derive the expressions for the variance of the market portfolio and for the beta
of each asset, in terms of the variance of each asset and of their covariance. [4]

Assume now that the risk-free rate is rf = 10%, the expected return of the market
portfolio is rM =18%, the variance of asset A is 4%, the variance of asset B is 2% and
their covariance is 1%.

(iii) Derive the value for the expected return on asset A and asset B. [4]

An investor wants an expected return of 20%.

(iv) Calculate the composition of the corresponding portfolio. [2]

(v) Derive the corresponding standard deviation using the Capital Market Line. [2]
[Total 13]

CT8 S2012–4
10 Let A and B be two investment portfolios taking values in [a,b] with cumulative
probability distribution functions of returns FA and FB respectively, and let the
investor’s smooth utility function be U.

(i) Write down the equation that the function U satisfies if the investor prefers
more to less. [1]

(ii) Explain what it would mean for portfolio A to first order stochastically
dominate portfolio B. [2]

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

if portfolio A first order stochastically dominates portfolio B, then the investor
prefers A to B. [6]
[Total 9]

END OF PAPER

CT8 S2012–5
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2012 examinations

Subject CT8 – Financial Economics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

D C Bowie
Chairman of the Board of Examiners

December 2012

© Institute and Faculty of Actuaries

 Subject CT8 (Financial Economics) – September 2012 – Examiners’ Report

General comments on Subject CT8

Subject CT8 introduces the main concepts and principles of financial economics. These are
developed in later subjects in the ST series of exams. This subject combines various types of
skills. In particular, along with CT7, it is one of the first where candidates are expected to
write lengthy passages of reasoned thought, rather than just complete calculations. This is a
skill that will be new to many and candidates are advised to pay particular attention to the
answers to this type of question by studying many past papers.

Comments on the September 2012 paper

The general performance was good and better than on the previous session (April 2012).
Candidates generally found this paper challenging, but well-prepared candidates scored well
across the whole paper and the best candidates scored close to full marks. As in previous
diets, questions that required an element of application of the core reading to situations that
were not immediately familiar proved more challenging to most candidates. The comments
that follow the questions concentrate on areas where candidates could have improved their
performance.

Page 2
 Subject CT8 (Financial Economics) – September 2012 – Examiners’ Report

1 (i) Let the risk neutral default probability for AA be p AA . Consider the equation
of value for a £100 investment in AA:

£106
100 = (1 − p AA ) × + p AA × 0 ⇒ p AA =1.8868%,
1.04

and similarly

£108
100 = (1 − pBB ) × + pBB × 0 ⇒ pBB = 3.7037%.
1.04

(ii) (a) The 95% VaR is zero. The 95% TailVar is

£106 p AA
= £106
p AA

(b) The 95% VaR is zero. The 95% TailVar is:

£108 pBB
= £108
pBB

(c) The distribution of returns is:

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

£54 with probability p AA (1 − pBB ) = 0.01817
£53 with probability pBB (1 − p AA ) = 0.03634
£0 with probability p AA pBB = 0.00070

So the 95% VaR is £107 − £54 = £53.

The 95% TailVaR is

£107 p AA pBB + £54(1 − p AA ) pBB

= £55
pBB

(iii) Investing in diversified (i.e. not perfectly correlated) assets generally leads to a
lower dispersion of returns and hence lower risk.

Portfolio (c) is diversified compared to (a) and (b). However, the 95% VaR
for portfolio (c) is higher than for either (a) or (b) where it is zero. So an
increase in VaR could, in this circumstance, correspond to a decrease in risk.

Zero VaR does not necessarily mean zero risk.

The 95% TailVaR for portfolio (c) is lower than (a) and (b).

Page 3
 Subject CT8 (Financial Economics) – September 2012 – Examiners’ Report

The question was framed sufficiently openly that candidates could quote values at risk
relative to the maximum return, the expected return or the initial investment. Full marks
were available for any approach if it was followed through correctly although the below sets
out answers relative to the maximum return.

In general, this was poorly answered with candidates struggling to gain more than a few
marks. Some candidates calculated the transition rates in part (i) instead of the probability or
calculated the probabilities assuming a continuous time model. In part (ii), many candidates
calculated VaR and TailVaR using a continuous model instead of the discrete model in the
question. Some candidates confused VaR and variance.

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

e6% − 1/1.2
q= = 0.62319 [1]
1.2 − 1/1.2

There are eight possible paths the option could take. The paths, probabilities of those
paths, final stock prices and option payoffs are shown in the following table.

Path Probability of path Final stock price Option payoff

Up up up q3 = 0.24203 691.2 Nil

Up up down q 2 (1 − q) = 0.14634 480 21.91

Up down up q 2 (1 − q) = 0.14634 480 21.91

Up down down (1 − q)2 q = 0.08848 333.33 18.26

Down up up q 2 (1 − q) = 0.14634 480 Nil

Down up down (1 − q)2 q = 0.08848 333.33 18.26

Down down up (1 − q)2 q = 0.08848 333.33 Nil

Down down down (1 − q)3 = 0.05350 231.48 Nil

The price of the option is then

V = e −3×6% ∑ probability of path × option payoff = 8.05p

paths

If candidates worked in units of £s rather than p, they will have found an answer of
£0.805 (or 80.5p) and full marks were available.

Also, if candidates took a down movement to mean 0.8St rather than St/1.2 then full
marks were available in this case.

Page 4
 Subject CT8 (Financial Economics) – September 2012 – Examiners’ Report

Largely well answered. Some candidates didn’t calculate the price correctly because they
miscalculated the number of paths to the nodes with non-zero payoffs. Some candidates
miscalculated the probability by using e-r rather than er. A few candidates calculated the
probability according to classical probability theory (favourable outcomes / possible
outcomes) rather than risk-neutral.

3 (i) The key assumptions are:

(a) That investors select their portfolios on the basis of the expect return
and the variance of that return over a single time horizon.

(b) Investors are never satiated. At a given level of risk, they will always
prefer a portfolio with a higher return to one with a lower return.

(c) Investors dislike risk. For a given level of return they will always
prefer a portfolio with lower variance to one with higher variance.

(ii) Suppose an investor can invest an any of N securities, i = 1, …, N .

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

N
RP = ∑xi Ri ,
i =1

where Ri is the return on security i .

The expected return on the portfolio E is

N
E = E [ RP ] = ∑xi Ei ,
i =1

where Ei is the expected return on security i .

The variance is

N
V = Var [ RP ] = ∑ xi x j Cij ,
i , j =1

where Cij is the covariance of the returns on securities i and j and we write
Cii =Vi .

(iii) A portfolio is efficient if the investor cannot find a better one in the sense that
it has both a higher expected return and a lower variance.

Page 5
 Subject CT8 (Financial Economics) – September 2012 – Examiners’ Report

When there are N securities the aim is to choose xi to minimise V subject to the
constraints

Σi xi = 1

and

E = EP, say,

in order to plot the minimum variance curve.

One way of solving such a minimisation problem is the method of Lagrangian

multipliers.

The Lagrangian function is

W = V − λ(E − EP) − μ(Σi xi − 1).

To find the minimum we set the partial derivatives of W with respect to all the xi and
λ and μ equal to zero. The result is a set of linear equations that can be solved.

The usual way of representing the results of the above calculations is by plotting the
minimum standard deviation for each value of EP as a curve in expected return –
standard deviation (E − σ) space. In this space, with expected return on the vertical
axis, the efficient frontier is the part of the curve lying above the point of the global
minimum of standard deviation.

Largely well answered. Some candidates forgot the “single time period” assumption in part
(i) or included simplifying assumptions such as “no transaction charges etc.” as major
assumptions. Some candidates confused efficient portfolios with optimal portfolios.

Page 6
 Subject CT8 (Financial Economics) – September 2012 – Examiners’ Report

4 (i) The model can be drawn as follows:

S2 = 89.888
q

S 1 = 84.8
q
S2 = 80.762
q
S 0 = 80 S 1 = 76.194

S2 = 72.562

Payoff
Call at 82 Put at 82
7.888 0
0 1.238
0 9.438

1
e5%/4 −
Now q = 1.05 = 0.55936.
1
1.06 −
1.05

So, c0 = e−5%/2 ⎡ q 2 × 7.888 + 0 ⎤ = 2.40707

⎣ ⎦

5%
−
(ii) (a) Similarly, p0 = e 2 ⎡(1 − q )2 × 9.438 + 2q (1 − q ) ×1.238⎤ = 2.38248
⎢⎣ ⎥⎦

5%
−
(b) The put-call parity entails c0 + 82e 2 = p0 + 80

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

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

At time zero, the value of the American put option is at least as great as the
European put option, i.e. greater than 2.38248. The intrinsic value of the
option is 2. Therefore early exercise is not optimal.

Page 7
 Subject CT8 (Financial Economics) – September 2012 – Examiners’ Report

After three months, if the first move is up the option is out of the money, so
early exercise is not optimal.

After three months, if the first move is down, the intrinsic value of the option
is 82 − 76.19048 = 5.8095. The value of holding on to the option until 6
months is given by

5%
−
e 4
( q ×1.238 + (1 − q ) × 9.438) = 4.7909.
So, it would be optimal to exercise the option early if the first move was
down.

Candidates who calculated a down move as multiplying by 0.95 rather than

dividing by 1.05 were awarded full marks.

Largely well answered with most candidates earning full marks in parts (i) to (iii). The
majority of candidates discussed whether it was optimal to exercise American put options in
general in part (iv), or even American call options, rather than the particular option in the
question.

5 The model should be arbitrage free.

Interest rates should be positive.

The short rate and other interest rates should exhibit some form of mean-reverting
behaviour.

It should be straightforward to calculate the prices of bonds and certain derivative

contracts.

The model should produce realistic dynamics.

The model should be able to be calibrated easily to current market data.

The model should be flexible enough to cope properly with a range of derivative
contracts.

The model should provide a satisfactory fit to historical data.

Generally well done as straightforward book work. Some candidates answered this with a
series of questions such as "is it easy to calculate? does it fit historical data?... In this
situation marks were awarded according to the extent that the candidates identified the key
points set out below. Some candidates did write other assumptions like “constant volatility”
or “the share follows geometric Brownian motion”.

Page 8
 Subject CT8 (Financial Economics) – September 2012 – Examiners’ Report

6 (i) Under the risk neutral measure Q the short rate under the Vasicek model has
the dynamics

dr ( t ) = α ( μ − r ( t ) ) dt + σdW (t )

The short rate under the Cox-Ingersoll-Ross model has the dynamics

dr ( t ) = α ( μ − r ( t ) ) dt + σ r (t ) dW (t )

(ii) So, if the short-rate changes, the volatility of the process is unchanged in the
Vasicek model, but it will change in the CIR model (an increase in the short
rate will lead to an increase in the volatility).

Most candidates gained full marks in part (i). Some candidates wrote about how a change in
volatility could affect the short-term rate rather than vice versa. One or two candidates only
included the sigma in the volatility term of the CIR model. Many candidates gave generic
statements about the interest rate models in answer to part (ii), rather than responding to the
question.

7 (i) Standard interpolation gives a volatility of σ = 436%

(ii) Under the risk free measure, the stock price S0.25 = S0 exp(σ Z0.25 −
0.5σ2(0.25) + 0.25r)

While the stock price at time 6 months is

S0.5 = S0.25 exp(2σ(Z0.5 − Z0.25 ) − 0.5(2σ)2 (0.25) + 0.25r)

= S0 exp(2σ(Z0.5 − Z0.25 ) + σ Z0.25 − 0.5σ2(1.25) + 0.5r)

Full marks were available if candidates provided the formulae under the real
world probability measure.

(iii) Since Z has stationary independent increments, S0.5 has the same distribution
as

S0 exp(√(2.5)σZ0.5 − 0.5σ2(1.25) + 0.5r),

which corresponds to the stock price at 6 months with volatility √(2.5)σ.

Now, using the Black-Scholes formula, the put price is

p = K−rT Φ(−d2) − S0 Φ(−d1).

d1 = 2.4378
d2 = -2.4368,

Page 9
 Subject CT8 (Financial Economics) – September 2012 – Examiners’ Report

so

p = 120(e−.5r Φ(−d2) − Φ(−d1)) = $1.179

In general, this was poorly answered. There was evidence of candidates spending a
significant amount of time in part (i) but many then proceeded with an assumed value for the
volatility and were awarded full marks where they completed parts (ii) and (iii) in a self-
consistent way. Most candidates forgot the volatility doubled between time three and six.
Several candidates managed to calculate a value in part (iii) using their assumed values from
part (i).

8 (i) Merton’s model assumes that a corporate entity has issued both equity and
debt such that its total value at time t is of F(t).

It is an example of a structural credit risk model.

F(t) varies over time as a result of actions by the corporate entity which does
not pay dividends on its equity or coupons on its bonds. Part of the corporate
entity’s value is zero-coupon debt with a promised repayment amount of L at a
future time T. At time T the remainder of the value of the corporate entity will
be distributed amongst the equity holders and the corporate entity will be
wound up.

The corporate entity will default if the total value of its assets, F(T) is less than
the promised debt repayment at time T, i.e. F(T)<L. In this situation, the bond
holders will receive F(T) instead of L and the equity holders will receive
nothing.

This can be regarded as treating the equity holders of the corporate entity as
having a European call option on the assets of the company with maturity T
and a strike price equal to the value of the debt.

The Merton model can be used to estimate either the risk-neutral probability
that the company will default or the credit spread on the debt.

(ii) Under the Merton model, the value at redemption is min(F(T), £3,200m),
where F(t) is the gross value of the company at time t.

Thus the value at time 0 is

e−3rE[min(F(3),3200)] = e−3rE[F(3) − max(F(3) − 3200,0)],

where the expectation is under the risk-neutral measure, so equals F(0) − C,

where C is a call option on the gross value with strike £3,200m.

(iii) The market value of the debt is £3,200 × £92.603/£100 = £2,963.3m

Page 10
 Subject CT8 (Financial Economics) – September 2012 – Examiners’ Report

The market value of the equity (i.e. the call option on the company’s assets is
then £6,979m − £2,963.3m = £4,015.7m.
We can calculate the implied volatility of the company’s assets as 29.8%

The risk neutral price for the insurance (ignoring credit risk of the insurer
themselves) is then:

£1m × e−6% × (1 − Φ(d2)) = £1m × e−6% × 0.085518 = £80,538.2

Whether or not this represents an arbitrate opportunity depends on whether

there is a market (e.g. credit default swaps) where you can trade these
contracts/go short in relation to Risky plc.

Candidates had no major problems in part (i) describing the Merton model. Some
candidates did confuse the facts that shareholders had a call option while bondholders had a
put, although given put-call parity there are various ways to value these options. Only some
candidates managed to answer part (ii) and some did answer it by reference to valuing a put
option rather than the call in the marking schedule for which full marks were awarded.

9 (i) Since equal market capitalisation: wA = 0.5 and wB = 0.5.

(ii) Let rM denote the return of the market portfolio, rA (resp. rB) denote the return
of asset A (resp. asset B).

Then, V(rM) = V(0.5rA + 0.5rB) = 0.52 * V(rA) + 0.52 * V(rB)

+ 2 * 0.52 cov(rA,rB).

BetaA = cov(rA,rM)/V(rM)
= (0.5 * V(rA) + 0.5 * cov(rA,rB))/ 0.52 * V(rA) + 0.52 * V(rB)
+ 2 * 0.52 cov(rA,rB)

As Cov(rA,rM) = cov(rA,0.5rA+0.5rB) = 0.5 * V(rA) + 0.5 * cov(rA,rB)

Similarly, BetaB = (0.5 * V(rB) + 0.5 * cov(rA,rB)) / 0.52 * V(rA) + 0.52

* V(rB) + 2 * 0.52 cov(rA,rB)

(iii) The equation of the Security Market line gives:

ri = rf + Betai (rM – rf) where ri is the expected return of asset i (for i = A,B).

Hence, using the numerical values, we get

rA = 0.2 and rB = 0.16

(iv) Using the separation theorem, we have:

Page 11
 Subject CT8 (Financial Economics) – September 2012 – Examiners’ Report

rP = w0 rf + wM rM

where w0 is the weight of the risk-free asset in the portfolio P and wM is the
weight of the market portfolio in the portfolio P.

Moreover, there is the constraint w0 + wM = 1

Solving the system leads to:

w0 = −0.25 and wM = 1.25

(v) The Capital Market Line equation is:

rP = rf + sigmaP * ((rM – rf) / sigmaM)

where sigmaP (resp. sigmaM) is the standard deviation of the portfolio P (resp.
the market portfolio.

So, we get sigmaP = 17.6%

This question posed little difficulty to well-prepared candidates. Some included the risk-free
asset in their answer to part (i). In part (ii), a lot of candidates defined beta in terms of the
market portfolio rather than the risky assets as asked for in the question. Part (iii) posed
little problem for the majority of candidates although some struggled to calculate a
numerical value for beta. Only a handful of candidates included the risk-free asset in part
(iv). The majority only included the risky assets.

10 (i) U ′ ( w) > 0 .

(ii) This means that the probability of portfolio B producing a return below a
certain value is never less than the probability of portfolio A producing a
return below the same value and exceeds it for at least some value of x .

Alternative answer:

First order stochastic dominance holds if:

FA ( x ) ≤ FB ( x ) , for all x , and

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

(iii) The expected utility of A is

b
E [U A ] = ∫ U ( w ) dFA ( w ) ,
a

Page 12
 Subject CT8 (Financial Economics) – September 2012 – Examiners’ Report

and the expected utility of an investment in portfolio B is

b
E [U B ] = ∫ U ( w ) dFB ( w ) .
a

Thus, if A is preferred to B

b b

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

a a

Now, the left hand side can be written as

∫ U ( w)[dFA ( w) − dFB ( w)]

a

and integrating by parts yields

b
⎡U ( w) ( FA ( w ) − FB ( w ) ) ⎤ − ∫ U ′ ( w ) [ FA ( w ) − FB ( w )]dw.
b
⎣ ⎦a
a

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

so for the expression to be positive we require the value of the integral to be
negative.

U ′ ( w ) > 0 by assumption, so for the integral to be negative, no matter what

the exact form of U ′ ( w ) , FA ( w ) − FB ( w ) must be less than or equal to zero
for all values of w with FA < FB for at least one value of w if the value is not
to be zero.

Largely well-answered. However, some candidates appeared to confuse inequality signs. In

part (i), this meant defining non-satiation as having a decreasing utility function while in part
(ii) this meant the distribution function of A was greater than that of B. Fewer candidates
than expected scored well in part (iii) for what appeared to be a textbook proof.

END OF EXAMINERS’ REPORT

Page 13
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

25 April 2012 (am)

Subject CT8 – Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. Mark allocations are shown in brackets.

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

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT8 A2012 © Institute and Faculty of Actuaries

1 (i) State the assumptions underlying the Black-Scholes market. [3]

(ii) State the defining characteristics of Brownian Motion. [2]

(iii) Explain what an examination of past option prices tell us about the
assumptions in (i) and (ii). [4]
[Total 9]

2 In a market where the CAPM holds there are five risky assets with the following
attributes per year.

Asset number 1 2 3 4 5

Expected return 6% 5% 8% 13% 11%

Market capitalisation (in $) 2.6m 3.9m 5.2m 1.3m
Beta 1.5

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

(i) Calculate the expected return on the market portfolio. [1]

(ii) Deduce the market capitalisation of asset 4 and the betas of all the other assets.
[3]

(iii) Calculate the beta of a portfolio P which is equally weighted in the five assets
and the risk-free asset. [1]

(iv) Explain whether or not this portfolio P lies on the Capital Market Line. [2]
[Total 7]

3 A non-dividend paying stock has a current price of S0 = 150p and trades in a market
which is arbitrage free and has a constant effective risk-free rate of interest r. After
one year the price of the stock could increase to 280p, or decrease to 120p. Over the
following year the price could increase from 280p either to 420p or to 322p. If the
stock price had decreased to 120p, then over the following year it could increase to
168p or decrease to 112p.

(i) Determine the range of values that the annual risk-free rate of interest could
take. [3]

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

(ii) Calculate the price at time 0 of a non-standard derivative which pays off
( S 2 − 100) 2 at the end of two years. [6]
[Total 9]

CT8 A2012–2
4 Let c be the price of a four- month European call option on a dividend paying share.
Assume the strike price is $30, the underlying is currently valued at $28 and a
dividend of $0.50 is expected in 2 months. The continuously compounded risk-free
rate is constant and equal to 5% p.a.

(i) Derive upper and lower bounds on the price c of this call option, taking into
account the dividend. [5]

The price of a put option with the same underlying, the same strike price and the same
maturity is $3.

(ii) Calculate the price c of the call option exactly. [5]

[Total 10]

5 Let X be a random variable denoting the rate of return on the fund ABC. The
(
distribution of X is N μ, σ2 . )
(i) Define VaRα ( X ) with α ∈ [ 0,1] . [1]

(ii) Show that:

(
VaRα = − μ + σΦ −1 ( α ) )
where Φ denotes the cumulative Normal distribution function.

(Hint: Consider the probability that X is less than VaRα ). [4]

(iii) Derive an expression for TailVaRα ( X ) given that:

1
TailVaRα = E ( X |X < VaRα ) . [4]
α

An investor holds £350m invested in ABC, the expected return on the fund is 10%
and the standard deviation of that return is 25%.

(iv) Calculate the VaR and TailVaR of this investment when α = 0.01. [2]
[Total 11]

CT8 A2012–3 PLEASE TURN OVER

6 (i) Write down a stochastic differential equation for the short rate r (t ) for the
Vasicek model. [1]

(ii) State the type of process of which the Vasicek model is a particular example.
[1]

(iii) Solve the stochastic differential equation in (i). [5]

(iv) State the distribution of r(t) for t given. [1]

(v) Derive the expected value and the second moment of r(t) for t given. [3]

(vi) Outline the main drawback of the Vasicek model. [1]

[Total 12]

7 The remuneration package for the CEO of a quoted company in the tax year 2012/13
includes a bonus proportional to the excess of the share price over 100p at
5 April 2013 at a rate of £50,000 per penny.

The company’s Finance Director wants to hedge the cost of this bonus as at 6
April 2012. The share price at that date is S0 = 90p.

The continuously compounded interest rate is 1% p.a. and the share price volatility is
18% p.a.

(i) Explain the bonus in terms of an option on the share price. [2]

(ii) Calculate the hedging portfolio of shares and cash the Finance Director should
hold to hedge the liability for the CEO’s bonus. [3]

The CEO will be liable to tax at 80% on the excess over £1m of this bonus and at
40% up to £1m. The Finance Director realises that if she purchases for the CEO a
portfolio of a call options with a strike of 100p and −b call options with a strike of
120p and gives this portfolio to the CEO on 6 April 2012 then the proceeds will be
liable for tax at only 40%.

(iii) (a) Calculate the values of a and b which ensure that the CEO would
receive the same net bonus. [5]

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

options are exercised).

(b) Calculate the amount this transaction will save the company. [2]
[Total 12]

CT8 A2012–4
8 In a Black-Scholes market, a special option with strike price a and maturity T on an
underlying (non-dividend bearing) stock with price process S, pays 100p at time T if
and only if the stock price at time T, ST, is more than a. Let Ia (x) denote the function
which takes the value 1 if x>a and 0 otherwise.

(i) Write down a formula, in terms of expectation, Ia, and the underlying stock
price, for the price D0(a) at time 0 of this security, specifying any other
notation that you use. [2]

(ii) Write down an equation connecting the price, C0(K) of the call option on S
with maturity T and strike price K, to the price of the special option on S, using
∞
the fact that max(x−k,0) = ∫ I a ( x ) da . [2]
k

(iii) Find a formula for the price of the special option on S, by differentiating the
Black-Scholes formula with respect to K. [3]

Suppose S0 = 110p, the continuously compounded risk-free rate is 1% p.a., and the
volatility of S is 20% p.a.

(iv) Calculate the price for a derivative security which pays S1 − 20p if S1 > 120p
and 0 otherwise. [3]
[Total 10]

9 (i) Describe the two state model for credit ratings and its generalisation to the
Jarrow-Lando-Turnbull model. [4]

Companies A and B are joint investors in a high risk project to build a new space
plane. Each of the two companies’ zero-coupon bonds are modelled according to a
two-state model. Company A’s bonds have a recovery rate of δA = 60%, while
Company B’s have a recovery rate of δB = 50%. All bonds mature in nine months.
Company A’s bonds have a current price of $82 per $100 nominal, Company B’s
bonds have a current price of $79 per $100 nominal. The continuously compounded
risk-free rate is 1.5% p.a.

(ii) Calculate the implied risk-neutral default intensities λA and λB, assuming that
they are constant. [4]

A competitor to the space plane project now starts to sell a derivative security which
pays $100,000 at the end of nine months if and only if both companies default within
the nine months (a double-default). The current price for the derivative is $7900.

(iii) Calculate the implied risk neutral probability of a double-default and the
corresponding constant rate. [2]

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

CT8 A2012–5 PLEASE TURN OVER

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

(ii) State the two major weaknesses of APT. [2]

[Total 6]

END OF PAPER

CT8 A2012–6
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2012 examinations

Subject CT8 – Financial Economics

Core Technical

Purpose of Examiners’ Reports

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and who are using
past papers as a revision aid, and also those who have previously failed the subject. The
Examiners are charged by Council with examining the published syllabus. Although
Examiners have access to the Core Reading, which is designed to interpret the syllabus, the
Examiners are not required to examine the content of Core Reading. Notwithstanding that,
the questions set, and the following comments, will generally be based on Core Reading.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report. Other valid approaches are always given appropriate credit; where there is a
commonly used alternative approach, this is also noted in the report. For essay-style
questions, and particularly the open-ended questions in the later subjects, this report contains
all the points for which the Examiners awarded marks. This is much more than a model
solution – it would be impossible to write down all the points in the report in the time allowed
for the question.

T J Birse
Chairman of the Board of Examiners

July 2012

© Institute and Faculty of Actuaries

 Subject CT8 (Financial Economics) – April 2012 – Examiners’ Report

General comments on Subject CT8

Subject CT8 introduces the main concepts and principles of financial economics. These are
developed in later subjects in the ST series of exams. This subject combines various types of
skills. In particular, along with CT7, it is one of the first where candidates are expected to
write lengthy passages of reasoned thought, rather than just complete calculations. This is a
skill that will be new to many, and candidates are advised to pay particular attention to the
answers to this type of question by studying many past papers.

Comments on the April 2012 paper

The general performance was good and better than on the previous session (September 2011).
Candidates generally found this paper challenging, but well-prepared candidates scored well
across the whole paper and the best candidates scored close to full marks. As in previous
diets, questions that required an element of application of the core reading to situations that
were not immediately familiar proved more challenging to most candidates. The comments
that follow the questions concentrate on areas where candidates could have improved their
performance. Candidates approaching the subject for the first time are advised to concentrate
their revision in these areas and the ability to apply the core reading to similar situations.

Page 2
 Subject CT8 (Financial Economics) – April 2012 – Examiners’ Report

1 (i) The assumptions underlying the Black-Scholes model are as follows:

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

2. There are no risk-free arbitrage opportunities.

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

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

5. There are no taxes or transaction costs.

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

small numbers of units.

(ii) A Brownian Motion Z has the following properties

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

{Zr , r ≤ s} whenever s < t.

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

on t − s.

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

N(0, t − s).

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

consequence of (1)−(3)).

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

values of volatility over the term of the option. Given observed option prices
in the market, it is possible to work backwards to the implied volatility, that is,
the value of σ which is consistent with observed option. Examination of
historic option prices suggests that volatility expectations fluctuate markedly
over time.

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

Page 3
 Subject CT8 (Financial Economics) – April 2012 – Examiners’ Report

2 (i) EM = 9%

(ii)

Asset number 1 2 3 4 5

Expected return 6% 5% 8% 13% 11%

Market capitalisation (in $) 2.6m 3.9m 5.2m 6.5m 1.3m
Beta 5/8 1/2 7/8 1.5 5/4

(iii) βP = 19/24

(iv) P does not belong to the Capital Market Line because (except in degenerate
cases) portfolios on the efficient frontier consist of linear combinations of the
market portfolio and the risk-free asset.

Generally answered well by candidates. Most candidates were able to score full marks on
parts (i) and (ii). The rest of the question proved to be a bit more difficult.

3 (i) The no arbitrage condition implies that d < 1 + r < u .

At the current time, this implies that 0.8 < 1 + r < 1.8667 .

After an up move we have 1.15 < 1 + r < 1.5.

After a down move we have 0.9333 < 1 + r < 1.4.

Since the rate of interest has to satisfy all of these inequalities, we obtain
15% < r < 40% .

(ii) The model can be drawn as follows:

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

q2

q1 S 1 = 280
S2 = 322, payoff is 2222 = 49, 284 .

q3
S 0 = 150 S 1 = 120 S 2 = 168, payoff is 682 = 4, 624 .

S2 = 112, payoff is 122 = 144 .

Page 4
 Subject CT8 (Financial Economics) – April 2012 – Examiners’ Report

Then we can calculate

180 − 120 336 − 322

q1 = = 0.375 , q2 = = 0.14286
280 − 120 420 − 322

144 − 112
and q3 = = 0.57143.
168 − 112

The value of the option is therefore

1
V= ⎡⎣102, 400q1q2 + 49, 284q1 (1 − q2 ) + 4, 624 (1 − q1 ) q3 + 144 (1 − q1 ) (1 − q3 ) ⎤⎦
(1 + r )2
= 15, 984.

Generally candidates scored well on this question.

4 (i) Consider a portfolio, A , consisting of a European call on the share and a sum
5% 5%
− −
of money equal to $30e 3 + $0.50e 6 .

After 4 months, portfolio A has a value which is equal to the value of the
underlying share plus the dividend invested for two months, provided that the
share value is above $30. If the value of the share is below $30, then the
payoff from portfolio A is great than that from the share with the dividend
reinvested. So

5% 5%
− −
c + $30e 3 + $0.50e 6 ≥ $28

⇒ c ≥ −$2

The call option gives the holder the right to buy the underlying share for $30.
So the payoff is always less than the value of the share after 4 months.

Therefore the value of the call option must be less than or equal to the value of
the share:

c0 ≤ $28.

Page 5
 Subject CT8 (Financial Economics) – April 2012 – Examiners’ Report

(ii) Consider the following two portfolios:

5% 5%
− −
A: one call option plus cash of $30e 3 + $0.50e 6
B: one put option plus one share
After four months both portfolios have value

5%
−
max {$30, S4 months } + $0.50e 6 .

Therefore they should have the same value at any time before 4 months, so

5% 5%
− −
c0 + $30e 3 + $0.50e 6 = $3 + $28,
and so c0 = 1.

Generally answered well by candidates. Most candidates were able to score full marks on
part (i).

5 (i) VaRα ( X ) = −t where P ( X < t ) = α.

(ii) Following the hint in the question:

α = P ( X < −VaRα )

⎛ X − μ −VaRα − μ ⎞
= P⎜ < ⎟
⎝ σ σ ⎠

⎛ −VaRα − μ ⎞
= P⎜ Z < ⎟
⎝ σ ⎠

where Z is a standard Normal random variable.

⎛ −VaRα − μ ⎞
Therefore = Φ ⎜ ⎟
⎝ σ ⎠
−VaRα − μ
⇒ Φ −1 ( α ) = ,
σ

and so VaRα = −( μ + σΦ −1 ( α )).

Page 6
 Subject CT8 (Financial Economics) – April 2012 – Examiners’ Report

(iii) As the loss distribution is continuous, we have

TailVaRα = E ( − X |X < −VaRα )

−VaRα
1
=− ∫ xϕμ,σ ( x ) dx
α
−∞

− Φ −1( α )
σ
= −μ − ∫ xϕ0,1 ( x ) dx
α
−∞

σ − Φ −1( α )
= −μ − ⎡⎣ −ϕ0,1 ( x ) ⎤⎦
α −∞

=
σ
α
(
ϕ Φ −1 ( α ) − μ )
(iv) VaR = −£350m [10% − 25% × 2.32635] = £168.56m

⎡ 25% 1 − 2×2.32635 ⎤
1 2

TailVaR = −£350m ⎢10% − e ⎥ = £198.21m

⎢⎣ 1% 2π ⎥⎦

There were typographical errors in the question which should have defined
TailVaRα = E( − X |X < −VaRα ) . Generous consideration was given to all scripts containing
any reasonable attempt in the marking of this question.

6 (i) dr ( t ) = α ( μ − r ( t ) ) dt + σdW ( t ) where W is a standard Brownian motion.

(ii) This process is an Ornstein-Uhlenbeck process.

(iii) Let r ( t ) = s (t )e −αt so

( )
ds ( t ) = d r ( t ) eαt =αeαt r ( t ) dt + eαt dr ( t )

= αeαt r ( t ) dt + eαt α ( μ − r ( t ) ) dt + eαt σdW ( t )

= αμeαt dt + σeαt dW ( t ) .

Page 7
 Subject CT8 (Financial Economics) – April 2012 – Examiners’ Report

t
( )
Thus s ( t ) = s ( 0 ) + μ eαt − 1 + σ ∫ eαs dW ( s ) ,
0
t
and r ( t ) = r ( 0 ) e −αt
(
+ μ 1− e −αt
) + σ∫ e α ( s −t )
dW ( s ) .
0

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

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

⎛ t
⎞
( )
E ( r ( t ) ) = E ⎜ r ( 0 ) e −α t + μ 1 − e −α t + σ ∫ eα ( s −t ) dW ( s ) ⎟
⎝ 0 ⎠
Hence,

E ( r ( t ) ) = r ( 0 ) e −α t + μ (1 − e −α t )

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

⎛⎛ ⎞ ⎞
2

( )
t
E ( r (t )) = E ⎜ r ( 0) e + μ 1 − e ( α ( s −t )
)
dW ( s ) ⎟ ⎟
2
⎜ −α t −α t
+σ ∫ e
⎜⎝ ⎠ ⎟⎠
⎝ 0

( ) = (r ( 0 ) e
t

E (r ( t )
2 −α t
+ μ 1− e( −α t
)) 2
+σ 2
∫e
2α ( s − t )
ds
0
(vi) The process may become negative which is undesirable in a nominal interest
rate model

This was again standard material from the core reading and more successful candidates
tended to score well, although this question proved to be generally challenging.

7 (i) The CEO essentially holds 5,000,000 call options on the stock with strike
100p and maturity 1 year.

(ii) Thus C = SΦ(d1) − Ke−rT Φ(d2),

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

and Φ(d2) = .26770

so that C = 3.2009p.

Page 8
 Subject CT8 (Financial Economics) – April 2012 – Examiners’ Report

Then ΔC = ∂C/∂S = Φ(d1) =.33005,

so the hedging portfolio is 5,000,000 ×.33005 = 1,650,250 shares
and 5,000,000 ×.032009 − 1,650,250 ×.9 = £1,325,180 short in cash.

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

0.6 × a × (S − 100) = 0.6 × 5,000,000 × (S −100)

so a = 5,000,000;

For S>120, then we need

0.6 ×{a(S − 100) − b(S −120)}= 600,000 + 0.2 × 5,000,000(S − 120)

Equating coefficients of S, we must have b = 3,333,333.

We can then check that the constant terms agree in this equation, too.

(b) The amount saved is the cost of b call options with the higher strike.

We get C ′ = SΦ(d1) − Ke−rT Φ(d2), with S = 90, K = 120, d1 =

−1.45268, d2 = −1.63268, Φ(d1) = .07316, SΦ(d2) = 0.05127

So C ′ = .4932p
The saving is 3,333,333 ×.004932 = £16,440.

Question 7 was generally found to be difficult. While part (i) was generally straightforward
for most candidates, parts (ii) and (iii) proved to be very challenging and were only answered
well by the best candidates.

8 (i) D0(a) = e−rT E[Ia(ST)]

∞
(ii) Since C0(K) = e−rTE[max(ST − K,0)] = e − rT E[ ∫ I a ( ST )da ], we see that
k
∞
C0(K) = ∫k D0 (a )da.

(iii) It follows that

D0(K) = −d/da C0(K) = −d/dK(SΦ(d1) −Ke−rT Φ(d2))

= e−rT Φ(d2) − Sφ(d1)(dd1/dK) − Ke−rT φ(d2)(dd2/dK),

where φ is the standard normal density.

Page 9
 Subject CT8 (Financial Economics) – April 2012 – Examiners’ Report

Now (dd1/dK) = −1/(Kσ√T) = (dd2/dK),

and Sφ(d1) = (1/√2π) exp(log S − d12/2) = Ke−rT φ(d2)
and so D0(K) = e−rT Φ(d2).

(iv) We can decompose the payoff for this security as the sum of a call with strike
120 and 1 special option also with strike 120p.

Thus the price is

(SΦ(d1) − Ke−rT Φ(d2) + 100e-rTΦ(d2))

p = 110Φ(d1) − (120e−r −100e-r) Φ(d2)
= 110 * (.3877867) − ( 19.80100) * 0.3138046 = 36.443p

This question proved to be a bit challenging, despite being well within the syllabus..

9 (i) In the two state model, the company defaults at time-dependent rate λ(t) if it
has not previously defaulted. Once it defaults it remains permanently in the
default state. It is assume d that after default all bond payments will be
reduced by a known factor (1 − δ), where δ is the recovery rate. Now we need
to change to the risk neutral measure, which will change the default rate to
λ′(t ). This rate is that implied by market prices.

The Jarrow-Lando-Turnbull model generalises the two-state model to n −1

credit ratings plus the default state with transitions possible between any pair
of states except for the default state which is absorbing.

(ii) The risk-neutral prices are given by

82 = 100e−rt(1 − (1 − δA) (1-exp(−λAt))),

and

79 = 100e−rt(1 − (1 − δB) (1-exp(−λBt))),

so

λA = −log [1-(1 − e.75r 82/100) / (1 − δA)] / .75 = .74204

and

λB = − log [1-(1 − e.75r 79/100) / (1 − δB)] / .75 = .68583.

(iii) Let p denote the risk-neutral double-default probability, then if V is the price
of the derivative security we have

V = 100,000 e−.75rp,

Page 10
 Subject CT8 (Financial Economics) – April 2012 – Examiners’ Report

So

P = (7900/100000) * e.75r = 0.07989,

the corresponding constant rate is –log (1 − p) / .75 = 0.111016.

(iv) Now we get a double-default when both companies default, so this can’t
happen at rate faster than min(λA, λB) = λB = .68583. This would give rise to a
price for the derivative of V ′ = 100000e−.75r p ′ , where p ′ = 1 − exp(− .75 λB)
= 0.40212 so V ′ = $39,763.

Alternatively, we can buy $200,000 nominal of risk-free zero coupon bond

and sell $200,000 nominal of company B’s bond. This will cost
200,000(e−.75r − .79) = $39,763 and will pay $100,000 in 9 months if and only
if company B defaults.

Clearly, we would not be willing to pay more than this for the derivative.

Few candidates failed to score well on this exercise.

10 (i) APT requires that the returns on any stock be linearly related to a set of factor
indices as shown below

Ri = ai + bi,1 I1 + bi,2 I2 + ... + bi ,L IL + ci ,

where Ri is the return on security i,

ai and ci are the constant and random parts respectively of the component of
return unique to security i,

I1 ... IL are the returns on a set of L indices,

bi,k is the sensitivity of security i to index k.

The more general result of APT, that all securities and portfolios have
expected returns described by:

Ei = λ0 + λ1 bi,1 + λ2bi,2 + ... + λLbi,L .

The principal strength of the APT approach is that it is based on the no-
arbitrage conditions.

Page 11
 Subject CT8 (Financial Economics) – April 2012 – Examiners’ Report

(ii) Weaknesses:

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

(2) We also need to come up with the correct factor forecasts. The hard part
is the factor forecasts: finding the amount of expected excess return to
associate with each factor. The simplest approach is to calculate a history
of factor returns and take their average. This implicitly assumes an
element of stationarity in the market.

This was standard material from the core reading and more successful candidates tended to
score well, although some struggled to get all points required for full marks.

END OF EXAMINERS’ REPORT

Page 12
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

28 September 2011 (am)

Subject CT8 — Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. Mark allocations are shown in brackets.

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

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT8 S2011 © Institute and Faculty of Actuaries

1 (i) Define an efficient portfolio in the context of modern portfolio theory. [1]

A market consists of two assets A and B. Annual returns on the two assets (RA and
RB) have the following characteristics:

Asset Expected return % Standard deviation %

A 6 20
B 10 20

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

(ii) (a) Calculate the proportion that would be invested in each of the two
assets in a minimum variance portfolio.

(b) Calculate the expected return of that portfolio.

[3]
[Total 4]

2 Consider the following three-factor model of security returns:

Ri = αi + βi1I1 + βi2I2 + βi3I3 + εi

Where:

• Ri is the return on security i

• αi, βi1, βi2 and βi3 are security-specific parameters
• I1, I2 and I3 are the changes in the three factors on which the model is based; and
• εi are independent random normal variables, each with variance σ2

(i) Describe three categories of model that could be used to help choose the
factors I1, I2 and I3. [6]

(ii) List examples of the variables that could be used for the factors I1, I2 and I3,
for two of these three categories of model. [2]
[Total 8]

CT8 S2011—2
3 An investor wishes to save for a retirement fund of £100,000 in 10 years’ time. The
instantaneous, constant continuously compounded risk-free rate of interest is 4% per
annum. The investor can purchase shares on a non-dividend paying security with
price St governed by the Stochastic Differential Equation (SDE):

dSt = St(μdt + σdZt)

where:

• Zt is a standard Brownian motion

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

(i) (a) Derive the distribution of St.

(b) Calculate the amount, A, that the investor would need to invest in
shares to give a 50:50 probability of building up a retirement fund of
£100,000 in 10 year’s time.
[4]

(ii) Calculate the following risk measures applied to the difference between the
value of the fund and £100,000, if the investor invests A.

(a) Variance
(b) Shortfall probability relative to £90,000
(c) 99% Value at Risk
[6]

The investor decides that they do not need more than £100,000 so they write a call
option giving up any upside return above £100,000. They also buy a put option to
remove the downside risk of receiving less than £100,000.

(iii) Calculate the net cost at time zero of purchasing enough shares to give
themselves a 50:50 chance of building up a retirement fund of £100,000,
writing the call option on those shares and buying the put option on the shares.
[2]
[Total 12]

CT8 S2011—3 PLEASE TURN OVER

4 Assume that there is no arbitrage in the market. A forward contract is available on a
physical asset. The continuously compounded costs of managing the asset are x% of
its value, and it provides an income stream of £y per ton payable at six monthly
intervals, a payment has just been made.

Let St be the spot price of one ton of the asset at time t and let r be the continuously
compounded risk-free rate of interest per annum which is assumed to be constant.

Derive the current price of a forward contract written on one ton of the asset with
maturity T years where (6 months < T < 1 year). [8]

5 (i) List the desirable characteristics of a model for the term structure of interest
rates. [4]

(ii) Write down the stochastic differential equation for the short rate rt under _ in
the Hull-White model. [1]

(iii) Indicate whether or not the Hull-White model shows the characteristics listed
in (i). [4]
[Total 9]

6 Under the real-world probability measure, P , the price of a zero-coupon bond with
maturity T is given by:

⎧⎪ σ2 ⎫⎪
B(t, T) = exp ⎨−(T − t )rt + (T − t )3 ⎬
⎩⎪ 6 ⎭⎪

where rt is the short rate of interest at time t and satisfies the following stochastic
differential equation under the real-world measure P :

drt = μrtdt + σdZt,

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

(i) Derive a formula for the instantaneous forward rate f(t, T), based on this
model. [2]

(ii) Derive an expression for the market price of risk. [4]

(iii) Deduce the stochastic differential equation for rt under the risk-neutral
measure _ defining all terms used. [2]
[Total 8]

CT8 S2011—4
7 A non-dividend-paying stock, St, has a current price of 200p. After 6 months the
price of the stock could increase to 230p or decrease to 170p. After a further 6
months, the price could increase from 230p to 250p, or decrease from 230p to 200p.
From 170p the price could increase to 200p or decrease to 150p. The semi-annually
compounded risk-free rate of interest is 6% per annum and the real-world probability
that the share price increases at any time step is 0.75. Adopt a binomial tree approach
with semi-annual time-steps.

(i) Calculate the state-price deflator after one year. [5]

(ii) Calculate, using the state-price deflator from (i), the price of a non-standard
option which pays out max{0, log(S1 − 180)} one year from now. [4]

(iii) State how the answer to (ii) would change if the real-world probability of a
share price increase at each time step was 0.6. [1]
[Total 10]

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

exercisable at two dates, after exactly one year and at expiry, after exactly two years.
If it is exercised at expiry it returns $1000 if and only if the stock price is below $2. If
it is exercised after one year it returns $500 if and only if the stock price is above $2.

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

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

(i) (a) Explain how the option should be priced after t = 1 (assuming that it is
not exercised at t = 1).

(b) Give an expression for the corresponding price, pt.

[4]

(ii) Denoting the price just after 1 year by p1+, explain why the fair price, p1, at
t = 1, is given by p1 = max(p1+, 500) if S1 < $2 and by p1 = p1+ if S1 > $2. [2]

(iii) (a) Show that a holder should exercise the option at t = 1 if S1 > k for a
suitable value of k.

(b) Calculate the value of k.

[4]
[Total 10]

CT8 S2011—5 PLEASE TURN OVER

9 A European call option and a European put option on the same stock with the same
strike price have an exercise date one year away and both are priced at 12p. The
current stock price is 300p.

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

(i) Calculate the common strike price, quoting any results that you use. [3]

Assume the Black-Scholes model applies.

(ii) Calculate the implied volatility of the stock. [4]

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

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

(a) Explain what the statement above means.

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

I(t) = m + a(I(t − 1) − m) + Z(t),

where the Z(t)’s are iid N(0, σ2) random variables and 0 < a < 1.
[4]

(ii) Discuss the differences between and suitability of mean-reverting and random
walk models for share prices, interest rates and inflation. [5]
[Total 9]

CT8 S2011—6
11 (i) Draw a diagram to illustrate the Jarrow-Lando-Turnbull model for credit
default, defining any notation used. [4]

A model was proposed for a country’s sovereign debt as follows:

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

Transition intensities λi,j are constant and as follows:

λ1,2 = 1; λ1,3 = 0; λ2,1 = 0.25, λ2,3 = 0.75; λ3j = 0 for all j and λ1,1 = λ2,2 = −1.

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

dp1 (t )
= − p1 (t ) + 0.25 p2 (t )
dt

and

dp2 (t )
= p1 (t ) − p2 (t ) .
dt

Set h(t) = 2p1 (t) − p2(t).

dh(t )
(ii) (a) Show that = −1.5h(t ).
dt

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

[2]

Suppose that this country’s economy is in state 2 at time 0.

(iii) Find the probability that it is in default at time 2. [4]

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

recovery rate of 60%.

(iv) (a) Deduce the price under this model for a zero-coupon bond in this
country with a redemption value of 100 and a redemption date in two
years’ time.

(b) Calculate the credit spread.

[3]
[Total 13]

END OF PAPER

CT8 S2011—7
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2011 examinations

Subject CT8 — Financial Economics

Core Technical

Purpose of Examiners’ Reports

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and who are using
past papers as a revision aid, and also those who have previously failed the subject. The
Examiners are charged by Council with examining the published syllabus. Although
Examiners have access to the Core Reading, which is designed to interpret the syllabus, the
Examiners are not required to examine the content of Core Reading. Notwithstanding that,
the questions set, and the following comments, will generally be based on Core Reading.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report. Other valid approaches are always given appropriate credit; where there is a
commonly used alternative approach, this is also noted in the report. For essay-style
questions, and particularly the open-ended questions in the later subjects, this report contains
all the points for which the Examiners awarded marks. This is much more than a model
solution – it would be impossible to write down all the points in the report in the time allowed
for the question.

T J Birse
Chairman of the Board of Examiners

December 2011

© Institute and Faculty of Actuaries

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

General comments on Subject CT8

Subject CT8 introduces the main concepts and principles of financial economics. These are
developed in later subjects in the ST series of exams. This subject combines various types of
skills. In particular, along with CT7, it is one of the first where candidates are expected to
write lengthy passages of reasoned thought, rather than just complete calculations. This is a
skill that will be new to many, and candidates are advised to pay particular attention to the
answers to this type of question by studying many past papers.

Comments on the September 2011 paper

The general performance was slightly worse than in April 2011 and candidates found this
paper more challenging, but well-prepared candidates scored well across the whole paper and
the best candidates scored close to full marks. As in previous diets, questions that required an
element of application of the core reading to situations that were not immediately familiar
proved very challenging to most candidates. The comments that follow the questions
concentrate on areas where candidates could have improved their performance. Candidates
approaching the subject for the first time are advised to concentrate their revision in these
areas and the ability to apply the core reading to similar situations.

Page 2
 Subject CT8 (Financial Economics Core Technical) — Examiners’ Report, September 2011

1 (i) A portfolio is efficient if the investor cannot find a better one in the sense that
it has the same expected return and a lower variance, or the same variance and
a higher expected return.

(ii) We have:

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

Which is a minimum at

VB − C AB
xA =
VA − 2C AB + VB

= 0.5

So xB = 0.5

And the expected return on the portfolio is 8%.

Generally candidates scored well on this question. Some students struggled to calculate the
weighting in each asset class or failed to distinguish between the correlation and the
correlation coefficient.

2 (i) Macroeconomic factor models

These use observable economic time series as the factors. They could include
factors such as the annual rates of inflation and economic growth, short term
interest rates, the yield on long term government bonds, and the yield margin
on corporate bonds over government bonds. A related call of model uses a
market index plus a set of industry indices as the factors.

Fundamental factor models

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

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

• the level of gearing;

• the price earnings ratio;
• the level of R&D spending; or
• the industry group to which the company belongs.

Commercial fundamental factor models are available which use many tens of
factors. They are used for risk control by comparing the sensitivity of a
portfolio to one of the factors with the sensitivity of a benchmark portfolio.

Page 3
 Subject CT8 (Financial Economics Core Technical) — Examiners’ Report, September 2011

Statistical factor models

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

returns data. Instead a technique called principal components analysis can be
used to determine a set of indices which explain as much as possible of the
observed variance. However, these indices are unlikely to have any
meaningful economic interpretation and may vary considerably between
different data sets.

(ii) There are many acceptable answers, but for example:

Macroeconomic factor model

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

Fundamental factor model

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

belongs

The candidates who were familiar with the bookwork scored very well. Some candidates
were able to score some marks using economic knowledge from subject CT7.

3 (i) Using Ito’s Lemma:

1 −1
d log St = dSt + 2 (dSt ) 2
St 2 St

⎛ σ2 ⎞
= ⎜μ − ⎟⎟ dt + σdZt
⎜ 2
⎝ ⎠

Written in integral form, this reads

⎛ σ2 ⎞
log St = log S0 + ⎜ μ − ⎟ t + σZt .
⎜ 2 ⎟⎠
⎝

⎪⎧⎛ σ2 ⎞ ⎫⎪
Or, finally, St = S0 exp ⎨⎜ μ − ⎟ t + σZt ⎬ .
⎜ 2 ⎟⎠
⎩⎪⎝ ⎭⎪

⎛ σ2 ⎞
So, St has a lognormal distribution with parameters ⎜ μ − ⎟ t = 0.08875t and
⎜ 2 ⎟⎠
⎝
σ2t = 0.0625t.

Page 4
 Subject CT8 (Financial Economics Core Technical) — Examiners’ Report, September 2011

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

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

£100, 000
= £41,168 = A
exp(0.08875 ×10 + 0.25 × 0)

(ii) (a) We know that:

2
Var( St ) = e2μt (eσ t − 1) or equivalently,

Var( ASt ) = 100, 0002 eσ

2
t
(e σ2t
)
−1

So the variance of the investment is:

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

= £41,1682 × 9.571
= 16,220,971,227.90

(b) As St has a lognormal distribution

P(£41,168 S10 < £90,000) = P (S10 < 2.1862) = P (logS10 < 0.7821)
= P((log S10 – 0.8875)/ 0.625 <− 0.1333) = 0.4470

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

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

S10 = £41,168 e0.8875− 0.625×2.3263 = £15,896.

So the VaR relative to A is £25,272 and relative to £100,000 is
£84,104.

(iii) In this case the investor has removed all risk, so by the principle of no
arbitrage the portfolio will earn the risk free rate. Therefore, the amount they
need to invest at time 0 is:

£100, 000
= £67,032.
e10×4%

Many candidates scored well on part (i) which was a fairly standard proof using Ito's
lemma.
Many struggled with manipulating the log-normal distribution and calculating risk metrics
relating to it.

Page 5
 Subject CT8 (Financial Economics Core Technical) — Examiners’ Report, September 2011

4 The proof of this result is an adaptation of that of the standard no arbitrage approach
to pricing forward contracts. For ease of exposition we use 100x% rather than x% in
the calculations.

Two self-financing portfolios are considered at time zero:

Portfolio A: entering into the forward contract to receive one ton of the asset at time
T. Its value at time zero is zero, and at time T it is ST − F0T .

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

x (T − 1 ) − r
F0T e− rT + ye 2 2 at time zero. Its value at maturity is S − F T by taking account
T 0
of the storage costs and the income stream.

Using the absence of arbitrage opportunity, both portfolios should have the same
value at any intermediate time, in particular at time 0. Hence:

( x + r )(T − 12 )
F0T = S0e( x + r )T − ye .

Many candidates struggled with the concept of creating two portfolios using the principle of
no arbitrage. They were unable to apply the core reading to a related situation. The
question was challenging overall, with many candidates struggling to score well.

5 (i) Arbitrage free.

Positive interest rates.
Mean reversion of rates.
Ease of calculation of bonds and certain derivative contracts.
Realistic dynamics.
Goodness of fit to historical data.
Ease of calibration to current market data.
Flexible enough to cope with a range of derivative contracts.

(ii) drt = α(μt − rt)dt + σdZt or alternatively dr = [ θ(t ) − ar ] dt + σdz

Where in both cases Z is a Brownian motion under .

(iii) Arbitrage free. Yes

Positive interest rates. No
Mean reversion of rates. Yes
Ease of calculation of bonds and certain derivative contracts. Yes
Realistic dynamics. No
Goodness of fit to historical data. Yes.
Ease of calibration to current market data. Yes
Flexible enough to cope with a range of derivative contracts. No.

This was standard material from the core reading and more successful candidates tended to
score well, although some struggled to get all points required for full marks.

Page 6
Subject CT8 (Financial Economics Core Technical) — Examiners’ Report, September 2011

6 (i) f(t, T) = log ,

σ2
= [rt − (T − t ) 2 ]
2

(ii) The market price of risk, γt, is defined as:

m(t , T ) − rt
γt = ,
S (t , T )

where

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

Now,

∂B(t , T ) ⎡ σ2 ⎤
= B(t , T ) ⎢ rt − (T − t ) 2 ⎥
∂t ⎣⎢ 2 ⎦⎥

∂B(t , T )
= B(t , T )[−(T − t )]
∂rt

∂ 2 B (t , T )
= B (t , T )(T − t ) 2
∂rt2

So, using Itô’s lemma, we have

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

and so

μrt
γt = .
σ

(iii) The stochastic differential equation for rt under the risk-neutral measure is
given by

drt =

where Z is a standard Brownian motion under

drt = μrt dt + σ(dZ − γ t dt )

⎛ μr dt ⎞
= μrt dt + σ ⎜ dZ − t ⎟
⎝ σ ⎠

Page 7
 Subject CT8 (Financial Economics Core Technical) — Examiners’ Report, September 2011

= μrt dt − μrt dt + σdZ

= σdZ .

Question 6 was generally challenging. While part (i) was generally straightforward for most
candidates, part (ii) where application of first principles was necessary was only answered
well by the best candidates.

7 (i) First we calculate the risk-neutral probability of an upwards movement in the

share price from each state:

1.03 × 200 − 170

q(200) = = 0.6
230 − 170

1.03 × 230 − 200

q(230) = = 0.738
250 − 200

1.03 ×170 − 150

q(170) = = 0.502
200 − 150

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

q (200)q (230)
A2(250) = = 0.742
(0.75 × 1.03) 2

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

A2(200) = = 0.900
2 × 0.75 × 0.25 × 1.032

[1 − q (200)][1 − q (170)]
A2(150) = = 3.004
(0.25 ×1.03) 2

(ii) The option premium, V, can be calculated as

V = EP (A2V2)

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

= 2.784

(iii) It would not change at all.

This question was overall well answered, showing that many candidates have understood the
broad concept of state price deflators. Well- prepared candidates were able to score near full
marks on all three parts of the question.

Page 8
 Subject CT8 (Financial Economics Core Technical) — Examiners’ Report, September 2011

Some candidates lost marks through ignoring the semi-annual interest rate. Part (iii) was
designed to test the understanding of the candidates on how option pricing theory works in
practice, but disappointingly many candidates got this part wrong.

8 (i) If the first exercise date has passed then the owner now has a derivative
contract which pays $1000 at time 2 years if and only if the stock price S2 < 2.

The derivative should then be priced using the formula

pt = EQ[e−r(2−t)C|Ft],

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

measure.

This gives a value of pt of

1000 e−r(2−t) Q(S2 < 2|Ft)

= 1000 e−r(2−t) Q(S2/St < 2/St)
= 1000 e−r(2−t) Q(log(S2/St) < log(2/St))
= 1000 e−r(2−t) Φ({log(2/St) − (.02- 0.045)(2− t)}/ (.3√ (2 − t))).

(ii) At t=1 the holder can choose between the value of the residual contract: p1+
and the current immediate exercise reward of $500 if S1 > 2 (and 0 otherwise).
A rational holder will maximise value by choosing whichever has a greater
current value.

There was a typo in the question where the inequalities were the wrong way
around, full credit will be given to students who assumed this part was correct
and had the inequalities the other way around.

In other words, an acceptable answer would be: At t=1 the holder can choose
between the value of the residual contract: p1+ and the current immediate
exercise reward of $500 if S1 < 2 (and 0 otherwise).

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

current value.

(iii) (a) Since the current exercise value increases with S1 and the value of
p1+ decreases with S1, the holder will choose to exercise the option at
t = 1 if and only if the stock price is greater than some critical value k.

(b) At the critical value the holder should be indifferent i.e. we should
have p1+ = $500. So we seek k such that

1000 e−r Φ({log(2/k) + .025}/.3) = 500

so Φ({log(2/k) + .025}/.3) = 0.51010

Page 9
 Subject CT8 (Financial Economics Core Technical) — Examiners’ Report, September 2011

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

so k = 2.0343

Performance on this question was very variable.

Part (i) was generally well-answered. A number of candidates highlighted that the inequality
was the wrong way around in part (ii). Part (iii) was generally poorly answered.

9 (i) Using put-call parity, 0 = S − Ke−rT, so K = SerT = 306.06p

(ii) d1 = (log(S/K) + r +½σ2T) / σ√T = ½σ,
while = (log(S/K) + r − ½σ2T)/σ√T = −½σ.

Thus C= SΦ(d1) − Ke−rT Φ(d2) = S(Φ(½σ) − Φ(−½σ)) = 300(2Φ(½σ) − 1)

so Φ(½σ) = 0.52 so σ = .1003 = 10.0%.

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

and 600 − 2600 ×3 = £7200 short in cash.

Generally answered well by candidates. Most candidates were able to score full marks on
part (i) and proceed to score well on parts (ii) and part (ii).

10 (i) (a) Mean reversion means that the force of inflation will tend to move
towards its average value.

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

the impulse at time t depends on the process one step before) whose
formula is of the form of the equation given in the question.

(b) Denote by i(t) the mean value of I(t), then taking expectations in the
formula, we see that i(t) = m + a(i(t −1) − m)
or i(t) − m = a(i(t − 1) − m). It follows that i(t) − m tends to zero at a
geometric rate.

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

If share prices follow a random walk, with positive drift, then those share
prices would be expected to tend to infinity for large time horizons.

However, there are many quantities which should not behave like this. For
example, we do not expect interest rates to jump off to infinity, or to collapse
back to zero.

Instead, we would expect some mean reverting force to pull interest rates back
to some normal range. In the same way, while inflation can change
substantially over time, we would expect them, in the long run, to form some
stationary distribution, and not run off to infinity. Similar considerations
apply to the annual rate of growth in share prices.

Page 10
 Subject CT8 (Financial Economics Core Technical) — Examiners’ Report, September 2011

In each case, these quantities are not independent from one year to the next;
times of high interest rates or high inflation tend to bunch together i.e. the
models are auto-regressive.

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

processes. These processes might include (log) yields, or the instantaneous
growth rate of income streams. The reason for the log transformation is to
prevent negative yields.

The question was straightforward bookwork. Candidates struggled to score full marks on
part (ii) but were generally able to describe the basic concepts of the two models.
Unfortunately many candidates chose to write extensive details about share price models and
their characteristics rather than focus on the question about the random walk versus mean
reverting models.

11 (i)

The n states represent 1 credit ratings plus default.

λij (t ) are the deterministic transition intensities from state i to state j at time t
under the real world measure P.

(ii) (a) h′(t ) = 2 p1′ (t) − p2′ (t) = − 3p1(t) + 3/2p2(t) = −3/2h(t).

Similarly

k ′(t ) = 2 p1′ (t) + p2′ (t) = − p1(t) − ½p2(t) = −½k(t).

(b) Solving these linear differential equations with initial conditions

h(0) = −1 and k(0) = 1 we get h(t) = −e−3/2t and k(t) = e−½t.

Page 11
 Subject CT8 (Financial Economics Core Technical) — Examiners’ Report, September 2011

It follows that p1(t) = ¼(h(t) + k(t)) = ¼(e−½t − e−3/2t)

while p2(t) = ½(k(t) − h(t)) = ½(e−½t + e−3/2t).

Now, since p3(t) = 1 − p1(t) − p2(t),

we obtain p3(t) = 1 − 3/4e−½t −1/4 e−3/2t.

And so p3(2) = .71164.

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

(b) The equivalent no-default interest rate is ½log(100/68.729) = 18.75%.

Thus the credit spread is 16.75%.

Few candidates failed to score well on parts (i) and (ii). In contrast, very few students were
able to apply the results to part (iii) where scores were disappointing and often nil.
Candidates did not understand the relevance of h(t) and k(t) and they may have gotten further
if they had worked with them. Marks were picked up in question (iv) where candidates
continued with the question.

END OF EXAMINERS’ REPORT

Page 12
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

20 April 2011 (am)

Subject CT8 — Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. Mark allocations are shown in brackets.

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

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT8 A2011 © Institute and Faculty of Actuaries

1 (i) State the six assumptions underlying the Black-Scholes market.

(ii) Give the four defining characteristics of a Brownian Motion Z, such that
Z0 = 0.
[5]

2 (i) State the main assumptions of modern portfolio theory. [2]

Three assets have the following characteristics:

Asset i Expected return Ei Volatility σi

1 4% 6%
2 6% 12%
3 8% 18%

The correlation between assets 1 and 2 is 0.75; while the correlation between asset 3
and both of the other two assets is zero.

(ii) (a) State the Lagrangian function that can be minimised to find the
minimum variance portfolio associated with a given expected return,
defining any notation used.

(b) By taking five partial derivatives of this function, calculate the

minimum variance portfolio which yields an expected return of 5%.
[7]
[Total 9]

3 A securities market has only three risky securities, A, B and C with the following
annual return attributes:

Asset A Asset B Asset C

Market capitalisation £100bn £150bn £250bn
Annual expected return 4% rB 6%

Assume that:

• the assumptions of the Capital Asset Pricing Model hold

• the market price of risk is 10% per annum
• the risk free rate is 3.3% per annum
• the expected annual return on the market portfolio is 5.3% per annum.

(i) Calculate σM, the standard deviation of the annual return on the market
portfolio. Quote any results that you use. [1]

(ii) Calculate rB, the expected annual return on asset B. [2]

(iii) Calculate the covariance of the annual returns on each asset with the annual
return on the market portfolio. State any further results that you use. [4]
[Total 7]

CT8 A2011—2
4 (i) Outline the three forms of the efficient market hypothesis. [6]

XYZ has just announced that its profits are up by 52% on last year. On the
announcement XYZ shares fell in price by 20%. Analysts had been predicting a rise
in profits of 65%. A friend says that this shows that the efficient markets hypothesis
is false.

(ii) Comment on this statement. [3]

[Total 9]

5 Assume that a non-dividend-paying security with price St at time t can move to either
St u or St d at time t + 1. The continuously compounded rate of interest is r, and u >
er > d. A financial derivative pays α if St+1 = St u and β if St+1 = St d.

A portfolio of cash (amount x) and the underlying security (value y) at time t exactly
replicates the payoff of the derivative at time t + 1.

(i) Derive expressions for x and y in terms of r, u, d, α and β. [4]

(ii) Derive an expression for the risk-neutral probability of the security having
value St u at time t + 1 in terms of (x + y), r, α and β. [2]

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

(iii) (a) Calculate the prices of at-the-money call and put options.
(b) Check that the put-call parity holds for this model.
[4]
[Total 10]

CT8 A2011—3 PLEASE TURN OVER

6 (i) Describe the lognormal model for security prices. [2]

A security price, St, is assumed to follow a lognormal model with drift μ = 4.28% per
annum and volatility 12% per annum. The price now is S0 = €1.83. The continuously
compounded risk-free rate of interest is 2% per annum.

(ii) Calculate, as at this date, the probability, p, that (S1 > €2.20). [2]

Someone now offers you an option which will pay €1000 if and only if the stock price
S1 > €2.20. They propose to charge €1000e−0.02p.

(iii) Explain whether or not you would buy this option. [4]

Assume now that the value of 4.28% for μ has been estimated from observations of
the security price over 10 years using the estimator μ′ ={log(S0) − log(S−10)}/10.

(iv) (a) Specify the distribution of μ′ − μ.

(b) Deduce the probability that μ′ − μ > 3%. [4]

(v) (a) Explain how your answer to (iii) would change if you knew that μ <
1.28% rather than 4.28%.

(b) Comment on this in the light of your answer to part (iv)(b). [3]
[Total 15]

7 (a) List five factors that effect the price of a European put option on a non-
dividend paying share.

(b) State how the premium for a European put option would change if each of
these factors increased.
[5]

CT8 A2011—4
8 Assume the Black-Scholes model applies.

(i) State an expression for the price of a derivative security with payoff D at
maturity date T in terms of the risk-neutral measure. [2]

An at the money European call option on a stock has an exercise date one year away
and a strike price of £118.57. The option is priced at £10. The continuously
compounded risk-free rate is 1% per annum.

(ii) (a) Estimate the implied volatility to within 1% per annum.

(b) Calculate the corresponding hedging portfolio in shares and cash for
1000 options on the share, quoting any results that you use.

(c) Calculate the option’s Vega.

[10]

(iii) Price a put on the same stock with the same expiry date and a strike price of
£110. [2]

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

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

(iv) Determine the hedging portfolio of the call option in terms of shares, cash and
the put option. [4]
[Total 18]

9 In an extension of the Merton model, a very highly geared company has two tiers of
debt, a senior debt and a junior debt. Both consist of zero coupon bonds payable in
three years time. The senior debt is paid before the junior debt.

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

(i) (a) State the value of the senior debt at maturity.

(b) Deduce the value of the junior debt at maturity.
[4]

The current gross value of the company is £3.2m. The nominal of the senior debt is
£1.2m and that of the junior debt is £2m. The continuously compounded risk-free rate
is 4% per annum, the volatility of the value of the company is 30% per annum and the
price of £100 nominal of the senior bond is £88.26.

(ii) Calculate the theoretical price of £100 nominal of the junior debt. [6]
[Total 10]

CT8 A2011—5 PLEASE TURN OVER

10 Let B(t,T) be the price at time t of a zero-coupon bond paying £1 at time T, rt be the
short-rate of interest, P be the real world probability measure and Q the risk neutral
probability measure.

(i) Write down two equations for the price of a zero-coupon bond, one of which
uses the risk-neutral approach to pricing and the other of which uses the state-
price-deflator approach to pricing. [2]

(ii) State the Stochastic Differential Equation (SDE) of the short rate rt under Q
for the Vasicek model and the general type of process this SDE represents. [3]

(iii) Solve the SDE for the short rate rt from (ii). [5]

(iv) Deduce the form of the distribution of the zero-coupon bond price under this
model. [2]
[Total 12]

END OF PAPER

CT8 A2011—6
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2011 examinations

Subject CT8 — Financial Economics

Core Technical

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

T J Birse
Chairman of the Board of Examiners

July 2011

© Institute and Faculty of Actuaries

 Subject CT8 (Financial Economics) — Examiners’ Report, April 2011

Overall the paper was answered well and candidates’ performance was satisfactory. The
comments below each question indicate where candidates had the most difficulty.

1 (i) [Unit 13 pp1-2, Unit 8 p2] I

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

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

motion.

2. There are no risk-free arbitrage opportunities.

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

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

5. There are no taxes or transaction costs.

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

small numbers of units.

(ii) [Unit 8 p3 para 1]

A Brownian Motion Z has the following properties:

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

{Zr, r ≤ s} whenever s < t.

(2) Z has stationary increments, i.e. the distribution of Zt − Zs depends

only on t − s.

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

(4) Z has continuous sample paths t → Zt

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

2 (i)
• It is assumed that investors select their portfolios on the basis of the
expected return and the variance of that return over a single time horizon.

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

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

• Investors are never satiated. At a given level of risk, they will always
prefer a portfolio with a higher return to one with a lower return.

Page 2
 Subject CT8 (Financial Economics) — Examiners’ Report, April 2011

• Investors dislike risk. For a given level of return, they will always prefer a
portfolio with lower variance to one with higher variance.

(ii) (a) Let the proportion invested in asset i, be xi , with expected return Ei ,
variance Vi and correlation ρ12. Let E be the return on the portfolio of
the three assets and let λ and μ be Lagrange multipliers. Then, the
Lagrangian function W satisfies:

3
W= ∑ xi2Vi + 2ρ12σ1σ2 x1x2 − λ( E1x1 + E2 x2 + E3 x3 − E ) − μ( x1 + x2 + x3 − 1)
i =1

= 36 x12 + 144 x22 + 324 x32 + 108 x1 x2 − λ(4 x1 + 6 x2 + 8 x3 − E ) − μ( x1 + x2 + x3 − 1)

∂W
(b) = 0 ⇒ 72x1 + 108x2 − 4λ − μ = 0
∂x1

∂W
= 0 ⇒ 108x1 + 288x2 − 6λ − μ = 0
∂x2

∂W
= 0 ⇒ 648x3 − 8λ − μ = 0
∂x3

∂W
= 0 ⇒ 4x1 + 6x2 + 8x3 = 5
∂λ

∂W
= 0 ⇒ x1 + x2 + x3 = 1
∂μ

Solving this set of simultaneous equations gives x1 = 0.7125,

x2 = 0.075 and x3 = 0.2125.

72x1 + 108x2 − 4λ − μ = 0 (1)

108x1 + 288x2 − 6λ − μ = 0 (2)
648x3 − 8λ − μ = 0 (3)
4x1 + 6x2 + 8x3 = 5 (4)
x1 + x2 + x3 = 1 (5)
(1) ⇒ μ = 72x1 + 108x2 − 4λ (6)
into (2) 36x1 + 180x2 − 2λ = 0 ⇒ λ = 18x1 + 90x2 (7)
(4) and (5) into (3) 648x3 − 144x1 − 468x2 = 0 (8)
(5) ⇒ x3 = 1 − x1 − x2 (9)
(7) into (4) ⇒ 4x1 + 6x2 + 8 − 8x1 − 8x2 = 5
⇒ 4x1 + 2x2 = 3
⇒ x2 = 1.5 − 2x1 (10)

Page 3
 Subject CT8 (Financial Economics) — Examiners’ Report, April 2011

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

648 − 792x1 − 1674 + 2232x1 = 0
1440 x1 − 1026 = 0
⇒ x1 = 0.7125
⇒ x2 = 0.075
⇒ x3 = 0.2125

Although most candidates could write down the Lagrangian, several missed the factor of 2
in front of the covariance term. The handling of the Lagrangian showed that many
candidates could write down the partial differential equations for optimisation, but were
unable to solve them simultaneously.

3 (i) The market price of risk is (EM − r)/σM so σM = (EM − r)/0.1 = .02/.1 = 20%

(ii) The market portfolio is in proportion to the market capitalisation since every
investor holds risky assets in proportion to that portfolio. Thus the market
portfolio is .2A +.3B + .5C and so EM = .2EA + .3EB + .5EC so
EB = (.053 − .2×.04 − .5×.06)/.3 = 5%.

(iii) Assets all lie on the securities market line, so Ei − r = βi(EM −r), where
βi = Cov(Ri, RM)/Var(RM).

It follows that βA = .007/.02 = .35, βB = .017/.02=.85 and βC = .027/.02 =

1.35.

Then Var(RM) = .04 (from part (i)) so Cov(RA, RM) = 0.014, Cov(RB, RM) =
0.034 and Cov(RC, RM) = 0.054.

Generally well-answered by most candidates.

4 (i) Bookwork Unit

Strong form EMH: market prices incorporate all information, both publicly
available and also that available only to insiders.

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

information.

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

information contained in the price history of that investment.

Page 4
 Subject CT8 (Financial Economics) — Examiners’ Report, April 2011

(ii) Any reasonable comments:-the market was expecting more and reacted
efficiently on the release of insider information. This does suggest that Strong
form EMH doesn’t hold. It doesn’t seem to contradict weak or semi-strong
EMH. However, the price fall could be an over-reaction which would
contradict the semi-strong form.

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

5 (i) Consider an investment of x in cash and y in the stock at time t. Equating the
value of this portfolio to the value of the derivative at time t = 1 we find the
two simultaneous equations:

xer + yu = α,
xer + yd = β.

Rearranging we find:

α −β
y= , and
u−d

β u − αd
x = e−r .
u−d

(ii) x + y = e−r[qα + (1 − q)β]

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

( x + y )e r − β
So q = .
α −β

(iii) (a) For the call option we have:

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

For the put option we have:

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

(b) The strike price (for the at-the-money option) is just St = 100.
Therefore, the put-call parity relation holds.

Several candidates misread the question and took y to denote the number of shares rather
than their initial value. There were also a significant number of careless errors in the
calculation.

Page 5
 Subject CT8 (Financial Economics) — Examiners’ Report, April 2011

6 (i) The lognormal model has independent, stationary normal increments for the
log of the asset price. Thus, if Su denotes the stock price at time u, then
log(St /Ss) ~ N(µ(t − s), σ2(t − s)) where µ is the drift and σ is the volatility
parameter.

(ii) p = P(S1 > €2.20) = P(log(S1/S0) > log(2.2/1.83)) = P(N(0,1) > (log(2.2/1.83)
− .0428)/.12) = 1 − Φ(1.17784) = 0.1194

(iii) No, I would not buy the contract. Assuming the log normal model, we are in a
Black-Scholes market and the fair price for the option is f = EQ[e−.02 C] where
C is the contract value at expiry date, and Q is the EMM. Under the EMM, the
discounted stock price will be a martingale i.e S will be lognormal with drift
.02 − ½ σ2 = .0128 and volatility σ. Now f = €1000e−.02 p′ ,
where p′ = Q(S1 > €2.20), and since S has a smaller drift under Q than under
the real-world measure, this will be a smaller price than I am being offered.

(iv) (a) μ′ is N(µ, σ2/10) so μ′ − µ ~ N(0, 0.00144).

(b) A priori, therefore, P( μ′ − µ > 0.03) = 1 − Φ(.03/√.00144)

= 1 − Φ (.79057) = .21459.

(v) (a) If the true value of µ is <0.0128 then p is smaller than p′ and so the
option is a bargain!

(b) The probability of this level of error in the estimate of µ is relatively

large even though we have 10 years of data.

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

generally.

The poorer candidates answered this question in a way that is inconsistent with the Core
Reading, taking the drift parameter to refer to the parameter in the Black Scholes model.
This resulted in incorrect numerical answers.

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

(1) The premium would decrease as the underlying share price increased.
(2) The premium would increase as the strike price increased.
(3) The premium would increase as the time to expiry increased.
(4) The premium would increase as the volatility of the underlying share
increased.
(5) The premium would decrease as interest rates increased.

A very well answered question.

Page 6
 Subject CT8 (Financial Economics) — Examiners’ Report, April 2011

8 (i) The unique fair price is V = EQ[e−rTD], where Q is the EMM

(ii) (a) Standard interpolation using the Black-Scholes formula gives σ = 20%
as follows:

using Black-Scholes, C = S0Φ(d1) − ke−rTΦ (d2), with

d1= (rT + ½σ2T)/σ√T = (.01 + ½σ2)/σ
and d2 = (.01 + ½σ2)/σ, S0 = k = 118.57 and C = 10.

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

gives Φ(d1) = .55633, Φ(d2) = .49668, and thus a trial value for C of
118.57 × (.55633 − e−.01 × .49668) = 7.65868.

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

gives Φ(d1)=.56553, Φ(d2)=. 46613, and thus a trial value for C of
118.57 × (.56553 − e−.01 × .46613) = 12.33579.

Interpolation gives a new trial value of σ of

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

With this value for σ we get a value of

d1 = 0.15 and d2 = −.05 which gives
Φ(d1) = 0.5596, Φ(d2) = 0.4801, and thus a trial value for C of
118.57 × (0.5596 − e−.01 × 0.4801) = 9.993.

Thus σ = 20%.

(b) The call’s Delta = ΔC = ∂f/∂S = Φ(d1), where

d1 = (log(S/K) + rT + ½σ2T) / σ√T = 0.15 and
Φ(.15) = 0.55962, so the hedge is 1000Δ = 559.62 units of stock and
£10,000 − 118.57 × 559.62 = − £56,354 in cash.

(c) Vega = VC = ∂f/∂σ = ∂/∂σ(SΦ(d1) − Ke−rT Φ(d2))

= (Sφ(d1) ∂d1/∂σ – Ke−rT φ(d2) ∂ d2/∂σ)
= (Sφ(0.15)(½ − r/σ2) + Ke−rT φ( − 0.05)(½ + r/σ2))
= 118.57× (0.25Xe−.01125 + 0.75×e−.00125×e−.01)/√(2π)
= 46.773
[since d2 = (log(S/K) + r − ½σ2T)/σ√T = −0.05 and
∂d2/∂σ = −(½ + (r + log(S/K))/σ2)]

(iii) The put price is p = Ke−rT Φ(−d2) − SΦ(−d1), where

d1 = (S/K) + r + ½σ2T)/σ √T = 0.52512 and
d2 = (log(S/K) + r − ½σ2T)/σ √T = 0.32512.
So the price is 110Xe−.01×.37254 − 118.57×.29975 = £5.0303

Page 7
 Subject CT8 (Financial Economics) — Examiners’ Report, April 2011

(iv) If we have a portfolio of a shares, b puts and m cash we require to match the
value, Delta and Vega of the option. This gives three equations:

(1) aS + bp + m =10
(2) a + b ΔP = ΔC
(3) bVP = VC

Equation (3) gives b = 1.18506;

equation (2) then gives a = 0.91484;
equation (1) gives m = −£104.43.

This question was generally not well answered, with errors being made in simple
calculations of hedging portfolios.

9 (i) (a) Under the Merton model, the value, Ft, of the firm follows a
Geometric BM under the EMM. It follows that the terminal value of
the debt is min(FT, L1), where Li is the tier i nominal debt (since FT is
available to pay the senior debt).

(b) Subtracting this value from the value of the firm we see that the assets
available to redeem the junior debt are max(FT − L1 ,0). It follows that
the terminal value of the junior debt is min(L2, max(FT − L1 ,0)).

(ii) Using a Black-Scholes approach, the current value of the senior debt is V1 =
E[e−rT min(FT, L1)] = E[e−rT (FT − max(FT − L1,0)] = F0 − C1, where C1 is
the initial value of a call on the value of the firm with strike L1. The current
value of the junior debt is V2 = E[e−rTmin(L2, max(FT − L1 ,0))].

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

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

C2 = E[e−rTmax(FT − (L1 + L2), 0))].

Using Black-Scholes, C2 = F0Φ(d1) − (L1 + L2) e−rT Φ(d2), with

d1 = (ln(F0/L1 + L2) + rT +½σ2T)/σ√T
= (ln(1) +.12 + ½*.09*3)/.3*√3 = 0.49075
and d2 = (ln(F0/L1 + L2) + rT−½σ2T)/σ√T = −.02887.

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

C2 = 3.2*.68819 − e−0.12*3.2*.48848 = 0.81583m = £815,830. Thus the
junior debt is worth = C1 − C2 = 32000000 − 1059120 − 815830 = 1325050.
This is the value of £2m nominal so the value of £100 nominal is £66.25.

With some notable exceptions, this question was generally very poorly answered.
Candidates were unable to perform calculations related to the Merton model, and were
unable to identify the payoffs from simple contingent contracts.

Page 8
 Subject CT8 (Financial Economics) — Examiners’ Report, April 2011

10 (i) Risk-neutral approach:

⎡ ⎤
B (t , T ) = EQ ⎢exp ⎛⎜ − ∫ ru du ⎞⎟ ⏐Ft ⎥
T

⎣ ⎝ t ⎠ ⎦

State-price deflator approach:

E P { A(T )⏐Ft }
B (t , T ) =
A(t )

Where A(t) is the deflator.

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

drt = α(μ − rt )dt + σdZt,

where Z is a Q-Brownian motion.

This is an Ornstein-Uhlenbeck process.

(iii) Consider st = eαtrt. Then

dst = αeαtrtdt + eαt drt

= αμeαtdt + σeαt dZt

t
Thus st = s0 + μ(eαt − 1) + σ ∫ eαu dZu
0

and consequently

t
rt = e−αtr0 + μ(1 − e−αt) + σ ∫ eα (u −t ) dZu
0

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

This question was largely from a section of the core reading with which some candidates
seemed unfamiliar. Candidates need to study the sections relating to interest rate models
more carefully. Candidates who knew the bookwork performed well.

END OF EXAMINERS’ REPORT

Page 9
Faculty of Actuaries Institute of Actuaries

EXAMINATION

8 October 2010 (am)

Subject CT8 — Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. Mark allocations are shown in brackets.

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

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

© Faculty of Actuaries
CT8 S2010 © Institute of Actuaries
1 An investor holds an asset that produces a random rate of return, R, over the course of
a year. The distribution of this rate of return is a mixture of normal distributions,
i.e. R has a normal distribution with a mean of 0% and standard deviation of 10% with
probability 0.8 and a normal distribution with a mean of 30% and a standard deviation
of 10% with a probability of 0.2.

S is the normally distributed random rate of return on another asset that has the same
mean and variance as R.

(i) Calculate the mean and variance of R. [3]

(ii) Calculate the shortfall probabilities for R and for S using:

(a) a benchmark rate of return of 0%

(b) a benchmark rate of return of –10% [4]

(iii) Comment on what the variance and shortfall probabilities at both benchmark
levels illustrate about the asset returns, by referring to the calculations in (i)
and (ii). [3]
[Total 10]

2 (i) Explain what is meant by “excessive volatility” of share prices. [2]

(ii) State two examples of empirical evidence of the “under-reaction” of share

prices to events. [4]
[Total 6]

3 Discuss whether one-factor models are good models for the short-rate of interest
(instantaneous risk free rate). Include discussion of extensions that may be
considered to improve the model. Illustrate your discussion by defining and referring
to particular models. [10]

4 (i) In the context of credit risk for defaultable bonds:

(a) give three examples of a credit event

(b) give three examples of an outcome of a default
(c) define the recovery rate [7]

(ii) Describe the two-state model for credit ratings. [4]

Two companies have zero coupon defaultable bonds in issue. Bond A has £2m
nominal in issue. Bond B has £3m nominal in issue. Both bonds redeem in exactly
2 years time.

Under a risk neutral measure, each bond defaults (not necessarily independently) at a
constant rate. Both bonds have a 60% recovery rate.

CT8 S2010—2
 Assume:

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

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

(iii) Evaluate the two default rates (under a risk-neutral measure). [4]

There is also a traded derivative security, D, priced at £52 which pays £100 after
2 years if (and only if) at least one of the bonds defaults.

(iv) (a) Determine a hedging portfolio for the security which pays £100 after
2 years if and only if both bonds default by considering fixed
portfolios consisting of bond A, bond B and security D and a risk-free
zero-coupon bond paying £100 at redemption in exactly 2 years.

(b) Calculate the fair price for the security that pays £100 if and only if
both bonds default.
[8]
[Total 23]

5 (i) State an expression for the price of a derivative security in a Black-Scholes

market in terms of the risk-neutral measure. [2]

A European call option on a stock has an exercise date one year away and a strike of
£6. The underlying stock has a current price of £5.50. The option is priced at 60p.
The stock price volatility has been estimated from other option prices as 20%.

(ii) Estimate the risk free rate of interest to within 0.5% p.a. assuming the Black-
Scholes model applies. [5]

A new derivative security has just been written on the underlying stock. This will pay
a random amount D in one year’s time, where D = S12.

(iii) Calculate the fair price for this new derivative security, quoting any further
results that you use. [5]

(iv) Determine the initial hedging portfolio (in units of the underlying stock and
cash) for this new derivative security. [4]
[Total 16]

CT8 S2010—3 PLEASE TURN OVER

6 Under the real-world measure P, W is a standard Brownian motion and the price of a
stock, S, is given by St = S0exp(σ Wt + (μ – 1/2 σ2)t). The continuously compounded
risk-free rate of interest is r and a zero coupon bond with maturity T has price
Bt = e−r(T−t). Suppose that in the market any contract which pays f(ST) at time T is
valued at:

pt = E[e–r(T–t) f(ST) ΛT |Ft],

where:

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

(i) (a) Prove, using Ito’s formula, that Λt is a martingale.

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

[5]

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

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

[5]
[Total 10]

7 (i) Define delta, gamma and vega for an individual derivative. [3]

(ii) Explain how gamma and vega can be used in the risk management of a
portfolio that is delta-hedged. [4]
[Total 7]

8 Consider a particular stock and denote its price at any time t by St . This stock pays a
dividend D at time T ' .

Let Ct and Pt be the price at time t of a European call option and European put option
respectively, written on S, with strike price K and maturity T ≥ T ' ≥ t . The
instantaneous risk-free rate is denoted by r.

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

[Hint: assume that when the dividend is paid it is used to pay off any borrowed
positions required as part of the proof.] [7]

CT8 S2010—4
9 Consider a two-period binomial model for a non-dividend paying stock whose current
price is S0 = 100. Assume that:

• over each of the next six-month periods, the stock price can either move up by a
factor u = 1.2 or down by a factor d = 0.8

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

(i) (a) Prove that there is no arbitrage in the market.

(b) Construct the binomial tree for the model. [2]

(ii) Calculate the price of a standard European call option written on the stock S
with strike price K = 100 and maturity one year. [5]

Consider a special European call option with strike price K = 100 and maturity one
year. The owner of such an option has the right to exercise her option at the end of
the year only if the stock price goes above the level L = 130 during or at the end of
the year.

(iii) (a) Calculate the initial price of this call option.

(b) Comment on the relationship between the price of the special call
option and the option in (ii). [4]
[Total 11]

END OF PAPER

CT8 S2010—5
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2010 examinations

Subject CT8 — Financial Economics

Core Technical

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

T J Birse
Chairman of the Board of Examiners

December 2010

© Institute and Faculty of Actuaries

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

1 (i) E[R] = 0.8 * 0% + 0.2 * 30% = 6%

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

(ii) Var(R) = 0.028 − 0.062 = 0.0244 = 0.15622

Prob(R < 0) = 0.8 * N(0; 0, 10%) + 0.2 * N(0; 30%, 10%) = 0.8 * 0.5 + 0.2 *
0.00135 = 0.4 + 0.00027 = 0.40027

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

Prob(R < −10%) = 0.8 * N(−10%; 0, 10%) + 0.2 * N(−10%; 30%, 10%) = 0.8
* 0.1587 + 0.2 * 0 = 0.1269

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

(iii) Variance suggests risks are the same

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

0% with R makes R look riskier than S

Benchmark at −10% suggests S riskier than R – overall wider “spread” of S

dominates at more extreme risk levels

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

standard normal lookups from tables.)

2 (i) Excessive volatility is when the change in market value of stocks (observed
volatility), cannot be justified by the news arriving. This is claimed to be
evidence of market over-reaction which was not compatible with efficiency.

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

two of these):

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

after their announcement. An example of under-reaction to information
which is slowly corrected.

2. Abnormal excess returns for both the parent and subsidiary firms
following a de-merger. Another example of the market being slow to
recognise the benefits of an event.

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

the poorest subsequent returns). The market appears to over-estimate the
benefits from mergers, the stock price slowly reacts as its optimistic view
is proved to be wrong.

Page 2
 Subject CT8 (Financial Economics Core Technical) — September 2010 — Examiners’ Report

3 One-factor models
All are arbitrage-free.
Vasicek: easy to implement but problem of possible negative interest rates

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

HW: more flexible as time-inhomogeneous, so better fit to market data (in particular
option prices)., but negative rates are possible

Limitations:

1) historical data shows changes in the prices of bonds with different terms to
maturity are not perfectly correlated

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

3) we need more complex models to deal effectively with more complex derivative
contracts e.g. any contract which makes reference to more than one interest rate
should allow these rates to be less than perfectly correlated

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

There is no perfect model. A good model depends on the data available and the use of
the model (basic assets, plain vanilla derivatives, more exotic derivatives, short or
long maturities…).

Fit to historical data; realistic dynamics

4 (i) (a) A credit event is an event which will trigger the default of a bond and
includes the following:

• failure to pay either capital or a coupon

• loss event
• bankruptcy
• rating downgrade of the bond by a rating agency such as Standard
• and Poor’s or Moody’s

(b) The outcome of a default may be that the contracted payment stream
is:
• rescheduled
• cancelled by the payment of an amount which is less than the
default-free value of the original contract
• continues but at a reduced rate
• totally wiped out
[any three of the above]

Page 3
 Subject CT8 (Financial Economics Core Technical) — September 2010 — Examiners’ Report

(c) In the event of a default, the fraction of the defaulted amount that can
be recovered through bankruptcy proceedings or some other form of
settlement is known as the recovery rate.

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

Under this simple model it is assumed that the default-free interest rate term
structure is deterministic with r(t) = r for all t.

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

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

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

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

(iii) The formula for the unit ZCB price is e−rT(1 − (1 − δ)(1 − e−λ(i)T)), where δ is
the recovery rate and λ(i) is the (constant) default rate for bond i and T is the
redemption time.

Thus

1.6 = 2e−0.06(1 − .4(1 – e−2λ(A))) and

2.2 = 3e−0.06(1 − .4(1 – e−2λ(B))),

so λ(A) = 0.2361

and

λ (B) = 0.4029

(iv) (a) We seek a portfolio consisting of a units of £100 nominal of bond A, b

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

If this is to perfectly hedge the security then its value at time 2 should
be zero unless both bonds default, in which case it should be 100.

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

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

Equating the corresponding values of the portfolio and of the new

security (at time 2) we obtain:

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

Page 4
 Subject CT8 (Financial Economics Core Technical) — September 2010 — Examiners’ Report

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

(b) Since this is a perfect hedge, the initial value of the hedging portfolio is
the fair price for the new security, so the fair price is
500e−0.06 − 250(1.6/2) − 250(2.2/3) − 52 = £34.55

5 (i) The unique fair price is V = EP[e−rTD], where P is the EMM

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

14.5%

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

EP[e−r S12] = EP[S02e−r exp(2σB1 + 2r − σ2)] = S02 exp(r +
σ2)=5.52exp(.185)=£36.40.

(iv) The amount of stock to hold in the hedging portfolio is Delta = ∂f/∂S, where f
is the price as a function of current stock price S. Thus the initial hedging
portfolio holds 2S0exp(r + σ2)=13.235 units of stock and is short £S02exp(r +
σ2) =£36.40.

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

It follows from Ito’s formula that

dΛt = (∂g/∂t (Wt , t) + (1/2) ∂2g/∂2x(Wt , t))dt + ∂g/∂x(Wt , t) dWt
= (−(1/2)k2g + (1/2)k2g)dt + kg dWt = kg dWt .

It follows that Λ is a (local) martingale.

Hence 1 = Λ0 = E[ΛT] = E[exp(kWT − 1/2k2T)

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

(ii) (a) When

f(x) = x, p0 = E[e−rt ST Λt|F0]

= E[e−rt S0exp(σ Wt +(μ −1/2 σ2)t)Λt|F0]
= E[e−rt S0exp((σ + m) Wt +(μ −1/2 σ2 −1/2 m2)t)|F0]
= e−rt S0exp(1/2 (σ + m)2t + (μ − 1/2 σ2 − 1/2 m2)t)
= S0exp((σm + μ − r)t)).

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

which holds if and only if m = (r − μ)/σ, there is an arbitrage
opportunity.

Page 5
 Subject CT8 (Financial Economics Core Technical) — September 2010 — Examiners’ Report

7 (i) Denote the individual derivative by f and assume this is written on an

underlying security S

∂f ∂f
Δ= ≡ (t, St ).
∂s ∂s

∂2 f
Γ=
∂s 2

ν = ∂f
∂σ

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

(ii) If the portfolio is Delta-hedged and has a high value of Γ then it will require
more frequent rebalancing or larger trades than one with a low value of
gamma. The need for rebalancing can, therefore, be minimised by keeping
gamma close to zero.

The value of a portfolio with a low value of vega will be relatively insensitive
to changes in volatility. Since σ is not directly observable, a low value of
vega is important as a risk-management tool. Furthermore, it is recognised
that σ can vary over time. Since many derivative pricing models assume that
σ is constant through time the resulting approximation will be better if ν is
small.

8 The proof of this result is an adaptation of that of the standard call-put parity. Two
(self-financing) portfolios are considered:

• Portfolio A: buying the call and selling the put at time t. Its value at time t is
Ct – Pt and at time T, it is ST − K in all states of the universe.

• Portfolio B: buying the underlying asset for St and borrowing

K exp ( −r (T − t ) ) + D exp ( − r (T '− t ) ) at time t. Its value at time t is then:
– ( K exp ( − r (T − t ) ) + D exp ( −r (T '− t ) ) − St ). At time T ' , the dividend D is paid
and added to the portfolio. Therefore the value at maturity of the portfolio is then
ST − K , taking into account the dividend payment.

Using the absence of arbitrage opportunity, both portfolios should have the same
value at any intermediate time, in particular at time t. Hence:

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

Page 6
 Subject CT8 (Financial Economics Core Technical) — September 2010 — Examiners’ Report

9 (i) (a) Key calculation in demonstrating no arbitrage is

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

(b) The binomial tree is:

144
120
100 96
80
64

(ii) To price the call option, we use the risk-neutral pricing formula. We use the
following simplifying notation:

( ) ( )
+ + +
Cuu = u 2 S0 − K = 44 ; Cud = ( udS0 − K ) = 0 ; Cdd = d 2 S0 − K = 0.

At time 1, we get in the upper state,

C1 ( u ) = exp ( − r ) ⎡⎣ qCuu + (1 − q ) Cud ⎤⎦ = 27.12 , and in the lower state

C1 ( d ) = exp ⎡⎣ qCud + (1 − q ) Cdd ⎤⎦ = 0 where the risk-neutral probability of an
exp ( r ) − d
upward move is q = = 0.6545 .
u−d

At time 0, C0 = exp ( −r ) ⎡⎣ qC1 (u ) + (1 − q ) C1 (d ) ⎤⎦ .

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

(iii) (a) Only one path is relevant for this barrier option “up-up”. Its
probability of occurrence is q2 and the associated payoff is Xuu = 44.
Using the risk-neutral valuation formula, we get:

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

(b) In practice this option “clearly” has less value than the option (ii)
because it pays off in fewer cases. However it has the same price
when calculated using the binomial tree approach – this reinforces the
need for choosing binomial trees carefully when pricing derivatives.

END OF EXAMINERS’ REPORT

Page 7
Faculty of Actuaries Institute of Actuaries

EXAMINATION

28 April 2010 (am)

Subject CT8 — Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. Mark allocations are shown in brackets.

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

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

© Faculty of Actuaries
CT8 A2010 © Institute of Actuaries
1 Let ( X t ; t ≥ 0 ) be a stochastic process satisfying:

t t
X t = X 0 + ∫ μ s ds + ∫ σ s dWs
0 0

where W is a standard Brownian motion.

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

with respect to t.

(i) State the stochastic differential equation for f ( t , X t ) . [2]

Let dX t = −γX t dt + σdWt .

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

t
X t = X 0 exp ( −γt ) + σ ∫ exp ( γ ( s − t ) ) dWs [6]
0
[Total 8]

2 Consider a stock paying a dividend at a rate δ and denote its price at any time t by St .
The dividend earned between t and T, T ≥ t, is St (eδ(T −t ) − 1) .

Let Ct and Pt be the price at time t of a European call option and European put option
respectively, written on the stock S, with strike price K and maturity T ≥ t . The
instantaneous risk-free rate is denoted by r.

Prove put-call parity in this context by adapting the proof of standard put-call parity
that applies to put and call options on a non-dividend paying stock. [8]

CT8 A2010—2
3 Consider a two-period binomial model for a non-dividend paying stock whose current
price is S0 = 100. Assume that:

• over each six-month period, the stock price can either move up by a factor u = 1.2
or down by a factor d = 0.8

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

(i) (a) Prove that there is no arbitrage in the market.

(b) Construct the binomial tree.
[2]

(ii) Calculate the price of a standard European call option written on the stock S
with strike price K = 100 and maturity one year. [5]

Consider a special type of call option with strike price K = 100 and maturity one
year. The underlying asset for this special option is the average price of the stock
over one year, calculated as the average of the prices at times 0, 0.5 and 1 measured in
years.

(iii) Calculate the initial price of this call option assuming it can be exercised only
at time 1. [5]
[Total 12]

4 Consider the following stochastic differential equation for the instantaneous risk free
rate (also referred to as the short-rate):

dr (t ) = a ( b − r (t ) ) dt + σdWt

Its solution is given by:

t
r ( t ) = r0 exp ( −at ) + b (1 − exp ( −at ) ) + σ exp ( −at ) ∫ exp ( as ) dWs
0

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

T
1 − exp ( −a (T − t ) ) σ
T

∫ r ( u )du = b (T − t ) + ( r (t ) − b ) a a
( )
+ ∫ 1 − exp ( −a (T − s ) ) dWs
t t

(i) Derive the price at time t of a zero-coupon bond with maturity T. [10]

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

(b) State the name and stochastic differential equation of an alternative

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

CT8 A2010—3 PLEASE TURN OVER

5 A European call option on a stock has an exercise date one year away and a strike
price of 320p. The underlying stock has a current price of 350p. The option is priced
at 52.73p. The continuously compounded risk-free interest rate is 4% p.a.

(i) Estimate the stock price volatility to within 0.5% p.a. assuming the Black-
Scholes model applies. [5]

A new derivative security has just been written on the underlying stock. This will pay
a random amount D in one year’s time, where D is 100 times the terminal value of the
call option capped at 1p (i.e. 100 times the lesser of the terminal value and 1p).

(ii) (a) State the payoff for this derivative security in terms of two European
call options.

(b) Calculate the fair price for this derivative security.

[5]

(iii) Calculate the risk neutral probability that the stock price is greater than 320p.
[4]
[Total 14]

6 (i) Describe the-two state model for credit ratings under the real world measure.
[9]

(ii) Explain how the two state model is generalised in the Jarrow-Lando-Turnbull
model. [3]
[Total 12]

7 (i) State the Cameron-Martin-Girsanov Theorem. [3]

(ii) Derive the value of a which makes exp(σBt – at) a martingale when B is a
standard Brownian Motion. [3]

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

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

real-world measure.

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

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

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

Motion under the Equivalent Martingale Measure.

(b) Calculate the risk-free rate of interest.

[8]
[Total 14]

CT8 A2010—4
8 Outline the main points you would make in a discussion of the statement:

The efficient markets hypothesis states that the market price is always correct and
therefore it is not possible for investors to make money from investing in shares.
[10]

9 An asset is worth 100 at the start of the year and is funded by a senior loan and a
junior loan of 50 each. The loans are due to be repaid at the end of the year; the
senior one with interest at 6% p.a. and the junior one with interest of at 8% p.a.
Interest is paid on the loans only if the asset sustains no losses.

Any losses of up to 50 sustained by the asset reduce the amount returned to the
investor in the junior loan by the amount of the loss. Any losses of more than 50
mean that the investor in the junior loan gets 0 and the amount returned to the investor
in the senior loan is reduced by the excess of the loss over 50.

The probability that the asset sustains a loss is 0.25. The size of a loss, L, if there is
one, follows a uniform distribution between 0 and 100.

(i) Calculate the variances of return for the investors in the junior and senior
loans. [8]

(ii) Calculate the shortfall probabilities for the investors in the junior and senior
loans, using the full return of the amounts of the loans as the respective
benchmarks. [2]
[Total 10]

END OF PAPER

CT8 A2010—5
Faculty of Actuaries Institute of Actuaries

EXAMINERS’ REPORT

April 2010 examinations

Subject CT8 — Financial Economics

Core Technical

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

R D Muckart
Chairman of the Board of Examiners

July 2010

© Faculty of Actuaries
© Institute of Actuaries
 Subject CT8 (Financial Economics Core Technical) — April 2010 — Examiners’ Report

1 (i) Write down Ito’s formula for f(t,Xt) when dX t = μt dt + σt dWt

∂f (t , X t ) ∂f (t , X t ) 1 ∂ 2 f (t , X t )
df (t , X t ) = dt + dX t + ( dX t )2
∂t ∂x 2 ∂x 2

1 ∂ 2 f (t , X t ) 2
=
∂f (t , X t )
∂t
dt +
∂f (t , X t )
∂x
( μt dt + σt dWt ) +
2 ∂x 2
(
σt dt )
⎛ ∂f (t , X t ) ∂f (t , X t ) 1 ∂ 2 f (t , X t ) 2 ⎞ ∂f (t , X t )
= ⎜ + μt + σ ⎟ dt + σt dWt
⎜ ∂ t ∂ x 2 ∂ 2 t ⎟ ∂ x
⎝ x ⎠

(ii) Consider Xt = Ut e−γt.

Then

dUt = d(eγt Xt) = γeγt Xt dt + eγt dXt

= γeγt Xt dt + eγt(−γ Xt dt + σdWt) = σeγt dWt .

Thus

t
Ut = U0 + σ ∫ e γs dWs
0

and consequently

t
+ σ ∫ e ( ) dWs
−γt −γt γ s −t
Xt = e Ut = X 0e
0

2 The proof of this result is an adaptation of that of the standard call-put parity. Two
(self-financing) portfolios are considered:

• Portfolio A: buying the call and selling the put at time t. Its value at time t is
Pt − Ct and at time T, it is ST − K in all states of the universe.

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

St exp ( −δ (T − t ) ) and borrowing K exp ( − r (T − t ) ) at time t. Its value at time t
is then K exp ( −r (T − t ) ) − St exp ( −δ (T − t ) ) . Its value at maturity is then
ST − K by taking into account the dividends which are paid continuously at rate
δ.

Page 2
 Subject CT8 (Financial Economics Core Technical) — April 2010 — Examiners’ Report

Using the absence of arbitrage opportunity, both portfolios should have the same
value at any intermediate time, in particular at time t. Hence:

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

Another proof can include the following portfolios:

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

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

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

(ii) To price the call option, we use the risk-neutral pricing formula. We use the
following simplifying notation:

( )
+
Cuu = u 2 S0 − K = 44;
+
Cud = ( udS0 − K ) = 0;

( )
+
Cdd = d 2 S0 − K = 0.

At time 1, we get in the upper state,

C1 ( u ) = exp ( −r ) ⎡⎣ qCuu + (1 − q ) Cud ⎤⎦ = 26.29 ,

and in the lower state

C1 ( d ) = exp(−r ) ⎡⎣ qCud + (1 − q ) Cdd ⎤⎦ = 0

where the risk-neutral probability of an upward move is

exp ( r ) − d
q= = 0.628 .
u−d

At time 0,

C0 = exp ( −r ) ⎡⎣ qC1 (u ) + (1 − q ) C1 (d ) ⎤⎦ .

Hence

C0 = 15.71 .

Page 3
 Subject CT8 (Financial Economics Core Technical) — April 2010 — Examiners’ Report

(iii) For the special option, we need to compute the average for the different
possible trajectories, the probability of each path and the associated payoff:

trajectory average probability payoff of the option

up − up X uu = 121.33 q 2 = 0.394 ( X uu − K )+ = 21.33
up − down X ud = 105.33 q (1 − q ) = 0.234 ( X ud − K )+ = 5.33
down − up X du = 92 (1 − q ) q = 0.234 ( X du − K )+ = 0
down − down X dd = 81.33 (1 − q )2 = 0.138 ( X dd − K )+ = 0
The price of the option is obtained as

( +
X 0 = exp ( −2r ) q 2 ( X uu − K ) + q (1 − q ) ( X ud − K )
+
) = 8.744 .
4 (i) The price of a zero-coupon bond can be written as

⎡ ⎛ T ⎞ ⎤
B (t , T ) = E ⎢ exp ⎜ − ∫ r ( s )ds ⎟ Ft ⎥ .
⎢ ⎜ ⎟ ⎥
⎣ ⎝ t ⎠ ⎦
T
Since ∫ r ( u )du is a Gaussian random variable, we can compute explicitly the
t
price of the zero-coupon bond in terms of the expected value and variance
T
(conditional) of ∫ r ( u )du :
t
⎡ ⎡T ⎤ 1 ⎡T ⎤⎤
B (t , T ) = exp ⎢ − E ⎢ ∫ r ( s )ds Ft ⎥ + V ⎢ ∫ r ( s )ds Ft ⎥ ⎥
⎢ ⎢⎣ t ⎥⎦ 2 ⎢⎣ t ⎥⎦ ⎥⎦
⎣
⎡T ⎤ ⎛ 1 − exp ( − a (T − t ) ) ⎞
where E ⎢ ∫ r ( s )ds Ft ⎥ = b (T − t ) + ( r ( t ) − b ) ⎜ ⎟ and
⎢⎣ t ⎥⎦ ⎜ a ⎟
⎝ ⎠

⎡T ⎤ σ2 σ2 2σ 2
( ) (
V ⎢ ∫ r ( s )ds Ft ⎥ = 2 (T − t ) − 3 exp ( −2a (T − t ) ) − 1 + 3 exp ( −a (T − t ) ) − 1 .
⎢⎣ t ⎥⎦ a 2a a
)

(ii) Main issue: possibility to have negative interest rates when using the Vasicek
model. An alternative is the CIR model:

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

Page 4
 Subject CT8 (Financial Economics Core Technical) — April 2010 — Examiners’ Report

5 (i) Try σ = 10%. Black Sholes formula gives a price of p10 = 44.05.
Try σ = 40%. Black Sholes formula gives a price of p40 = 76.05.

Interpolating gives a trial value of

(76.05 − 52.73) / (76.05 − 44.05) * 10 + (52.73 − 44.05) / (76.05 − 44.05) * 40
= 20.2%.

Evaluating gives p20.2 = 52.96.

Interpolation with p40 give

σ = ((76.05 − 52.73) * 20.2 + (52.73 − 52.96) * 40) / (76.05 − 52.96) = 21.9%
(to the nearest .5%)

p21.9 = 54.75.

Actual answer is 20%.

(ii) The payoff is

100min(1, max(ST − 320,0)) = 100(max(ST − 320,0) − max(ST − 321,0))
so is 100 times the difference between two call options with the corresponding
strikes.

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

and hence the value of the derivative is p = 100 * (52.73−52.06) = 67p.

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

Thus its price is approximately e−rP(S1 > 320) (where P is the EMM).

So

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

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

⎛S ⎞
ln ⎜ 1 ⎟ and use it to calculate the probability directly.
⎝ S0 ⎠

Page 5
 Subject CT8 (Financial Economics Core Technical) — April 2010 — Examiners’ Report

6 (i) A model can be set up, in continuous time, with two states N (not previously
defaulted) and D (previously defaulted). Under this simple model it is
assumed that the default-free interest rate term structure is deterministic with
r(t) = r for all t. If the transition intensity, under the real-world measure P,
from N to D at time t is denoted by λ(t), this model can be represented as:

λ(t)
No default, N Default, D

and D is an absorbing state.

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

PrP(X(t + dt) = N | X(t) = N) = 1 − λ(t) dt + o(dt) as dt → 0,

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

Another correct answer will be:

⎛ T ⎞
PrP(X(T) = N | X(t) = N) = exp ⎜ − ∫ λ s ds ⎟
⎜ ⎟
⎝ t ⎠

⎛ T ⎞
PrP(X(T) = D | X(t) = N) = 1 − exp ⎜ − ∫ λ s ds ⎟
⎜ ⎟
⎝ t ⎠

If τ is a stopping time defined as:

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

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

⎧0 if τ > t ,
N(t) = ⎨
⎩1 if τ ≤ t.

Then τ can be interpreted as the time of default and N(t) can be interpreted is
the number of defaults up to and including time t.

It is assumed that if the corporate entity defaults all bond payments will be
reduced by a known, deterministic factor (1 − δ) where δ is the recovery rate,
i.e. for a zero-coupon bond which is due to pay 1 at time T, the actual
payment at time T will be 1 if τ > T and δ if τ ≤ T.

Page 6
Subject CT8 (Financial Economics Core Technical) — April 2010 — Examiners’ Report

The formula for the zero-coupon bond price is

⎛ ⎛ ⎛ T ⎞⎞⎞
P ( t , T ) = B ( t , T ) ⎜1 − (1 − δ ) ⎜1 − exp ⎜ − ∫ λ s ds ⎟ ⎟ ⎟
⎜ ⎜ ⎜ ⎟⎟⎟
⎝ ⎝ ⎝ t ⎠⎠⎠

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

(ii) A more general and more realistic model with multiple credit ratings rather
than the simple default/no default model, used above was developed by
Jarrow, Lando and Turnbull. In this model there are n – 1 credit ratings plus
default.

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

state j at time t are denoted by λij(t) where the λij(t) are assumed to be
deterministic then this model for default risk can be represented by the
following diagram:

λ2j(t) j
2 λj2(t)
λj,n-1(t)
λn-
λ12(t) ()
λ21(t)

1 n-
1

λ2n(t)
λ1n(t) λn-1,n(t)

In this n-state model transfer is possible between all states except for the
default state n, which is absorbing.

Page 7
 Subject CT8 (Financial Economics Core Technical) — April 2010 — Examiners’ Report

7 (i) (The Cameron-Martin-Girsanov theorem)

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

suppose that γ t is a previsible process. Then there exists a measure Q
t
equivalent to P and where Z t = Zt + ∫ γ s ds is a standard Brownian motion
0
under Q .

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

equivalent to P then there exists a previsible process γ t such that
t
Z t = Zt + ∫ γ s ds is a Brownian motion under Q .
0
1 2
(ii) The answer is a = σ . This can be proved using two different approaches:
2
for showing all working correctly using one of the approaches below.

(1) Write the martingale condition and consider the expected value of the
process at time t, conditional on the filtration up to an earlier time s.

(2) Write Ito’s formula for the function f(t,Bt) = exp(sigma Bt – at), and set
the drift term equal to 0.

(iii) We know that e−rt St is a martingale under the EMM and so is e−rtDt. So,
setting Wt = Bt + ct we can write e−rt St = S0exp(0.2Wt − (r + 0.2c − 0.2)t) and
we require r + 0.2c − 0.2 = 1/2(0.2)2 = 0.02.

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

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

Eliminating r from these two equations gives

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

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

8
• EMH states that market fully reflects all available information and the implication
is therefore that investors are not able to make “excess” returns (rather than any
returns at all!).

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

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

Page 8
 Subject CT8 (Financial Economics Core Technical) — April 2010 — Examiners’ Report

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

Reasonable to conclude the other way round as studies of directors’ share
dealings suggest that, even with inside information, it is difficult to out-perform.

• Difficult to define publicly available information – might be that some very

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

• Investors taking higher risks may earn higher returns – this does not contradict the
EMH.

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

• Conflicting empirical evidence from supporters and detractors.

• Difficult to determine when, precisely, information arrives.

9 (i) Let J be the return to the investor in the junior loan.

J = 54, with probability 0.75

= 0 with probability 0.25 * 0.5

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

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

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

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

Var[J] = 2291 − 43.6252 = 388

S = return to investor in senior loan

S = 53 with prob 0.75

= 50 with prob 0.25 * 0.5

= 50 * U with prob 0.25 * 0.5

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

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

Var[S] = 2523 − 49.1252 = 110

Page 9
 Subject CT8 (Financial Economics Core Technical) — April 2010 — Examiners’ Report

Alternative answers:

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

possible answers.

In the detailed solution above, it is total return.

If using percentage return, as a percentage, then

J = 0.08 with probability 0.75, −1 with probability 0.25 * 0.5 and U − 1 with
probability 0.25 * 0.5 with U uniformly distributed over [0,1]

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

S = 0.06 with probability 0.75, 0 with probability 0.25 * 0.5 and U − 1 with
probability 0.25 * 0.5 with U uniformly distributed over [0,1].

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

(ii) Pr(J < 50) = 0.25

Pr(S < 50) = 0.125

END OF EXAMINERS’ REPORT

Page 10
Faculty of Actuaries Institute of Actuaries

EXAMINATION

1 October 2009 (am)

Subject CT8 — Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. Mark allocations are shown in brackets.

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

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

© Faculty of Actuaries
CT8 S2009 © Institute of Actuaries
1 (i) State the general form of the equation used in multifactor models of security
returns, defining any terms you use. [3]

(ii) Describe the different categories of factors that are used in these models and
illustrate your answer with suitable examples. [6]
[Total 9]

2 (i) In the context of time series models of financial markets explain the difference
between cross-sectional and longitudinal properties of statistical distributions.
[2]

(ii) Discuss the difference between cross-sectional and longitudinal estimates of

stock volatility assuming:

(a) stock prices follow a multiplicative random walk.

(b) the Wilkie model is being used to model financial variables.
[4]
[Total 6]

3 A small bank wishes to improve the performance of its investments by investing £1m
in high returning assets. An investment bank has offered the bank two possible
investments:

Investment A: A diversified portfolio of shares and derivatives which can be

assumed to produce a return of £R1 million where R1 = 0.1 + N, where
N is a normal N(1,1) random variable.

Investment B: An over-the-counter derivative which will produce a return of £R2

million where the investment bank estimates:

R2 = 1.5 with probability 0.99

−5.0 with probability 0.01.

The chief executive of the bank says that if one investment has a better expected
return and a lower variance than the other then it is the best choice.

(i) (a) Calculate the expected return and variance of each investment A
and B.

(b) Discuss the chief executive’s comments in the light of your

calculations.
[6]

CT8 S2009—2
 (ii) Calculate the following risk measures for each of the two investments A and
B:

(a) semi-variance of return

(b) shortfall probability of the returns falling below 0
(c) shortfall probability of the returns falling below −2
[3]

(iii) (a) Define other suitable risk measures that could be calculated.
(b) Discuss what the risk measures in (iii) (a) would show. [4]

(iv) Compare the merits of the two investments A and B. [2]

[Total 15]

4 An investor invests a proportion xi of the assets in his portfolio in the ith of N

securities.

(i) State the expected return and variance of his portfolio. Define any notation
you use. [2]

Securities with the properties in the table below are available to an investor. The
statistics in the table refer to the next year.

A B
Expected return 4% 3%
Variance of return 16%% 4%%
Correlation coefficient between assets ρAB = 1

The investor combines the securities to form a portfolio.

(ii) Calculate the relative amount which should be invested in each security to
give a portfolio with the minimum possible variance. (Note: you may assume
that short selling securities is allowable.) [4]

(iii) Show that if it is possible to borrow at the rate of 1% p.a. over the next year, it
is possible for the investor to make a risk free profit over the year without
using any of his own capital. [4]
[Total 10]

CT8 S2009—3 PLEASE TURN OVER

5 A derivative security entitles the holder to a payment, at time T, of max0≤t≤T St, where
St is the price at time t of a security.

Assume that S satisfies St = S0exp(σ Bt + (r −1/2 σ2)t) under the risk neutral measure,
where B is a standard Brownian motion and r is the risk-free rate of interest.

(i) Derive the probability density of max0≤s≤t Bs + μs. (Hint: use the formula in
section 7.2 of the Formulae and Tables for Actuarial Examinations). [4]

(ii) Determine an expression for pt, the fair price of the derivative security at time
t. You need not evaluate the resulting integral. [4]
[Total 8]

6 (i) Describe the two-state model for credit-ratings. [4]

In a two state model a zero-coupon defaultable bond is due to redeem at par in two
years’ time. If default occurs the recovery rate is δ. The continuously compounded
risk free rate of return is r, Under the probability measure Pλ, the default intensity is
constant and equal to λ and the defaultable bond price is Dt, given by:

Dt = δe−r(2−t), if default has occurred prior to time t

= e−r(2−t)(δ(1 − e−λ(2−t)) + e−λ(2−t)) otherwise.

(ii) Show that Pλ is an equivalent martingale measure for this model. [3]

A derivative contract pays $1,000 after two years if and only if the bond has
defaulted.

(iii) (a) Determine a constant portfolio in the defaultable bond and cash which
replicates the derivative.

(b) Calculate the fair price for the derivative. [5]

(iv) Explain how your answer to (iii) relates to the fact stated in part (ii). [3]
[Total 15]

7 (i) State the main assumptions underlying the Black-Scholes model for a security
price. [4]

(ii) Comment on how realistic these assumptions are in practice. [4]

[Total 8]

CT8 S2009—4
8 (i) Define a state-price deflator in the context of continuous time models for
security prices. [3]

(ii) Give a formula for the state-price deflator in the Black-Scholes model when
the risk-free rate of interest is r and the stock price satisfies:

dSt = St(μdt + σdZt)

under the real-world measure P, where Z is a standard Brownian motion. [3]

A derivative contract pays exp(γZ1) if Z1 > 1, and zero otherwise, where Z0 = 0 and γ
= (μ − r) / σ.

(iii) Calculate the price pt, at each time t, of this derivative contract, using your
answer to part (ii), or otherwise. [5]
[Total 11]

9 Comment on the difference between real-world and risk-neutral measures in the

context of the valuation of derivative securities using a binomial tree. [4]

10 Prove that it is never optimal to exercise an American call written on a non-dividend

paying stock before maturity. [7]

11 (i) Define the market price of risk in the context of pricing zero coupon bonds
using diffusion models for the short-rate of interest. Define any notation you
use. [2]

(ii) Prove that the market price of risk at a given time t is constant for all zero-
coupon bonds with maturities T > t in the case where the diffusion model for
the short-rate of interest has only one factor. Define any notation you use. [5]

Hint: construct a self-financing strategy involving zero coupon bonds of maturities T1

and T2 and a cash account.
[Total 7]

END OF PAPER

CT8 S2009—5
Faculty of Actuaries Institute of Actuaries

Subject CT8 — Financial Economics.

Core Technical

September 2009 Examinations

EXAMINERS REPORT

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

R D Muckart
Chairman of the Board of Examiners

December 2009

Comments for individual questions are given with the solutions that follow.

© Faculty of Actuaries
© Institute of Actuaries
 Subject CT8 (Financial Economics. Core Technical) — September 2009 — Examiners’ Report

1
(i) Ri = ai + bi,1 I1 + bi,2 I2 + .......+ bi,L IL + ci

Where

Ri is the return on security i.

ai and ci are the constant and random parts respectively of the component of
return unique to security i.

I1 ........ IL are the changes in a set of L factors which explain the variation in Ri
about the expected return.

bi,k is the sensitivity of security i to factor k.

(ii) Macroeconomic factor models

These use observable economic time series as the factors.

Examples: rate of inflation, economic growth, short term interest rates, yields
on long-term government bonds, yield margin on corporate bonds over
government bonds.

Fundamental factor models

These use company specific variables as the factors.

Examples: level of gearing, price earnings ratio, the level of R & D spending,
the industry group to which the company belongs

Statistical factor models

Principal components analysis is used to determine a set of indices which

explain as much as possible of the observed variance.

These indices are unlikely to have any meaningful economic interpretation and
may vary considerably between different data sets.

2
(i) Cross-sectional property fixes a time horizon and looks at the distribution over
all the simulations. E.g. what will inflation be next year? The estimates are
implicitly conditional on past information. They can be deduced from prices
of options and other derivatives.

Page 2
 Subject CT8 (Financial Economics. Core Technical) — September 2009 — Examiners’ Report

Longitudinal property looks at the distribution over a long period of time. E.g.
what will the distribution of inflation be over the next 1000 years? Unlike
cross sectional properties does not reflect market conditions at a particular
time.

(ii)
a. Estimates are the same — random walk returns are independent across
years.
b. The main point is longitudinal volatilities are higher. Longitudinal
volatilities represent unconditional values whilst cross-sectional
volatilities depend on the information set. The difference between the
two shows the value of extra information. Over long horizons the two
values converge to the same point. Students might draw a graph similar
to that on Unit 6 page 13.
Equity Price and Real Dividend Volatility

20%

18% Equity Price (longitudinal)

Equity Price (cross-sectional)
16% Real Dividends (longitudinal)
Real Dividends (cross-sectional)
14%
Percent annulaised volatility

12%

10%

8%

6%

4%

2%

0%
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50
Time (years)

3
(i) Investment A
Expected return = E[0.1 + N] = 0.1 + 1 = 1.1
Variance = 1

Investment B
Expected return = 1.5 0.99 5.0 0.01 = 1.435
Variance = (1.435 1.5)2 0.99 + (1.435 – ( 5))2 0.01 = 0.418275

Investment B has both higher expected return and lower variance so would be
preferred on this basis. However there is an issue with the possibility of very
bad returns. Also there might be an issue with the estimated probabilities of
investment B being somewhat unreliable as they are probably derived from the
fat tail part of a distribution. Thus it might be wise to have a margin of error
regarding this calculation in particular.

Page 3
 Subject CT8 (Financial Economics. Core Technical) — September 2009 — Examiners’ Report

(ii)
a. Investment A
Semivariance = 0.5

Investment B
Semivariance = (1.435 –( 5))2 0.01 = 0.41409

b. Investment A
Shortfall probability of return below 0.
This is probability of the return from N(1,1) being below
0.1 = 0.13567.

Investment B
Shortfall probability of return below 0 is 0.01.

c. Investment A
Shortfall probability of return below 2.
This is probability of the return from N(1,1) being below
2.1 = 0.00097.

Investment B
Shortfall probability of return below –2 is 0.01.

(iii) Definitions of VAR, Tail VaR and Expected Shortfall. (Unit 1, page 3)
Clearly will show high but unlikely risk in the tail of Investment B.

(iv) Give points for sensible discussion:

Might not always be best to optimise on basis of expected return and variance.

No one ―correct‖ measure of risk — different definitions give different

orderings in this case.

Which investment is preferable depends somewhat on solvency of company

— can they afford large, albeit unlikely, losses (analogies with ―credit
crunch‖).

Consider the rest of portfolio.

(i) Expected Return = i xi Ei

where Ei is expected return on security i.

Variance is i j xi xj Cij

where Cij is the covariance of the returns on securities i and j and Cii = Vi

Page 4
 Subject CT8 (Financial Economics. Core Technical) — September 2009 — Examiners’ Report

where Vi is variance of security i.

(Unit 2 page 2)

(ii) Proportion in A = (VB – CAB) / (VA + VB 2CAB)

From (Unit 2 page 3) or can fairly easily be calculated from first principles

CAB = 1 sdA sdB = 1 4% 2% = 8%%

Thus Proportion in A = (4%% 8%%) / (16%% + 4%% 2 8%%) = 1

Proportion in B = 2
i.e. Short sell a unit of A and buy 2 of B.

(iii) Expected Return of portfolio in (ii) is 1 4+2 3 = 2%

Variance = 12 16%% + 22 4%% + 2 2 1 2% 4% = 0

(i.e. risk free)

Now if we borrow at 1% p.a. can invest in the portfolio in (ii) make a return of
2% pay back the loan and will have make 1% over the year.

5
(i) The formula states that

P(max0 s t Bs+ s > y) = (( y + t) / t) + e2 y ( (y + t) / t).

Thus the density of max0 s t Bs+ s is

–d/dy( (( y + t) / t) + e2 y ( (y + t) / t))

Page 5
 Subject CT8 (Financial Economics. Core Technical) — September 2009 — Examiners’ Report

= 2 e2 y ( (y + t) / t)) + e2 y exp( (y + t)2 / t) / (2 t))

+ exp( ( y + t)2/t) / (2 t))

= 2 e2 y ( (y + t) / t)) + 2 exp( ( y + t)2 / t) / (2 t)). [4]

(ii) We need to price the derivative under the risk neutral measure. Under this
measure,

max0 s T Ss = S0 exp(max0 s T Bs + s(r 1/2 2))

= S0exp( (max0 s T Bs + s)),

with = (r 1/2 2) / , and B a standard Brownian motion. Thus the price is

E[e-rTS0exp( (max0 s T Bs + s))]

-rT ( y + T)2/2T
= e S0 [2 e / (2 T) -2 e2 y ( (y + T)/ T)]exp( y)dy [4]
[Total 8]

6
(i) The model is a continuous time Markov with two states: N (not previously
defaulted) and D (previously defaulted). Under this simple model it is
assumed that the default-free interest rate term structure is deterministic with
r(t) = r for all t. If the transition intensity, under the real-world measure P,
from N to D at time t is denoted by λ(t), this model can be represented as:

(t)
No default, N Default, D

and D is an absorbing state.

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

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

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

(ii) We need to show that under P , E[e rt Dt |Fs] = e rs Ds.

If the default time τ s then e rs Ds= e rs e-r(2-s)= e rt Dt.
If s τ, then e rt Dt= e 2r, if default has occurred prior to time t

= e 2r( (1 e (2 t)) +e (2 t)) otherwise.

Thus,
E[e rt Dt |Fs]= e 2r(1- e (t-s))+ e 2r( (1 e (2 t)) +e (2 t)) e (t-s)

Page 6
 Subject CT8 (Financial Economics. Core Technical) — September 2009 — Examiners’ Report

=e 2r(( (1 e (2 s)) +e (2 s)) which is e rs Ds in this case.

(iii) Seeking a portfolio of the form aD + bB, we need the value to be 1000 at time
2 if default has occurred, so we need a + b = 1000. Similarly we need the
value to be zero at time 2 if default has not occurred, so we need a + b = 0.
Hence b = a and b = 1000/(1 ).
The fair price for the derivative must be the set-up cost for this portfolio which
is be-2r +aD0=1000/(1 )( e-2r- e 2r( (1 e 2 ) + e 2 ))=1000 e-2r(1- e 2 )

(iv) We need to check that the initial value of this portfolio is E[e 2rV] under P :
under P , E[e 2rV]= 1000e 2rP(default)= 1000e 2r(1- e 2 ) as required (V is
the final value of the derivative).

This then accords with the fact that if we can hedge without arbitrage
then the price is that given by the EMM

7
(i) The assumptions underlying the Black-Scholes model are as follows:

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

motion.
2. There are no risk-free arbitrage opportunities.
3. The risk-free rate of interest is constant, the same for all maturities
and the same for borrowing or lending.
4. Unlimited short selling (that is, negative holdings) is allowed.
5. There are no taxes or transaction costs.
6. The underlying asset can be traded continuously and in
infinitesimally small numbers of units.
(ii) It is clear that each of these assumptions is unrealistic to some degree, for
example:
Share prices can jump. This invalidates assumption 1. since geometric
Brownian motion has continuous sample paths. It also invalidates
assumption 2. However, hedging strategies can still be constructed which
substantially reduce the level of risk.
The risk-free rate of interest does vary and in a unpredictable way.
However, over the short term of a typical derivative the assumption of a
constant risk-free rate of interest is not far from reality. (More specifically
the model can be adapted in a simple way to allow for a stochastic risk-
free rate, provided this is a predictable process.)
Unlimited short selling may not be allowed except perhaps at penal rates
of interest. These problems can be mitigated by holding mixtures of
derivatives which reduce the need for short selling. This is part of a
suitable risk management strategy as discussed in Section 2 below.
Shares can normally only be dealt in integer multiples of one unit, not
continuously and dealings attract transaction costs: invalidating
assumptions 2., 5., 6. and 7. Again we are still able to construct suitable
hedging strategies which substantially reduce risk.

Page 7
 Subject CT8 (Financial Economics. Core Technical) — September 2009 — Examiners’ Report

Distributions of share returns tend to have fatter tails than suggested by the
log-normal model, invalidating assumption 1.

8
(i) A corollary to the Cameron-Martin-Girsanov theorem states that there exists a
process t such that, for any FT -measurable derivative payoff X at time T ,

EQ [ X Ft ] EP T X Ft
t

rt
Define At e t

The process At is called a state-price deflator (also deflator; state-price

density; pricing kernel; or stochastic discount factor). [3]

(ii) If we define t = exp( Zt ½ 2t), where = ( r)/ , then the state price
deflator is At = te rt. [3]

(iii) If a contract has terminal value V then its price at time t is EP[ATV/At|Ft]. So in
this case we obtain

pt = EP[exp( Z1) 1(Z1>1)exp( Z1 ½ 2) e r/ (exp( Zt ½ 2t) e rt)|Ft]

= P[Z1 > 1|Ft]exp( Zt (½ 2 + r)(1 t))
= (1 ((1 Zt) / √(1 t))) exp( Zt (½ 2 + r)(1 t)) [5]

9
The real-world probability measure P can be interpreted in the following way. Let A
be some event contained in F (for example, suppose that A is the event that S1 is
greater than or equal to 100). Then P( A) is the actual probability that the event A
will occur. On a more intuitive level with m independent realisations of the future
instead of one we would find that the event A occurs on approximately a proportion
P( A) occasions (with the approximation getting better as m gets larger and larger).

Two measures P and Q which apply to the same sigma-algebra F are said to be
equivalent if for any event E in F : P( E ) 0 if and only if Q( E ) 0 , where P( E )
and Q( E ) are the probabilities of E under P and Q respectively.

In the context of the binomial model and using the above definition of equivalence the
only constraint on the real-world measure P is that at any point in the binomial tree
the probability of an up move lies strictly between 0 and 1. The only constraint on Q
is the same but this can be equated to the requirement that the risk-free return must lie
strictly between the return on a down move and the return on an up move. This gives
us considerable flexibility in the range of possible equivalent measures.

Page 8
 Subject CT8 (Financial Economics. Core Technical) — September 2009 — Examiners’ Report

10
Consider an investor holding an American call. She needs some cash at time t T .
Two strategies are available for her:

(i) She sells the options on the market and gets the price of it in exchange CtA ,
(ii) She exercises the option and obtains the intrinsic value St K.

But, we know that CtA CtE max 0; St K exp r T t .

Hence CtA max 0; St K exp r T t St Ke r (T t )

St K.

As a consequence, the first strategy is better and it is never optimal for the agent to
exercise her option early.

11
(i) B(t,T) = Zero-coupon bond price
= price at t for £1 payable at T
r(t) = instantaneous risk-free rate of interest at t

Take a specific bond with maturity at T1. Suppose its SDE under the real-
world measure P is

dB(t T1 ) B(t T1 ) m(t T1 )dt S (t T1 )dW (t )

where, besides S(t, T1), m(t, T1) might be stochastic. The market price of risk
is defined as

m(t T1 ) r (t )
(t T1 )
S (t T1 )

(ii) Define Ct = cash account at time t

Portfolio A: at units of B(t, T2) and bt units of Ct

Portfolio B: 1 unit of B(t, T1)

Self financing implies:

atB(t, T2) + btCt = B(t, T1)

and

Page 9
 Subject CT8 (Financial Economics. Core Technical) — September 2009 — Examiners’ Report

at dB(t, T2) + bt dCt = dB(t, T1)

So

at B(t, T2) [m(t, T2) dt + S(t, T2) dWt]

+ btrtCt dt = B(t, T1) [m(t, T1) dt + S(t, T1) dWt]

equating the coefficients of dt and dWt we obtain

S (t , T1 ) B(t , T1 )
at =
S (t , T2 ) B(t , T2 )

1 m(t , T2 ) B(t , T1 ) S (t1T1 )

and bt = m(t , T1 ) B (t , T1 )
rt Ct S (t , T2 )

Substituting these back:

S (t1T1 ) B(t , T1 )
B(t , T2 )
S (t , T2 ) B(t , T2 )

1 m(t , T2 ) B(t , T1 ) S (t , T1 )
Bt m(t , T1 ) B(t , T1 )
rt Bt S (t , T2 )

B(t , T1 )

Simplifying:

S (t , T1 ) 1 m(t , T2 ) S (t1T1 )
m(t , T1 ) 1
S (t , T2 ) rt S (t , T2 )

m(t , T1 ) rt m(t , T2 ) rt
S (t , T1 ) S (t , T2 )

END OF EXAMINERS’ REPORT

Page 10
Faculty of Actuaries Institute of Actuaries

EXAMINATION

22 April 2009 (am)

Subject CT8 — Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. Mark allocations are shown in brackets.

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

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

© Faculty of Actuaries
CT8 A2009 © Institute of Actuaries
1 Describe what is meant by an arbitrage opportunity. [3]

2 One of your colleagues says that the stock market is not efficient because some
accounting ratios have been shown to have predictive powers.

(i) Explain which of the main forms of efficiency is most relevant to this
situation. [2]

(ii) Comment on whether you agree with your colleague. [2]

(iii) Explain the difference between active and passive fund management in terms
of the concept of market efficiency. [2]
[Total 6]

3 (i) Outline the relevant empirical evidence and theoretical arguments regarding
the behaviour of stock prices for each of the properties below.

(a) The volatility of returns over time.

(b) The expected value of returns over time.
(c) Whether stock prices are mean reverting.
(d) The statistical distribution of returns.
[8]

(ii) (a) Discuss the extent to which a continuous time lognormal model of
security prices can capture the statistical properties empirically
observed or expected in the stock market.

(b) Outline other possible processes which may be used.

[6]
[Total 14]

4 (i) State how investors are assumed to make decisions in modern portfolio theory
(MPT). [1]

(ii) Define an efficient portfolio in the context of MPT. [1]

An investor can invest in only three assets which are uncorrelated with one another.
The assets have the following characteristics:

Asset A Expected Rate of Return Standard Deviation

A 9% 18%
B 5% 8%
C 4% 0%

(iii) Calculate the efficient frontier for the investor taking into account the numbers
provided in the table above. [8]

(iv) Explain how an investor with a quadratic utility function would select a
portfolio from those making up the efficient frontier. [1]
[Total 11]

CT8 A2009—2
5 (i) Define the market price of risk in the CAPM. [1]

The table below gives the annual returns conditional on the state of the economy for
all the assets in an investment market.

Economic State Asset Probability

Stock Property Bonds
Recession 0% 1% 2% 0.1
Normal 5% 3% 3% 0.7
Boom 10% 7% 3% 0.2
Value of asset (bn) 100 50 100

(ii) Calculate the market price of risk given that the risk free annual rate of return
is 2.5%. [4]

(iii) Discuss the particular issue a young investor might face in using the CAPM.
[2]
[Total 7]

6 Describe three different approaches to modelling credit risk. [6]

7 (i) Set out a formula for the stock-price, St, in the Black-Scholes model under the
equivalent martingale measure. [2]

A European call option on a stock has an exercise date one year away and a strike
price of £2. The underlying stock has a current price of £1.80. The continuously
compounded risk free rate of interest is 5% p.a. The option is priced at 20p.

(ii) Estimate the volatility of the stock price process to within 1% p.a., assuming
the Black-Scholes model applies. [5]

A new derivative security has just been written on the underlying stock. This will pay
a random amount D in one year’s time, where D is £1 if S0.5 > £2 and S1 > 2S0.5, is
50p if S0.5 < £2 and S1 > 2 S0.5 and is zero otherwise.

(iii) Derive an expression in terms of the distribution function and/or density

function of the standard normal distribution for the fair price for this derivative
security. [6]
[Total 13]

CT8 A2009—3 PLEASE TURN OVER

8 (i) Explain what is meant by self-financing in the context of continuous-time
derivative pricing, defining all notation used. [4]

(ii) Define the delta of a derivative, defining all notation and terms used other than
those already defined in your answer to (i). [2]

(iii) Explain how delta and self-financing are used in the martingale approach to
valuing derivatives. [4]
[Total 10]

9 The zero-coupon bond market is assumed to be arbitrage-free and complete. Consider

the following model for the instantaneous forward rate process:

df (t , T ) = a (t , T )dt + σ(t , T )dWt

where (Wt ; t ≥ 0 ) is a standard Brownian motion with respect to the risk-neutral

probability measure Q.

(i) State how the price of a zero-coupon bond is related to the instantaneous
forward rate. [2]

Using Itô calculus, it is possible to prove that the dynamics for the zero-coupon bond
price are given under Q as follows:

dB (t , T )
= m(t , T )dt + S (t , T )dWt ,
B (t, T )

where
2
T ⎛T ⎞
m(t , T ) = r (t ) − ∫ a (t , s )ds + ⎜ ∫ σ(t , s )ds ⎟
⎜ ⎟
t ⎝t ⎠
T
S (t , T ) = − ∫ σ(t , s )ds.
t

(ii) Explain the relationship between a and σ under the condition that the bond
market is complete. Give reasons for your answer. [6]
[Total 8]

CT8 A2009—4
10 Consider a three-period binomial model for a stock with the following parameters:
u = 1.2, d = 0.9 and S0 = 60. Assume that the discretely compounded risk-free rate of
interest is r = 11% per period.

(i) (a) Verify that there is no arbitrage in the market.

(b) Construct the binomial tree.
[3]

(ii) Calculate the price of a standard European call option with maturity date in
three periods and strike price K = 60. [7]

A new “knock-in” option is introduced which has the following characteristics:

If the value of the stock crosses the level 80 during the whole life of the
option, the contract holder has the right to obtain the difference between the
value of the stock at maturity (in three periods) and 60.

(iii) Calculate the price of this new option. [4]

[Total 14]

11 Consider a forward contract on gold. Suppose that there is a fixed storage cost of £c
per ounce, paid at the end of the period and c is the same for any time period less than
one year. Let St be the spot price of one ounce of gold at time t and r be the
continuously compounded risk-free rate of interest which is assumed to be constant.

Derive the price at time t of a forward contract written on one ounce of gold at the
start of the year, with maturity T years (T < 1).
[8]

END OF PAPER

CT8 A2009—5
Faculty of Actuaries Institute of Actuaries

Subject CT8 — Financial Economics

Core Technical

EXAMINERS’ REPORT

April 2009

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

R D Muckart
Chairman of the Board of Examiners

June 2009

© Faculty of Actuaries
© Institute of Actuaries
 Subject CT8 (Financial Economics Core Technical) — April 2009 — Examiners' Report

1 Put in simple terms, an arbitrage opportunity is a situation where we can make a sure
profit with no risk. This is sometimes described as a free lunch. Put more precisely
an arbitrage opportunity means that:

(a) We can start at time 0 with a portfolio which has a net value of zero (implying
that we are long in some assets and short in others).

(b) At some future time T:

• the probability of a loss is 0

• the probability that we make a strictly positive profit is greater than 0

2 (i) Semi-strong form because linked to publically available information.

(ii) It is true that some ratios have predictive power.

This may not violate market-efficiency as the ratios may be acting as a proxy
for risk.

(iii) Active managers believe market is not fully efficient hence they attempt to
detect mispricings.

Passive managers believe in efficiency and just diversify across the whole
market.

3 (i) (a) Direct statistical evidence shows volatility varies over time. Volatility
implied from option prices also shows volatility/volatility expectations
vary over time.

(b) Good theoretical reasons to expect this to vary over time. Equities
should give a risk premium over bonds and bond yields vary over time.
Empirically difficult to test.

(c) Empirically unsettled. Some evidence for mean reversion but rests
heavily on the aftermath of a few dramatic crashes also conversely
some evidence of momentum effects.

(d) Strong empirical evidence that prices are non-normal. Crashes happen
more than would be expected. In addition more days with small/no
changes than one would expect.

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 Subject CT8 (Financial Economics Core Technical) — April 2009 — Examiners' Report

(ii) Some problems with random walk. Can consider the points in (i) again:

(a) Random walk assumes constant volatility — ARCH would be better in

this respect. Also processes with non-normal returns can give a similar
effect.

(b) Random walk assumes drift is constant.

(c) No allowance for mean reversion in random walk.

(d) Random walk does assume normality. Quite a few alternatives. Levy
processes, jump processes like Poisson.

The above answer incorporates what is in the core reading. Quite a

few processes which are not mentioned are valid e.g. GARCH,
EGARCH, QGARCH.

4 (i) Select on the basis of expected return and variance of return over a single time
horizon.

(ii) A portfolio is efficient if an investor cannot find a better one in the sense that
it has both a higher expected return and a lower variance.

(iii) The basic idea is that the efficient frontier is a straight line which is the
tangent to the efficient frontier (of risky assets) which passes through the point
in (s.d., return) space corresponding to the risk-free asset.

Initially need to find the portfolio using A and B that maximises

(expected return – 4%)/standard deviation

Put say proportion x of assets in A and (1 − x) in B.

Expected return of risky portfolio is 0.09x + 0.05(1 − x)

Standard deviation of risky portfolio is

[(0.18x)2 + (0.08(1 − x))2]0.5

Thus need to find x to maximise

[0.09x + 0.05(1 − x) – 0.04]/ [(0.18x)2 + (0.08(1 − x))2]0.5

Method is to take logs.

Page 3
 Subject CT8 (Financial Economics Core Technical) — April 2009 — Examiners' Report

Need to maximise

ln[0.01 + 0.04x] – 0.5ln[0.0324x2 + 0.0064(1 − x)2]

= ln[0.01 + 0.04x] – 0.5ln[0.0064 − 0.0128x + 0.0388x2]

Differentiate and set to zero.

0.04/[0.01 + 0.04x] – 0.5[− 0.0128 + 0.0388.2x]/ [0.0064 − 0.0128x +

0.0388x2] = 0

x is found to be 0.4969

(Can also calculate x using Lagrangian multipliers)

When x is 0.4969
Expected return of risky portfolio is 0.069876
Standard deviation of risky portfolio is 0.09808

Thus the efficient frontier is the straight line through (0.04.0) and (0.069876,
0.09808).

(iv) Portfolio would be that corresponding to the point where the utility
indifference curve of the investor touched the efficient frontier.

5 (i) The market price of risk is (Em – r)/σm.

(ii) Em = (100 × (0% × 0.1 + 5% × 0.7 + 10% × 0.2) +

50 × (1% × 0.1 + 3% × 0.7 + 7% × 0.2) +
100 × (2% × 0.1 + 3% × 0.7 + 3% × 0.2)) ÷ 250

= 4.08%

σ2m. = [(100 × 0% + 50 × 1% + 100 × 2%) ÷ 250 – 3.36%]2 × 0.1 +

[(100 × 5% + 50 × 3% + 100 × 3%) ÷ 250 – 3.36%]2 × 0.7 +
[(100 × 10% + 50 × 7% + 100 × 3%) ÷ 250 – 3.36%]2 × 0.2

= 0.00022736

Thus the market price of risk is (4.08% – 2.5%)/1.5078%

= 1.0479

(iii) The investor should consider their own human capital which is likely to be
large and unpredictable compared to their other assets.

Page 4
 Subject CT8 (Financial Economics Core Technical) — April 2009 — Examiners' Report

6 Structural models

Structural models are explicit models of a corporate entity issuing both equity and
debt. They aim to link default events explicitly to the fortunes of the issuing
corporate entity. An example of a structural model is the Merton model.

Reduced form models

Reduced form models are statistical models which use observed market statistics
rather than specific data relating to the issuing corporate entity. The market statistics
most commonly used are the credit ratings issued by credit rating agencies such as
Standard and Poor’s and Moody’s.

Reduced form models use market statistics along with data on the default-free market
to model the movement of the credit rating of the bonds issued by a corporate entity
over time. The output of such models is a distribution of the time to default.

Intensity-based models

Intensity-based models model the factors influencing the credit events which lead to
default and typically (but not always) do not consider what actually triggers the credit
event.

7 (i) St = S0 exp(σZt + (r − ½σ2)t), where Z is a standard Brownian motion.

Alternative solution: dS_t/S_t = r dt + σ dZ_t

(ii) Apply B-S formula with K = 2, S = 1.8, r = 0.05, t = 1 and sigma = 0.2, gives
c = 0.10. With sigma = 0.4, c = 0.24. Try sigma = 0.2 + 0.2 * 0.1/0.14 = 0.34
and get c = 0.20.

(iii) The unique fair price is V = EP[e−rTD], where P is the EMM. Thus

V = e−r[P(S0.5>£2 and S1 > 2S0.5) + 0.5 P(S0.5 < £2 and S1> 2S0.5)]

= e−r{integral from 2 to infinity Prob[S_1 > 2x] * f(x) dx +

Integral from 0 to 2 0.5 Prob[S_1 > 2x] f(x) dx}

= e−r{integral from 2 to infinity Phi( (ln(2x) − ln(1.8) – 0.05)/0.34 )

phi((ln(x) − ln(1.8) − 0.025)/0.24 ) dx +

Integral from – infinity to 2 0.5 Phi( (ln(2x) − ln(1.8) – 0.05)/0.34 ) phi

((ln(x) − ln(1.8) − 0.025)/0.24)dx}

Where Phi is the cumulative standard normal distribution function and phi is
the standard normal density function. Standard deviation of ln(S_0.5) is
0.34/sqrt(2) = 0.24.

Page 5
 Subject CT8 (Financial Economics Core Technical) — April 2009 — Examiners' Report

There is another way to solve the problem and the price can be calculated
directly from

P(S0.5 > 2 and S1 > 2 S0.5) = P(S0.5 > 2 and S1/S0.5 > 2)
= P(S0.5 > 2) * P(S1/S0.5 > 2) since S1/S0.5 is independent of S0.5.

P(S0.5 > 2) = P(σZ0.5 + (r − 0.5σ2) *0.5 > ln(2) − ln(1.8))

= P(Z > x)

with

x = [1/(σ * 0.5 )] * [ln(2) − ln(1.8)) − (r − 0.5σ2) * 0.5]

Similarly, defining

y = [1/(σ * 0.5 )] * [ln(2)) − (r − 0.5 σ2) * 0.5 ]

we get

V = e−r * [(1 − ϕx) * (1 − ϕy) + 0.5 * ϕx * (1 − ϕy)]

where ϕx is the cumulative normal distribution at x.

8 (i) Suppose that at time t we hold the portfolio (φt , ψ t ) where φt represents the
number of units of St held at time t and ψt is the number of units of the cash
bond held at time t . We assume that St is a tradeable asset as described
above. The only significant requirement on (φt , ψ t ) is that they are previsible:
that is, that they are Ft − -measurable (so φt and ψt are known based upon
information up to but not including time t ).

Let V (t ) be the value at time t of this portfolio: that is, V (t ) = φt St + ψt Bt .

Now consider the instantaneous pure investment gain in the value of this
portfolio over the period t up to t + dt : that is, assuming that there is no
inflow or outflow of cash during the period [t , t + dt ]. This is equal to

φt dSt + ψt dBt

The instantaneous change in the value of the portfolio, allowing for cash
inflows and outflows, is given by

dV (t ) ≡ V (t + dt ) − V (t ) = φt dSt + St d φt + d φt .dSt + Bt d ψt + ψt dBt .

Page 6
Subject CT8 (Financial Economics Core Technical) — April 2009 — Examiners' Report

The portfolio strategy is described as self-financing if dV (t ) is equal to

φt dSt + ψt dBt : that is, at t + dt there is no inflow or outflow of money
necessary to make the value of the portfolio back up to V (t + dt ) .

(ii) Delta is just one of what are called the Greeks. The Greeks are a group of
mathematical derivatives which can be used to help us to manage or
understand the risks in our portfolio.

Let f (t , s ) be the value at time t of a derivative when the price of the

underlying asset at t is St = s .

The delta for an individual derivative is

∂f ∂f
Δ= ≡ (t , St ).
∂s ∂s

(iii) In the martingale approach we showed that there exists a portfolio strategy
(φt , ψ t ) which would replicate the derivative payoff. We did not say what φt
actually is or how we work it out. In fact this is quite straightforward.

First we can evaluate directly the price of the derivative

Vt = e − r (T −t ) EQ [ X | Ft ]

either analytically (as in the Black-Scholes formula) or using numerical

techniques.

In general, if St , represents the price of a tradeable asset

∂V
φt = (t , St ).
∂s

φt is usually called the Delta of the derivative.

The martingale approach tells us that provided:

• we start at time 0 with V0 invested in cash and shares

• we follow a self-financing portfolio strategy
• we continually rebalance the portfolio to hold exactly φt units of St with
the rest in cash

then we will precisely replicate the derivative payoff.

Page 7
 Subject CT8 (Financial Economics Core Technical) — April 2009 — Examiners' Report

B (t , T ) = exp ⎡⎢ − ∫ f (t , u )du ⎤⎥ .
T
9 (i)
⎣ t ⎦

(ii) Since the bond market is complete, the discounted price of a zero-coupon
bond is a martingale with respect to the risk-neutral probability measure.
Using Itô, the dynamics for the discounted zero-coupon bond price B (t , T ) are:

d B (t , T )
= ( m(t , T ) − r (t ) ) dt + S (t , T )dWt
B (t,T )

As to be a martingale, the drift term should be equal to 0:

( m(t , T ) − r (t ) ) = 0
In other words

2
T ⎛T ⎞
∫ a (t , s ) ds =
⎜∫
⎜ σ (t , s ) ds ⎟ .
⎟
t ⎝t ⎠

10 (i) (a) There is no arbitrage in the market since d = 0.9 < 1.11 < 1.2 .

(b)

103.68

86.4

72 77.76

60 64.8
54 58.32

48.6

43.74

Page 8
Subject CT8 (Financial Economics Core Technical) — April 2009 — Examiners' Report

(ii) To price the call option, we use the risk-neutral pricing formula. We use the
following simplifying notation:

( );
+
Cuuu = u 3 S0 − K

= ( u dS − K ) ;
+
2
Cuud 0

= ( ud S − K ) ;
+
2
Cudd 0

= (d S − K ) .
+
3
Cddd 0

At time 2, we get in the upper state,

1
C2 ( uu ) = ⎡ qCuuu + (1 − q ) Cuud ⎤⎦ ,
1+ r ⎣

in the medium state,

1
C2 ( ud ) = ⎡ qCuud + (1 − q ) Cudd ⎤⎦
1+ r ⎣

Page 9
 Subject CT8 (Financial Economics Core Technical) — April 2009 — Examiners' Report

and in the lowest state,

1
C2 ( dd ) = ⎡ qCudd + (1 − q ) Cddd ⎤⎦ ,
1+ r ⎣

where the risk-neutral probability of an upward move is

q=
(1 + r ) − d .
u−d

At time 1, we get in the upper state,

1
C1 ( u ) = ⎡ qC2 ( uu ) + (1 − q ) C2 ( ud ) ⎤⎦ ,
1+ r ⎣

and in the lower state,

1
C1 ( d ) = ⎡ qC2 ( ud ) + (1 − q ) C2 ( dd ) ⎤⎦ .
1+ r ⎣

At time 0,

1
C0 = ⎡ qC1 (u ) + (1 − q ) C1 (d ) ⎤⎦ .
1+ r ⎣

Hence

C0 = 16.68 .

(iii) Two paths are relevant for this knock-in option: “up-up-up” and “up-up-
down”. The associated payoff are respectively Cuuu with probability
q 3 and Cuud with probability q 2 (1 − q ) . The price at time 0 of the option is
therefore:

1 ⎡ q 3Cuuu + q 2 (1 − q ) Cuud ⎤ = 12.82

Knock − in0 =
⎣ ⎦
(1 + r )3

Page 10
 Subject CT8 (Financial Economics Core Technical) — April 2009 — Examiners' Report

11 The proof of this result is an adaptation of that of the standard spot-forward parity.
Two (self-financing) portfolios are considered:

• Portfolio A: buying the forward contract at time t. Its value at time t is 0 and at
time T, it is ST − FtT .

• ( )
Portfolio B: buying the underlying asset and borrowing FtT − c exp ( − r (T − t ) )

( )
at time t. Its value at time t is then FtT − c exp ( − r (T − t ) ) − St . Its value at

maturity is ST − FtT by taking into account the storage costs.

Using the absence of arbitrage opportunity, both portfolios should have the
same value at any intermediate time, in particular at time t. Hence:

FtT = St exp ( r (T − t ) ) + c .

END OF EXAMINERS’ REPORT

Page 11
Faculty of Actuaries Institute of Actuaries

EXAMINATION

24 September 2008 (am)

Subject CT8 — Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. Mark allocations are shown in brackets.

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

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

© Faculty of Actuaries
CT8 S2008 © Institute of Actuaries
1 Two assets are available for investment. Asset 1 returns a percentage 4B%, where B
is a Binomial random variable with parameters n = 3 and p = 0.5. Asset 2 returns a
percentage 2P%, where P is a Poisson random variable with parameter µ = 3.
Assume a benchmark return of 3%.

(i) Calculate the following three measures of investment risk for each asset:

(a) variance
(b) semi-variance and
(c) shortfall probability [6]

An investor has £1,000 to invest in one of the assets.

(ii) Explain which asset the investor should choose assuming a utility function of
the form:

u(x) = -(1,060 - x)2 : x < 1,060;

0 : x ≥ 1,060.
[2]
[Total 8]

2 (i) State the form of an equation that is appropriate to determine the relationship
between the observed historical returns of a number of securities and a set of
explanatory factors. Define all the terms you use. [2]

(ii) State the main features of:

(a) macroeconomic factor models

(b) fundamental factor models and
(c) statistical factor models
[6]
[Total 8]

3 (i) (a) Define Beta in the Capital Asset Pricing Model (CAPM)
(b) Explain why Beta is used in pricing securities.
[2]

In a market where the CAPM holds the following parameters are known:

Risk-free rate of interest = 6%

Expected market rate of return = 12%
Standard deviation of an efficient portfolio’s returns = 0.50
Standard deviation of the market returns = 0.7

(ii) Calculate the expected return on the portfolio. [2]

CT8 S2008—2
 (iii) An investor is evaluating the risk and expected return of a portfolio of N
securities.

Explain how many parameters need to be estimated if:

(a) the evaluation is made using mean-variance portfolio theory without

any assumed cross-sectional structure in the variances of the securities.

(b) the CAPM is assumed to hold.

[3]
[Total 7]

4 One of your colleagues tells you that the work of Shiller conclusively proves that the
stock-market overreacts.

(i) Outline the nature of Shiller’s findings. [4]

(ii) Discuss whether you agree with your colleague. [4]

[Total 8]

5 State the defining properties of a standard Brownian motion. [4]

6 Consider an asset S paying a dividend at a constant instantaneous rate of δ, a forward

contract with maturity T written on S and a constant, instantaneous (continuously
compounded) risk-free rate of r.

Derive the price at time t of the forward contract, using the no-arbitrage principle. [8]

7 Consider a one-period Binomial model of a stock whose current price is S0 = 40 .

Suppose that:

• over a single period, the stock price can either move up to 60 or down to 30
• the continuously compounded risk-free rate is r = 5% per period

(i) Show that there is no arbitrage in the market. [1]

(ii) Calculate the price of a European call option with maturity date in one period
and strike price K = 45 using each of the following methods:

(a) by constructing a risk-neutral portfolio; and

(b) by constructing a replicating portfolio
[9]
[Total 10]

CT8 S2008—3 PLEASE TURN OVER

8 (i) Write down the formula for the value at time t < T of a derivative payment due
at time T in a market where the Black-Scholes formula applies, defining any
notation that you use. [3]

A non-dividend paying stock has price St at time t < T. A derivative contract

based on the stock pays $1 at time T if and only if the stock price at time T, ST,
is at least K.

Assume the following:

risk-free interest rate: 7% p.a. continuously compounded

stock price volatility: 25% p.a.
dividend yield: nil
T = 18 months
S0 = $1.1

(ii) Derive a formula for V0, the value of the derivative contract. [5]

(iii) Calculate the value at time 0 of a derivative which delivers one unit of the
stock at time T if and only if the stock price at time T, ST, is at least K. [3]

(iv) Calculate the value of a derivative which delivers 150,000 shares of the stock
if and only if the stock price at time T, ST, satisfies $1.2 ≤ ST < $1.5. [6]
[Total 17]

9 (i) Explain why an investor might want to Vega-hedge a portfolio. [3]

(ii) Derive a formula for the Vega of a European call option on a non-dividend
paying stock in a market where the assumptions underpinning Black-Scholes
apply. [4]

(iii) (a) Determine the PDE satisfied by Vega by differentiating the Black-
Scholes PDE.

(b) Show that if a portfolio is Gamma-hedged, then its Vega satisfies the
Black-Scholes PDE. [4]
[Total 11]

10 State how the price at time t of a zero-coupon bond paying £1 at T (denoted by

B(t, T)) is related to:

(a) spot rate curve

(b) instantaneous forward rate curve
(c) instantaneous risk free rate

Define all notation used. [4]

CT8 S2008—4
11 (i) Describe the Merton model for assessing credit risk. [5]

A company has just issued a zero-coupon bond of nominal value £8m with maturity
of one year. The value of the assets of the company is £10.009m and this value is
expected to grow at an average of 10% per annum compound with an annual volatility
of 20%. The company is expected to be wound up after one year when the assets will
be used to pay off the bond holders with the remainder being distributed to the equity
holders. Shares in the company are currently traded at a market capitalisation of
£2.9428m.

(ii) Estimate the risk-free rate of interest in the market to within 1% p.a., stating
any additional assumptions that you make. [10]
[Total 15]

END OF PAPER

CT8 S2008—5
Faculty of Actuaries Institute of Actuaries

Subject CT8 — Financial Economics

Core Technical

EXAMINERS’ REPORT

September 2008

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

R D Muckart
Chairman of the Board of Examiners

November 2008

© Faculty of Actuaries
© Institute of Actuaries
 Subject CT8 (Financial Economics) — September 2008 — Examiners’ Report

1 (i) Asset 1 (random return X):

Mean = 4‰np = 4‰3‰½ = 6%;

Variance = 42‰npq = 16‰3‰½‰½ = 12%%;
Lower semi-variance = 3/8‰ (6 - 4)2+1/8‰ (6 - 0)2 = 6%%
(can just use symmetry of distribution around the mean);
Shortfall probability = P(4B < 3) = P(B = 0) = 1/8.

Asset 2 (random return Y):

Mean = 2‰µ = 2‰3 = 6%;

Variance = 22‰ µ =4‰3 = 12%%;
Lower semi-variance = e-3(32/2‰ (6 - 4)2 + 3/1‰ (6 - 2)2 + 1.(6 - 0)2)
= 5.078%%;
Shortfall probability = P(2P < 3) = P(P = 0 or 1) = e-3 (1 + 3) = .1991

(ii) Maximising the expected utility corresponds to minimising the lower semi-
variance, hence choose asset 2.

2 (i) A multifactor model of security returns attempts to explain the observed

historical return by an equation of the form

Ri = ai + bi,1 I1 + bi,2 I2 + ... + bi,L IL + ci ,

where Ri is the return on security i,

ai and ci are the constant and random parts respectively of the
component of return unique to security i,
I1 ... IL are the changes in a set of L factors which explain the variation
of Ri about the expected return ai,
bi,k is the sensitivity of security i to factor k.

(ii) Macroeconomic factor models

These use observable economic time series as the factors. They could include
factors such as the annual rates of inflation and economic growth, short term
interest rates, the yields on long term government bonds, and the yield margin
on corporate bonds over government bonds.

Fundamental factor models

Fundamental factor models are closely related to macroeconomic models but

instead of (or in addition to) macroeconomic variables the factors used are
company specific variables. These may include such fundamental factors as:

• the level of gearing

• the price earnings ratio
• the level of R&D spending

Page 2
 Subject CT8 (Financial Economics) — September 2008 — Examiners’ Report

• the industry group to which the company belongs

Statistical factor models

Statistical factor models do not rely on specifying the factors independently of

the historical returns data. Instead a technique called principal components
analysis can be used to determine a set of indices which explain as much as
possible of the observed variance. However, these indices are unlikely to have
any meaningful economic interpretation and may vary considerably between
different data sets.

3 (i) (a) Beta of security i = Covar[Ri, RM]/VM

(b) Beta is useful because it allows the expected return of any security to
be expressed as a linear function of that security’s covariance with the
market as a whole.

(ii) Using the formula in (i)(a), Expected Return = 6 + 0.50/0.70(12 - 6) = 10.29%

(iii) (a) Need expected return for each security N, variance of each security N,
covariance between each pair of securities N(N - 1)/2.

(b) Just need Beta for each security, expected market return, and market
variance. Total of N + 2.

4 (i) The claim of “excessive volatility” was first formulated into a testable
proposition by Shiller in 1981. He considered a discounted cashflow model of
equities going back to 1870. By using the actual dividends that were paid and
some terminal value for the stock he was able to calculate the perfect foresight
price, the “correct equity” price if market participants had been able to predict
future dividends correctly. The difference between the perfect foresight price
and the actual price arise from the forecast errors of future dividends. If
market participants are rational we would expect no systematic forecast errors.
Also if markets are efficient broad movements in the perfect foresight price
should be correlated with moves in the actual price as both react to the same
news.

Shiller found strong evidence that the observed level of volatility contradicted
the EMH.

(ii) However, subsequent studies using different formulations of the problem

found that the violation of the EMH only had borderline statistical
significance. Numerous criticisms were subsequently made of Shiller’s
methodology, these criticisms covered

• the choice of terminal value for the stock price

Page 3
 Subject CT8 (Financial Economics) — September 2008 — Examiners’ Report

• the use of a constant discount rate

• bias in estimates of the variances because of autocorrelation

• possible non-stationarity of the series, i.e. the series may have stochastic trends
which invalidate the measurements obtained for the variance of the stock price

Although subsequent studies by many authors have attempted to overcome the

shortcomings in Shiller’s original work there still remains the problem that a model
for dividends and distributional assumptions are required. Some equilibrium models
now exist which calibrate both to observed price volatility and also observed dividend
behaviour. However, the vast literature on volatility tests can at best be described as
inconclusive.

5 Standard Brownian motion (also called the Wiener process) is a stochastic process
{Bt , t ≥ 0} with state space S = R and the following defining properties:

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

s < t.

• Bt has stationary increments, i.e. the distribution of Bt − Bs depends only on t − s.

• Bt has Gaussian increments, i.e. the distribution of Bt − Bs is N(0, t − s).

• Bt has continuous sample paths t → Bt.

• B0 = 0.

• (Note that the stationarity property is not needed separately if the Gaussian
property is set out in detail.)

6 The proof of this result is an adaptation of that of the standard spot-forward parity.
Two (self-financing) portfolios are considered:

• Portfolio A: take a long position in the forward contract at time t. Its value at time
t is 0 and at time T, it is ST − FtT .

• Portfolio B: buying a fraction exp ( −δ (T − t ) ) of the underlying asset and

borrowing FtT exp ( −r (T − t ) ) at time t. Its value at time t is then –
( FtT exp ( − r (T − t ) ) − exp ( −δ (T − t ) ) St ). Its value at maturity is
ST − FtT (assuming reinvestment of dividends).

Page 4
 Subject CT8 (Financial Economics) — September 2008 — Examiners’ Report

Using the absence of arbitrage opportunity, both portfolios should have the same
value at any intermediate time, in particular at time t. Hence:

FtT = exp ( ( r − δ )(T − t ) ) St .

3 3
7 (i) There is no arbitrage in the market since d = < exp ( 0.05 ) < u = .
4 2

(ii)
• First method: we construct a risk-neutral portfolio with 1 underlying asset
and m call options. We choose the value of m such that this portfolio is risk
neutral (its value in the upper state and in the lower state at time 1 should
coincide). In this case, m = −2 . Then, we use a no arbitrage argument:
since the portfolio is risk-neutral, it should have the same rate of return as
the risk-free asset. Hence, the initial value of the call:

C0 satisfies S0 − 2C0 = 30e−r,

so C0 = 5.732 .

• Second method: We use a replicating portfolio. This is a self-financing

portfolio with ϕ0 invested in the risk-free asset and ϕ1 underlying asset at
time 0. Its initial value is therefore V0 = ϕ0 + ϕ1S0 . At time 1, the portfolio
should replicate the payoff of the call option. Therefore:
Vu = ϕ0 exp ( r ) + ϕ1Su = Cu and Vd = ϕ0 exp ( r ) + ϕ1S d = Cd . We can
deduce the value of ϕ0 and ϕ1 : ϕ0 = −14.27 and ϕ1 = 0.5 . By no arbitrage,
the initial value of the portfolio and that of the call option should coincide.

Hence C0 = 5.732 .

8 (i) EQ[e-r(T-t)X|Ft], where X is the amount payable, Q is the risk-neutral measure

and Ft is the sigma-algebra generated by the stock-price history up to time t.

(ii) From (a), the price is EQ[e-rT1(K ≤ ST)|F0] = e-rTQ(K ≤ ST)|.

Now, under Q, ST = S0exp(σWT + (r - ½σ2)T), where W is a standard
Brownian motion. Thus, V0 = e-rTQ(WT > (ln(K/S0) - (r - ½σ2)T)/ σ)
= e-rT(1 - Φ((ln(K/S0) - (r - ½σ2)T)/ σ√T)) = e-rTΦ(d2), where Φ is the
standard normal distribution function and d2 is as in the Black-Scholes
formula in the tables.

Page 5
 Subject CT8 (Financial Economics) — September 2008 — Examiners’ Report

(iii) If we are long one unit of this derivative and short K units of the derivative in
part (ii) then we effectively hold a call option. Thus the value of this derivative
must be the sum of the value of the call and KV0 i.e S0Φ(d1).

(iv) If we go long 150,000 contracts of the type in part (iii) with a strike of 120p
and short 150,000 such contracts with a strike of 150p then we have duplicated
the contract. Thus the fair price is

1.1×150,000×(Φ(ln(S0/120) + (r + ½σ2)T)/σ√T) - Φ(ln(S0/150)

+ (r + ½σ2)T)/ σ√T)))
=1.1× 150,000×(Φ(.21184) - Φ(-.51694)) = 165,000×(.58389 - .30260)
= £46,413.

9 (i) The value of a portfolio with a low value of vega will be relatively insensitive
to changes in volatility. Put another way: it is less important to have an
accurate estimate of σ if vega is low. Since σ is not directly observable, a
low value of vega is important as a risk-management tool. Furthermore, it is
recognised that σ can vary over time. Since many derivative pricing models
assume that σ is constant through time the resulting approximation will be
better if ν is small.

(ii) Let f denote the price of a call option, then f(s,T) = sΦ (d1) - K e-rTΦ(d2),
where d1 = (ln(S0/K) + (r + ½σ2)T)/ σ√T and d2 = d1 - σ√T. It follows (since
Φ’(x) = exp(-x2/2)/√2π) that V= s (exp(-d12/2)/√2π)∂d1/∂σ - K e-rT
(exp(-d22/2)/√2π)∂d2/∂σ = s (exp(-d12/2)/√2π)∂ (d1 - d2)/∂σ
= s (exp(-d12/2)/√2π)√T.

(iii) Differentiating the Black-Scholes PDE in σ gives us

∂V /∂t + rs∂V /∂s+½σ2s2∂2V /∂s2+σs2∂2f /∂s2=rV.

Then, since Γ=∂2f /∂s2, we see that in the case where Γ=0 we have
∂V /∂t + rs∂V /∂s+½σ2s2∂2V /∂s2=rV.

And so V satisfies the Black-Scholes PDE.

10 We will make use of the following notation:

B(t,T) = Zero-coupon bond price

= price at t for £1 payable at T
r(t) = instantaneous risk-free rate of interest at t
C(t) = unit price for investment at the risk-free rate
F(t,T,S) = forward rate at t for delivery between T and S
f(t,T) = instantaneous forward-rate curve
R(t,T) = spot-rate (zero-coupon yield) curve

Page 6
 Subject CT8 (Financial Economics) — September 2008 — Examiners’ Report

Zero-coupon bond prices are related to the spot-rate and forward-rate curves in the
following way:

−1
R (t , T ) = log B(t , T ) for t < T
T −t

or B(t , T ) = exp[− R(t , T )(T − t )]

1 B(t , T )
F (t , T , S ) = log for t < T < S
S −T B(t , S )

∂
f (t , T ) = lim F (t , T , S ) = − log B(t, T )
S →T ∂T

B (t , T ) = exp ⎡⎢ − ∫ f (t , u )du ⎤⎥ .
T
or
⎣ t ⎦

⎡ ⎤
B (t , T ) = EQ ⎢exp ⎛⎜ − ∫ r (u )du ⎞⎟ r (t ) ⎥
T

⎣ ⎝ t ⎠ ⎦

for specific models.

It is important to remember that Q is an artificial computational tool. It is determined

by combining (a) the model for r(t) under the real world measure P and (b) the market
price of risk established from knowledge of the dynamics of one bond.

11 (i) Merton’s model assumes that a corporate entity has issued both equity and
debt such that its total value at time t is of F(t). F(t) varies over time as a
result of actions by the corporate entity which does not pay dividends on its
equity or coupons on its bonds. Part of the corporate entity’s value is zero-
coupon debt with a promised repayment amount of L at a future time T. At
time T the remainder of the value of the corporate entity will be distributed
amongst the equity holders and the corporate entity will be wound up.

The corporate entity will default if the total value of its assets, F(T) is less than
the promised debt repayment at time T i.e. F(T) < L. In this situation, the bond
holders will receive F(T) instead of L and the equity holders will receive
nothing. This can be regarded as treating the equity holders of the corporate
entity as having a European call option on the assets of the company with
maturity T and a strike price equal to the value of the debt.

The Merton model can be used to estimate either the risk-neutral probability
that the company will default or the credit spread on the debt.

(ii) We assume the Merton model, so the value of the company is the value of a
call on the assets. The underlying is the gross value and the strike is the debt.

Page 7
 Subject CT8 (Financial Economics) — September 2008 — Examiners’ Report

Thus S0 = 10.009, σ = 0.2, T = 1, K = 8, and 2.9428 is the value of the call (at
time 0).

So, 2.9428 = 10.009Φ((ln(10.009/8) + .02 + r)/0.2) - 8e-rΦ((ln(10.009/8)

-.02 + r)/0.2) = 10.009Φ(1.2202 + 5r) - 8e-rΦ(1.0202 + 5r). This is a
differentiable and increasing function of r so interpolation should get a
solution.

Setting r = 10%, we get 10.009Φ(1.2202 + 5r) - 8e-rΦ(1.0202 + 5r) =

10.009Φ(1.7202) - 8e-.1Φ(1.5202) = 10.009 × 0.95730
- 8e-.1 × 0.93577 = 2.80786, so we need to increase r.

Setting r = 15%, we get 10.009Φ(1.2202 + 5r) - 8e-rΦ(1.0202 + 5r) =

10.009Φ(1.9702) - 8e-.1Φ(1.7702) = 10.009 × 0.97559 - 8e-.15 × 0.96166
= 3.14301, so we need to decrease r.

Interpolating gives r = 10 + 5X(2.9428 - 2.80786)/(3.14301 - 2.80786)%

= 12%.

If we try r =12%, we get 10.009Φ(1.2202 + 5r) - 8e-rΦ(1.0202 + 5r)

= 10.009Φ(1.8202) - 8e-.12Φ(1.6202) = 10.009 × 0.96564 – 8e-.12 × 0.94740
= 2.9429, so r = 12%.

END OF EXAMINERS’ REPORT

Page 8
Faculty of Actuaries Institute of Actuaries

EXAMINATION

16 April 2008 (am)

Subject CT8 — Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. Mark allocations are shown in brackets.

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

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

© Faculty of Actuaries
CT8 A2008 © Institute of Actuaries
1 Define Gamma and Vega for a derivative written on a portfolio of assets in a market
where the assumptions underpinning the Black-Scholes model hold. [3]

2 State the stochastic differential equation for geometric Brownian motion and its
solution. (No proof is required.) [4]

3 Consider a two-period Binomial model of a stock whose current price S0 = 100.

Suppose that:

• over each of the next two periods, the stock price can either move up by 10% or
move down by 10%

• the continuously compounded risk-free rate is r = 8% per period

(i) Show that there is no arbitrage in the market. [1]

(ii) Calculate the price of a one-year European call option with a strike price
K = 100 . [4]
[Total 5]

4 (i) Outline the two-state model for credit ratings assuming constant transition
intensity. [5]

(ii) State the formula for the zero-coupon bond price in terms of the risk-neutral
default rate λ, when this rate is deterministic. [3]
[Total 8]

5 An investor is considering investing in one of two assets. The distribution of returns

from each asset is shown below:

Asset 1 Asset 2
Return (%) Probability (%) Return (%) Probability (%)
-1 81/3 0 50
11 912/3 20 50

(i) Calculate for each asset:

(a) the variance

(b) semi-variance
(c) and shortfall probability

Where necessary assume a benchmark return of 0%. [4]

(ii) Explain which asset an investor with a quadratic utility function would choose.
[2]

(iii) State the reasons why variance of return is frequently used as a measure of
risk. [3]
[Total 9]

CT8 A2008—2
6 (i) Outline the assumptions used in modern portfolio theory regarding investor
behaviour that are necessary to specify efficient portfolios. [3]

(ii) An investor can construct a portfolio using only two assets X and Y. The
statistical properties of the two assets are shown below:

X Y

Expected return 12% 8%

Variance of return 30% 15%
Correlation coefficient between assets 0.5
X and Y

Assuming that the investor cannot borrow to invest:

(a) Determine the composition of the portfolio which will give the investor
the highest expected return.

(b) Calculate the composition of the portfolio which will give the investor
the minimum variance.
[3]

(iii) Explain and sketch how the investor would choose a utility maximising
portfolio. [3]
[Total 9]

7 (i) State the assumptions, additional to those used in modern portfolio theory, that
allow the capital asset pricing model (CAPM) to be consistent with an
equilibrium model of prices in the whole market. [5]

(ii) Explain why in the CAPM all investors should hold all risky assets in
proportion to the market capitalisation of those assets. [2]

In an investment market there are three risky assets available. The table below shows
the returns each of the assets will earn in the three possible states of the world and the
current market capitalisation of the assets. Assume a risk free rate of return of 4% is
available.

States Probability Asset 1 Asset 2 Asset 3

1 0.4 5% 6% 7%
2 0.1 8% 2% 1%
3 0.5 3% 5% 4%
Market Capitalisation 30,000 50,000 30,000

(iii) Calculate the market price of risk under the CAPM. [4]
[Total 11]

CT8 A2008—3 PLEASE TURN OVER

8 Consider a continuous time log-normal model for a security price, S, with parameters
μ and σ.

(i) Write down formulae for:

(a) the log-return of the process

(b) the expected value of an investment at a specified future time
(c) the variance of the value of an investment at a specified future time
[3]

(ii) Explain what the model implies about market efficiency. [2]

(iii) Outline the empirical evidence for and against the model. [5]
[Total 10]

9 Consider two call options, which are identical (same maturity, same underlying asset)
except for the strike price. Denote by C(K) the price at time 0 of the call option with
strike price K. Stating the key arguments required, prove that, if there are no arbitrage
opportunities, the following relation holds true, for K1 ≤ K 2 .

∀λ ∈ [ 0,1] λC ( K1 ) + (1 − λ ) C ( K 2 ) ≥ C ( λK1 + (1 − λ ) K 2 ) [10]

10 In a situation where the zero-coupon bond market is arbitrage-free and complete,

consider the following Vasicek model for the short-rate process:

dr (t ) = a ( b − r (t ) ) dt + σdWt

where (Wt ; t ≥ 0 ) is a standard Brownian motion with respect to the risk-neutral

probability measure Q.

(i) State the general expression r(t) of the solution of this stochastic differential
equation. [2]
T
(ii) Derive an expression for ∫ r (u)du , where t and T are given.
t
Hint: consider the stochastic differential equation of r(u), for u ≥ t .
[6]
T
(iii) State the distribution of ∫ r (u)du . [1]
t

(iv) Derive the price of a zero-coupon bond at time t with maturity T ≥ t related to
T
the distribution of ∫ r (u)du . [6]
t
[Total 15]

CT8 A2008—4
11 A stock is currently priced at €8.20. A writer of 100,000 units of a one year European
call option on this stock with an exercise price of €8 has hedged the option with a
portfolio of 75,000 shares and a loan. The annual risk-free interest rate (continuously
compounded) is 7% and no dividends are payable during the life of the option.

Assume the Black-Scholes pricing formula applies.

(i) (a) Derive an expression for the Delta of the option.

(b) State the value of the Delta in this case.
[4]

(ii) Calculate the implied volatility of the stock to within 0.1% p.a., assuming that
it is below 100%. [5]

(iii) Calculate:

(a) the value of the loan

(b) the price of the option [4]

(iv) (a) Calculate the current price of a one year European put option with the
same exercise price.

(b) State any assumptions you make in your calculation in (iv)(a).

[3]
[Total 16]

END OF PAPER

CT8 A2008—5
Faculty of Actuaries Institute of Actuaries

Subject CT8 — Financial Economics

EXAMINERS’ REPORT
April 2008

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

M A Stocker
Chairman of the Board of Examiners

June 2008

© Faculty of Actuaries
© Institute of Actuaries
 Subject CT8 (Financial Economics Core Technical) — April 2008 — Examiners’ Report

1 Gamma

∂2 f
Γ=
∂s 2

Vega

ν = ∂f
∂σ

f is the price of the derivative; s is the price of the underlying asset; σ is the volatility
of the stochastic process of the price of the underlying

2 Consider the stochastic differential equation

dSt = αSt dt + σSt dBt .

(
log St = log S0 + α − ½σ2 t + σBt )
or, finally,

( )
St = S0 exp ⎡ α − ½ σ2 t + σBt ⎤ .
⎣ ⎦

3 (i) There is no arbitrage in the market since

d < exp(r) < u with r = 8%.

(ii) To price the call option, we use the risk-neutral pricing formula. The risk-
neutral probability of an upward move is

exp(r ) − d
q= = 0.9164.
u−d

The price of the call is determined by a backward procedure:

⎧Cuu = (u 2 S0 − K ) + = 21
⎪⎪ ⎧C1 (u ) = exp(− r )(qCuu + (1 − q )Cud ) = 17.7655
+
⎨Cud = (udS0 − K ) = 0 ⇒ ⎨
⎪ 2 + ⎩C1 (d ) = exp(− r )(qCud + (1 − q )Cdd ) = 0
⎪⎩Cdd = ( d S 0 − K ) = 0
⇒ C0 = exp(−r )(qC1 (u ) + (1 − q )(C1 (d )) = 15.0292

Page 2
 Subject CT8 (Financial Economics Core Technical) — April 2008 — Examiners’ Report

4 (i) The two-state model for credit ratings with a constant transition intensity.

A model can be set up, in continuous time, with two states N (not previously
defaulted) and D (previously defaulted). Under this simple model it is
assumed that the default-free interest rate term structure is deterministic with
r(t) = r for all t. If the transition intensity, under the real-world measure P,
from N to D at time t is denoted by λ(t), this model can be represented as:

λ(t)
No default, N Default, D

and D is an absorbing state.

T
(ii) B(t,T) = e-r(T-t) [1 - (1 - δ)(1 - exp(- ∫ λ ( s )ds ))]
t

5 (i) Mean Return

Asset 1 -1 × 81/3% + 11 × 912/3% = 10%

Asset 2 0 × 50% + 20 × 50% = 10%

Variance of Return

Asset 1 (10 – (-1))2 × 81/3% + (10 – 11)2 × 912/3% = 11%%

Asset 2 (10 - 0)2 × 50% + (10 – 20)2 × 50% = 100%%

Semi-Variance of Return

Asset 1 (10 –(-1))2 × 81/3% = 10.08333%%

Asset 2 (10 - 0)2 × 50% = 50%%

Shortfall Probability

Asset 1 81/3%

Asset 2 0%
(ii) Both have same expected return. The variance is appropriate risk measure in
this case.

=> Choose Asset 1

(iii)
• Mathematically tractable.
• Leads to elegant solutions for optimal portfolios.

Page 3
 Subject CT8 (Financial Economics Core Technical) — April 2008 — Examiners’ Report

• Often a good approximation to the other possible methodologies.

• Gives optimum portfolios if returns are normally distributed or investors
have quadratic utility functions

6 (i) Investors select their portfolios on the basis of the expected return and the
variance of the return over a single time horizon.

Investors are never satiated. At a given level of risk, they will always prefer a
portfolio with a higher return to one with a lower return.

Investors dislike risk. For a given level of return they will always prefer a
portfolio with lower variance to one with higher variance.

(ii) (a) 100% in X – expected return of 12%

(b) Proportion in X = (VY + CXY)/(VX + VY + CXY)

= (15%% - 0.5 × (30%% - 15%%)0.5)/(30%% + 15%%
+ 0.5 × (30%% - 15%%)0.5)
= 18.47%

(iii) Plot indifference curves in return-standard deviation space.

Utility is maximised by choosing the portfolio on the efficient frontier where

the frontier is at a tangent to the indifference curve.

Graphically candidates should reproduce a diagram similar to Figure 3 from

the core reading.

Page 4
 Subject CT8 (Financial Economics Core Technical) — April 2008 — Examiners’ Report

7 (i) The extra assumptions of CAPM are:

• All investors have the same one-period horizon.

• All investors can borrow or lend unlimited amounts at the same risk-free
rate.

• The markets for risky assets are perfect. Information is freely and
instantly available to all investors and no investor believes that they can
affect the price of a security by their own actions.

• Investors have the same estimates of the expected returns, standard

deviations and covariances of securities over the one-period horizon.

• All investors measure in the same “currency” e.g. pounds or dollars or in

“real” or “money” terms.

(ii) If investors have homogeneous expectations, then they are all faced by the
same efficient frontier of risky securities. If in addition they are all subject to
the same risk-free rate of interest, the efficient frontier collapses to the straight
line in E − σ space which passes through the risk-free rate of return on the E-
axis and is tangential to the efficient frontier for risky securities.

All rational investors will hold a combination of the risk-free asset and the
portfolio of risky assets at the point where the straight line through the risk-
free return touches the original efficient frontier. Because this is the portfolio
held in different quantities by all investors it must consist of all risk assets in
proportion to their market capitalisation. It is commonly called the “market
portfolio”. The proportion of a particular investor’s portfolio consisting of the
market portfolio will be determined by their risk-return preference.

(iii) The market price of risk is (Em – r)/σm, where

Em = (30,000 × (5% × 0.4 + 8% × 0.1 + 3% × 0.5) +

50,000 × (6% × 0.4 + 2% × 0.1 + 5% × 0.5) +
30,000 × (7% × 0.4 + 1% × 0.1 + 4% × 0.5)) ÷ 110,000

= 4.8273%

σm. = [(30,000 × 5% + 50,000 × 6% + 30,000 × 7%)

÷ 110,000 – 4.8273%]2 × 0.4 +
[(30,000 x 8% + 50,000 × 2% + 30,000 × 1%)
÷ 110,000 – 4.8273%]2 × 0.1 +
[(30,000 × 3% + 50,000 × 5% + 30,000 × 4%)
÷ 110,000 – 4.8273%]2 × 0.5

= 9.7264 × 10-5 = 0.9862%2

Page 5
 Subject CT8 (Financial Economics Core Technical) — April 2008 — Examiners’ Report

Thus the market price of risk is (4.8273% – 4%)/0.9862%

= 83.89%

8 (i) (a) log(Su) − log(St) ~ N[μ(u − t), σ2(u − t)]

(b) E[Su] = St exp(μ(u − t) + ½σ2(u − t))

(c) Var[Su] = (St)2 exp(2μ(u – t) + σ2(u − t)). [exp(σ2(u − t)) – 1]

(ii) As the model incorporates independent returns over disjoint intervals, it is

impossible to use past history to deduce that prices are cheap or dear at any
time.

(iii) Technical analysis does not lead to excess performance.

Estimates of σ vary widely according to what time period is considered, and

how frequently the samples are taken.

Examination of historic option prices suggests that implied volatility based on

the Black Scholes model fluctuate markedly over time.

There appears to be some evidence for some mean reversion in markets, but
the evidence rests heavily on the aftermath of a small number of dramatic
crashes. Furthermore, there also appears to be some evidence of momentum
effects, which imply that a rise one day is more likely to be followed by
another rise the next day.

In particular, market crashes appear more often than one would expect from a
normal distribution.

While the random walk produces continuous price paths, jumps or

discontinuities seem to be an important feature of real markets. Furthermore,
days with no change, or very small change, also happen more often than the
normal distribution suggests.

One measure of these non-normal features is the Hausdorff fractal dimension

of the price process. A pure jump process (such as a Poisson process) has a
fractal dimension of 1. Random walks have a fractal dimension of 1½.
Empirical investigations of market returns often reveal a fractal dimension
around 1.4.

Page 6
 Subject CT8 (Financial Economics Core Technical) — April 2008 — Examiners’ Report

9 The idea is to assume that the converse inequality holds true and show that this leads
to an arbitrage opportunity. More precisely, let us assume that

∀λ ∈ [ 0,1] λC ( K1 ) + (1 − λ ) C ( K 2 ) < C ( λK1 + (1 − λ ) K 2 ) .

Then we construct the following (self-financing) portfolio:

• At time 0: we sell one call with strike price K3 = λK1 + (1 − λ ) K 2 and buy λ calls
with strike K1 and (1− λ ) calls with strike K 2 . We lend the difference. The total
value of the portfolio at time 0 is equal to 0.

At time 0
sell C (K3) C (K3)
buy λC (K1) − λC (K1)
buy (1 − λ) C(K2) − (1 – λ) C(K2)
lend the difference M ≡ λC (K1) + (1 − λ) C(K2) − C(K3)
Total 0

• At time T: we look at the various possibilities depending on the value ST of the

underlying asset at that time. In all situations, the terminal value of the portfolio is
either >0 or ≥ 0 .

ST < K1 K1 < ST < K3 K3 < ST < K2 K2 < ST

λC (K1) 0 λ (ST – K1) λ (ST − K1) λ (ST − K1)
(1 − λ) C(K2) 0 0 0 (1 − λ) (ST − K2)
C (K3) 0 0 − (ST − K3) − (ST − K3)
lending M exp(rT) M exp (rT) M exp (rT) M exp (rT)
M exp (rT) M exp (rT)
Total M exp (rT) > 0 + λ (ST − K1) > 0 + (1 − λ) (K2 − ST) > 0 M exp (rT) > 0

This is an arbitrage opportunity. Hence the result.

10 (i) This is an Ornstein-Uhlenbeck process. The solution is given by:

t
r ( t ) = r0 exp ( − at ) + b (1 − exp ( −at ) ) + σ exp ( − at ) ∫ exp ( as ) dWs .
0

(ii) Using similar arguments, we can get for u ≥ t :

u
( )
r ( u ) = r (t ) exp ( − a ( u − t ) ) + b 1 − exp ( − a ( u − t ) ) + σ exp ( − au ) ∫ exp ( as ) dWs .
t

Page 7
 Subject CT8 (Financial Economics Core Technical) — April 2008 — Examiners’ Report

Hence

T T T T u
( )
∫ r ( u )du = r (t )∫ exp ( −a ( u − t ) )du + b∫ 1 − exp ( −a ( u − t ) ) du + σ∫ exp ( −au ) ∫ exp ( as ) dWs du.
t t t t t

After some computation:

T
1 − exp ( −a (T − t ) ) σ
T

∫ r ( u )du = b (T − t ) + ( r (t ) − b ) a
+
a∫
( )
1 − exp ( −a (T − s ) ) dWs .
t t

T
(iii) Hence, ∫ r ( u )du is also a Gaussian random variable.
t

(iv) Since the bond market is complete, the price of a zero-coupon bond can be
written as

⎡ ⎛ T ⎞ ⎤
B (t , T ) = E ⎢ exp ⎜ − ∫ r ( s )ds ⎟ Ft ⎥ .
⎢ ⎜ ⎟ ⎥
⎣ ⎝ t ⎠ ⎦
T
Since ∫ r ( u )du is a Gaussian random variable, we can compute explicitly the
t
price of the zero-coupon bond in terms of the expected value and variance
T
(conditional) of ∫ r ( u )du :
t

⎡ ⎡T ⎤ 1 ⎡T ⎤⎤
B (t , T ) = exp ⎢ − E ⎢ ∫ r ( s )ds Ft ⎥ + V ⎢ ∫ r ( s )ds Ft ⎥ ⎥ .
⎢ ⎢⎣ t ⎥⎦ 2 ⎢⎣ t ⎥⎦ ⎥⎦
⎣

11 (i) Let f denote the price of a call option, then

f(s,T) = sΦ (d1) - Ke-rTΦ(d2),

where

d1 = (ln(S0/K) + (r + ½σ2)T)/ σ√T and d2 = d1-σ√T.

It follows (since Φ’(x) = exp(-x2/2)/√2π) that

Δ = ∂f/∂s = Φ(d1) + s exp(-d12/2)/√2π)∂d1/∂s-Ke-rT exp(-d22/2)/√2π)∂d2/∂s.

Page 8
Subject CT8 (Financial Economics Core Technical) — April 2008 — Examiners’ Report

If we now notice that

∂d1/∂s = ∂d2/∂s

and

d22 = d12 - (2r + σ2)T - 2 ln(s/K) +σ2T = d12 - 2rT - 2ln(s/K)

we see that the last two terms in the expression for Δ cancel and we are just
left with Δ = Φ (d1).

In this case, we must have 100,000Δ = 75,000 and so Δ = 0.75.

(ii) Δ = .75 and so d1 = 0.6745. It follows (rearranging the expression for d1) that
(.02469 + .07 + 0.5σ2) = 0.6745σ. Solving the quadratic we obtain (choosing
the root less than 1) σ = 0.6745 ± √0.26557 = 0.159165 = 15.9%.

(iii) We need to calculate:

Ke-rTΦ(d2) = 8e-rΦ(d1-σ√T ) = 8e-r 0.696825 = £5.19772

Clearly, the value of the loan is = £519,772 and the option price is

100,000 * 8.2 * 0.75 - 519,772 = £95,228.

(iv) Use put-call parity. This merely assumes that borrowing is allowed and the
market is arbitrage free.

p0 = c0 + Ke-rT – S0 = .95228 + 8 e-rT - 8.2 = .21143

END OF EXAMINERS’ REPORT

Page 9
Faculty of Actuaries Institute of Actuaries

EXAMINATION

26 September 2007 (am)

Subject CT8 — Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. Mark allocations are shown in brackets.

4. Attempt all 8 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.

© Faculty of Actuaries
CT8 S2007 © Institute of Actuaries
1 (i) Define the Δ, Γ, θ, λ, ρ and ν for an individual derivative security. [6]

(ii) Explain put-call parity and use it to calculate the delta and gamma of a
European call option on a non-dividend paying stock with the same strike and
maturity as the put option. [4]

A portfolio with a delta of zero consists of cash, European put options, P, on a stock
and 1 million shares of the underlying (non-dividend paying) stock . The delta of a
single put option is –0.212, while the gamma is 0.377.

Two further derivatives on the stock are also traded: a European call option, C, with
the same strike and maturity as P and another derivative security, D, with a delta of
0.222 and a gamma of 0.111.

(iii) Calculate n, the number of put options in the original portfolio of cash, stock
and P. [2]

(iv) Calculate the numbers of derivatives D and C that have to be purchased and
added to the portfolio so that both the delta and gamma of the expanded
portfolio are zero. [4]
[Total 16]

2 A binomial model for a non-dividend-paying security with price St at time t is as

follows: the price at time (t + 1) is either 1.25St (up-jump) or 0.8St (down-jump).
Cash receives interest of 10% per time unit.

(i) Calculate the risk neutral probability measure for this model. [3]

The value of S0 is 100. A derivative security with price Dt at time t pays the following
returns at time 2:

D2 = 1 : if S2 = 156.25
D2 = 2 : if S2 = 100
D2 = 0 : if S2 = 64.

(ii) Determine D1 when S1 = 125 and when S1 = 80 and hence calculate the value
of D0. [5]

(iii) Derive the corresponding hedging strategy, i.e. the combination of the
underlying security and the risk free asset required to hedge an investment in
the derivative security. [4]

(iv) Comment on your answer to (iii) in the light of your answer to part (ii). [1]
[Total 13]

CT8 S2007—2
3 (i) State the assumptions underlying the Black-Scholes option pricing formula
and discuss how realistic they are. [6]

A discounted stock price can be written as:

St = cosh(σZt) exp(-σ2t),

where Zt is a standard Brownian motion under the real world measure P .

Hint: cosh(x) = (ex + e – x)/2.

(ii) Apply Ito’s formula to derive an SDE satisfied by St . [5]

(iii) Explain why the discounted stock price (under P ) is not a martingale. [1]

(iv) State the SDE satisfied by St under the equivalent martingale measure. [2]
[Total 14]

4 (i) State the general zero-coupon bond pricing formula in terms of random short
rates. Define all notation used. [2]

(ii) State the SDEs defining the dynamics of the short rates under the risk-neutral
measure for each of the Vasicek, Cox-Ingersoll-Ross and Hull & White
models. Define all notation used. [6]

(iii) State the zero-coupon bond price formula for the Vasicek model. [3]

(iv) Comment on the limitations of one-factor interest rate models. [3]

[Total 14]

5 Consider a special company that has just issued a zero-coupon bond of nominal value
£10m with maturity 10 years. The value of the assets of the company is £20m and
this value is expected to grow at an average of 10% per annum compound with an
annual volatility of 40%. The company is expected to be wound up after 10 years
when the assets will be used to pay off the bond holders with the remainder being
distributed to the equity holders.

A constant risk-free rate of return of 5% p.a. compounded continuously is available in

the market.

Calculate the credit spread on the debt for the zero-coupon bond. State any additional
assumptions that you make.

Hint: use the Merton model. [8]

CT8 S2007—3 PLEASE TURN OVER

6 A market consists of three assets A, B and C. Annual returns on the three assets (RA,
RB and RC) have the following characteristics:

Asset Expected return % Standard deviation %

A 9 20
B 6 20
C 3 10

The correlation between the returns are as follows: Corr(RA, RB) = -¼ ,

Corr(RB, RC) = -½ and Corr(RA, RC) = -½.

(i) Calculate the variance of the returns of each asset and the covariances between
the returns of each pair of assets. [5]

(ii) Define an efficient portfolio for the corresponding mean-variance portfolio

model. [2]

Efficient portfolios for this model are of the form ( 92 , 92 , 95 )T + c(4, 1, -5)T , for a
suitable choice of c, where the vector represents proportions of the investor’s capital
invested in assets A, B and C respectively.

(iii) (a) Determine an expression in terms of c for the variance of an efficient

portfolio.

(b) Deduce the global minimum variance and the portfolio that attains it.
[4]
Assume that the risk-free rate of interest is 4% p.a.

(iv) (a) Determine the tangent that passes through (0%, 4%) to the original
efficient frontier in (standard deviation, mean return) space.

(b) Deduce the market capitalisations of the three assets consistent with
the Capital Asset Pricing Model if the total market capitalisation is
£180 bn. [6]
[Total 17]

CT8 S2007—4
7 Consider a corporate bond that will return £1 per bond to an investor at the end of a
year provided the borrower does not default during the year. The constant annual
probability of default is 4%.

Investor 1 holds one thousand such bonds that depend on the same borrower.

Investor 2 holds one thousand such bonds, each of which depends on a different
borrower. Each borrower defaults (or not) independently of the other borrowers, but
with the same probability of 4%.

All bonds were purchased at par.

(i) For each investor calculate (using suitable approximations if necessary):

(a) the variance of the investment

(b) the 95% value at risk
(c) the 90% value at risk
(d) the probability of shortfall relative to a target level of shortfall of 0
[10]

(ii) Comment on your answers to (i). [3]

[Total 13]

8 (i) Outline the three forms of the Efficient Markets Hypothesis. [3]

(ii) State two reasons why it is hard to test whether any of the three forms hold in
practice. [2]
[Total 5]

END OF PAPER

CT8 S2007—5
Faculty of Actuaries Institute of Actuaries

EXAMINATIONS
September 2007

Subject CT8 — Financial Economics

EXAMINERS’ REPORT

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

M A Stocker
Chairman of the Board of Examiners

December 2007

© Faculty of Actuaries
© Institute of Actuaries
 Subject CT8 (Financial Economics) — September 2007 — Examiners’ Report

1 (i) The Greeks are the derivatives of the price of a derivative security with respect
to the different parameters needed to calculate the price. Thus:

∂f ∂2 f ∂f ∂f ∂f ∂f
Δ= ;Γ = 2 ;θ= ;λ = ;ρ= ;ν = ;
∂s ∂s ∂t ∂q ∂r ∂σ

where f is the value of the derivative, s is the price of the underlying security,
q is the continuous dividend yield on the security, σ is the volatility, r is the
interest rate and t is time. In each case the relevant Greek measures sensitivity
(rate of change) of the option price to change in that variable.

(ii) Suppose we hold one European call option with strike k and maturity T and
are short one put with the same strike and maturity. Our payoff at maturity is
exactly the same as if we held one share of the underlying and were short k
zero coupon bonds with maturity T. The value at time 0 of such a payoff,
under the assumption of no arbitrage, is S0 − ke−rT , where St is the price of the
stock and r is the risk-free interest rate. Thus is P and C are the price at time 0
of the put and call, we have:

C = P + S0 - ke-rT

Hence ΔC = ΔP + 1 and ΓC = ΓP .

(iii) Since the original portfolio is delta-hedged, and the delta of a share is 1, we
must have

-.212n + 1M = 0 ⇒ n = 4716981.

(iv) Using the formulae in part (ii), the delta and gamma of the call are .788 and
.377 respectively. The Γ of the original portfolio is

1M × .377 = 377,000,

so we need:

.222d + .788c = 0

and

.111d + .377c + .377 × 4716981 = 0.

Solving these two simultaneous equations, we get

c = 104, 605, 990, d = −371, 304, 146.

Page 2
 Subject CT8 (Financial Economics)) — September 2007 — Examiners’ Report

2 (i) We need to equate the expected average return on the stock and the return on a
bond: so we solve solve 1.25p + 0.8q = 1.1 ⇒ p = 23 . Thus, under Q, the risk-
neutral measure, S is a multiplicative random walk with up-jump
probability 23 .

(ii) The fair price at time t for a claim of X payable at time T is

EQ [e− r (T −t ) X | Ft ], so, if S1 = 125,

D1 = (p × 1 + q × 2)/1.1 = 4/3.3 = 1.2121,

while if S1 = 80 the fair price

D1 = (p × 2 + q × 0)/1.1 = 4/3.3 = 1.2121.

Hence, the value D0 = 1.2121/1.1 = 1.1019.

(iii) to hedge at time 1 if S1 = 125 we let the amount invested in the stock be φ and
the amount invested in cash be ψ and solve:

1.25φ + 1.1ψ = 1

0.8φ + 1.1ψ = 2

which gives

20
φ= = -2.22222 (the equivalent shareholding is
9
-2.2222/125 = -.017778)
340
and ψ = = 3.4343.
9

If S1 = 80 then we solve

1.25φ + 1.1ψ = 2

0.8φ + 1.1ψ = 0

which gives

40
φ= = 4.4444 (the equivalent shareholding is
9
4.4444/80 = .0556),
320
and ψ = − = -3.2323.
99

Page 3
 Subject CT8 (Financial Economics) — September 2007 — Examiners’ Report

Finally, we solve

1.25φ + 1.1ψ = 1.2121

0.8φ + 1.1ψ = 1.2121

which gives

1.2121
φ = 0 and ψ = = 1.1019.
11

(iv) This last is obvious since the value of D1 doesn’t depend on S1 and hence we
must hedge using the risk-free asset only.

3 (i) No frictions; short-selling permitted; small investor (i.e. does not “move
market”); market is arbitrage-free; stock price is given by dSt = μtStdt + σStdBt
for some process μt, where B is a Brownian motion.

All are, in some sense, implausible. Friction (spreads and commission) is

present; short-selling is available but on very different terms; “small investor”
not true for an investment bank; stock-market returns are not compatible with
normality (fat tails); arbitrages occur (for short periods).

(ii) (a) Since

St = cosh(σZt) exp(-σ2t),

S can be written as

St = f(Zt, t),

where

2
f(x, t) = cosh(σx)e−σ t .

Applying Ito’s lemma we get that

1
dSt = f x dZt + ( ft + f xx )dt
2

2 1 2
= σ sinh(σZt )e −σ t dZt + ( σ2 cosh(σZt ) − σ2 cosh(σZt ))e−σ t dt
2

2 1 2
= σe −σ t sinh(σZt )dZt − σ2e −σ t cosh(σZt )dt
2

Page 4
 Subject CT8 (Financial Economics)) — September 2007 — Examiners’ Report

2 1
= σ e −2σ t − St2 dZ t − σ 2 St dt.
2

(b) The drift (the dt) term is not 0.

(c) The drift term would be zero under the risk-neutral measure: the dZ
term would be unchanged, therefore we’d get:

2
dSt = σ e −2σ t − St2 dZt ,

where Z is a Brownian Motion under the risk-neutral measure.

4 (i) The general (zero coupon) bond pricing formula is

T
B(t, T) = E[exp(- ∫t rs ds ) | Ft ],

where B(t, T) is the price at time t of the ZCB with maturity T, and r is the
random short rate.

(ii) Under the Vasicek model we have

drt = α(μ - rt) dt + σdZt,

where Z is Brownian Motion under the risk-neutral measure, Q, and α, μ and

σ are positive constants.

Under the Cox-Ingersoll-Ross (CIR) model,

drt = α(μ - rt) dt + σ rt dZt .

Finally, in the Hull and White model,

drt = α(μt - rt) dt + σdZt,

for a deterministic function of t, μt.

(iii) The corresponding bond-pricing formula for the Vasicek model is

B(t, T) = exp(a(T – t) – b(T – t)r(t)),

where b(τ) = 1−e−ατ and a(τ) = (b(τ) - τ) (μ - σ2 ) − σ 2 b( τ) 2 .

α 2α 2 4α

Page 5
 Subject CT8 (Financial Economics) — September 2007 — Examiners’ Report

(iv) Historical data suggests that three factors are necessary;

historically, there have been sustained periods of both high and low interest
rates with periods of both high and low volatility — features which are
difficult to capture without more random factors;

we need more complex models to deal with more complex derivative

contracts, for example those which depend on more than one interest rate
should allow for these rates to be less than perfectly correlated.

5 Assume no other debt, frictionless markets, perfect information, black scholes type
model for the movement of the assets

Use black scholes to calculate the value of a call option based on the value of the
assets exceeding a strike of 10 after 10 years. Equal to equity of firm = E = 15.07631

Value of bond is B = 20 – E = 4.923688

1 8
Solve 10*exp(-10 rb) = B ⇒ rb = − ln = 7.085%
10 10

rb – 5% = credit spread in continuously compounded form = 2.085%

6 (i) Var(RA) = Var(RB) = .22 = .04, Var(RC) = .12 = .01.

Cov(RA, RC) = Cov(RB, RC) = -.5 × .2 × .1 = -.01,
Cov(RA, RB) = -.25 × .2 × .2 = -.01.

(ii) An efficient portfolio is one with minimum variance of return for the given
expected return, or maximum expected return for the given variance.

(iii) (a) The variance is given by

2 2 2
⎛2 ⎞ ⎛2 ⎞ ⎛5 ⎞
⎜ + 4c ⎟ × .04 + ⎜ + c ⎟ × .04 + ⎜ − 5c ⎟ × .01
⎝9 ⎠ ⎝9 ⎠ ⎝9 ⎠

⎛2 ⎞⎛ 2 ⎞ ⎛2 ⎞⎛ 5 ⎞ ⎛2 ⎞⎛ 5 ⎞
−2 × .01⎜ + 4c ⎟ ⎜ + c ⎟ − 2 × .01⎜ + c ⎟ ⎜ − 5c ⎟ − 2 × .01⎜ + 4c ⎟ ⎜ − 5c ⎟
⎝9 ⎠⎝ 9 ⎠ ⎝9 ⎠⎝ 9 ⎠ ⎝9 ⎠⎝ 9 ⎠

= .01/9 + 1.35c2 = .001111 + 1.35c2

(b) Thus the minimum variance portfolio is when c = 0 with variance

.001111 and portfolio ( 92 , 92 , 95 )T .

Page 6
 Subject CT8 (Financial Economics)) — September 2007 — Examiners’ Report

(iv) It follows from previous answers that the efficient frontier consists of points of
the form (σc, rc) with c ≥ 0, rc = .05 + .27c and σc = .001111 + 1.35c 2 . Now
the tangent at the point parametrised by c has gradient

rc′ .001111+1.35c 2
gc = σ′c
= .27 1.35c

and this intercepts the vertical axis at the point

.27(.001111+1.35c 2 )
p = rc - gcσc = .05 + .27c - 1.35c
.

Setting p = 0.04 we obtain

.04 × 1.35c = (.05 + .27c) 1.35c - .27(.001111 + 1.35c2).

Rearranging this we get

2
c = .27 × .001111/.0135 = .02222 = .
90

The corresponding portfolio is ( 14 , 11 , 4 )T . If the CAPM holds then these

45 45 9
should be the proportions corresponding to the market capitalisation of the
companies so they should be (56bn,44bn,80bn) respectively.

7 (i) Investor 1:

(a) variance = 10002*0.04*0.96 = 38,400

(b) value at risk = 0 as there is a less than 5% chance of any loss
(c) value at risk = 0
(d) prob of shortfall = 4%

Investor 2:

(a) variance = 1000*.04*.96 = 38.4

(b) normal approximation has mean 0.04*1000 = 40 and std deviation of

6.20 (sqrt of above).

(c) VaR = 40 + 1.645*6.20 = 50.2

(d) VaR = 40 + 1.282*6.20 = 47.9

(e) probability of shortfall = c.100% (mean loss is over 6 standard

deviations from 0)

Page 7
 Subject CT8 (Financial Economics) — September 2007 — Examiners’ Report

(ii) Investor 2 is clearly holding a more diversified portfolio, but two of four
measures of risk would suggest the diversified portfolio was riskier.

Value at risk is highly sensitive to the confidence level chosen with 90% level
suggesting investor 2 is riskier than investor 1 and 95% level vice versa.

8 (i) The three forms are:

Strong — stock prices reflect all current information relevant to the stock,
including information which is not public.

Semi-strong — stock prices reflect all current, publicly available information

relevant to the stock.

Weak — stock prices reflect all information available in the past history of the
stock price.

(ii) Tests need to make assumptions (which may be invalid) such as normality of
returns or stationarity.

Transaction costs may prevent the exploitation of anomalies, so that the EMH
might hold net of transaction costs.

Allowance for risk: the EMH does not preclude higher returns as a reward for
risk; however the EMH does not tell us how to price such risks.

END OF EXAMINERS’ REPORT

Page 8
Faculty of Actuaries Institute of Actuaries

EXAMINATION

13 April 2007 (am)

Subject CT8 — Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. Mark allocations are shown in brackets.

4. Attempt all 9 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.

© Faculty of Actuaries
CT8 A2007 © Institute of Actuaries
1 (i) Derive an expression for the theta of an option under the Black-Scholes model
involving delta and gamma. [4]

(ii) Explain why a deep out of the money call option in the Black-Scholes world
will experience a rate of return close to the risk-free rate of return. [2]
[Total 6]

2 Consider a set of risky assets in a mean-variance framework where:

Vi = variance of the return for asset i

Cij = covariance between the returns of assets i and j where i ≠ j

(i) Derive an expression for the variance of a portfolio of N such assets where xi
is the relative weight of asset i in the portfolio. Assume that the weights sum
to unity and that short selling is prohibited. [3]

(ii) Show that the variance of the returns of a very large portfolio of equally
weighted allocations to the assets depends mainly on the average covariance
between the asset returns. [5]
[Total 8]

3 Consider a two period recombining binomial model for St, the price of a non-dividend
paying security at times t = 0, 1 and 2, with real world dynamics:

St +1 = St u with probability p
= St d with probability 1 − p

and u > d > 0.

There also exists a risk-free instrument that offers a continuously compounded rate of
return of 5% per period.

The state price deflator in this model after one period is:

A1 = 0.7610 when S1 = S0u

= 1.5220 when S1 = S0 d

The price of a derivative at time 0 that pays 1 at time 2 if S2 < S0 is 0.1448.

(i) Calculate the value of p. [5]

(ii) Calculate the risk-neutral probability measure. [2]

(iii) Calculate the price at time 0 of a derivative that pays 1 at time 2 if S2 > S0
using the risk-neutral probability measure derived in (ii). [2]
[Total 9]

CT8 A2007—2
4 An investor is contemplating an investment with a payoff of R, where R has the
probability density function f, given by:

f(t) = 0 : t < 0.5

f(t) = c/t4 : t ≥ 0.5,

for c = 0.375. All amounts are in units of £ million.

Calculate the following two measures of risk for the net return when the cost of the
investment is 0.7:

(a) downside semi-variance of return

(b) Value at Risk at the 5% level
[9]

5 Consider a single period multifactor model of security returns where:

K
Ri = αi + ∑ βij I j + εi
j =1

where:

Ri = return on security i

αi, βij are security specific parameters

εi = cross-sectionally independent random component of return that is also

independent of all Ij

Ij = cross-sectionally independent rate of change in factor j

(i) Derive an expression for the covariance between the returns of two securities
in terms of the statistical properties of the factors using the model above. [4]

(ii) Explain the implications of your expression in (i) for constructing a diversified
portfolio. [3]

(iii) Explain how the multifactor model above can be used to form an asset pricing
theory when combined with the principle of no-arbitrage. [5]
[Total 12]

CT8 A2007—3 PLEASE TURN OVER

6 (i) State the SDEs under the risk-neutral measure for r(t), the default-free
instantaneous rate of interest at time t, under the following two models,
defining all notation used:

(a) Hull & White

(b) 2-factor Vasicek
[4]

(ii) State the advantages of the Hull & White model over the single factor Vasicek
model. [4]

(iii) Explain the limitations of using a model with only one factor, taking into
account both theoretical and empirical considerations. [4]
[Total 12]

7 Consider a special type of scheme that has an obligation to pay £10,000 in exactly one
year. There is currently £9,000 in the fund created to meet this obligation and it is
invested in the shares of an infinitely divisible non-dividend paying security with
price St governed by the SDE:

dSt = St ( μ dt + σ dZt )

where:

Zt is a standard Brownian motion

μ = 0.10
σ = 0.20
t is the time since the start of the year
S0 = 1
a risk free rate of return of 5% p.a. compounded continuously is available.

(i) Derive the distribution of S1. [4]

(ii) Calculate the following risk measures applied to the surplus of the scheme
where the surplus of the scheme is defined as the difference between the value
of the fund and the obligation at the end of the year:

(a) variance
(b) shortfall probability relative to a benchmark surplus of £0
[6]

(iii) Calculate the cost of a put option to protect against the surplus being negative
at the end of the year. [3]
[Total 13]

CT8 A2007—4
8 (i) Explain the difference between an efficient market and an arbitrage-free
market. [4]

Empirical investigations of stock market returns have revealed a fractal dimension

of 1.4.

(ii) Explain what this means about the distribution of returns. [2]

(iii) Explain how mean-reversion in the stock market can be consistent with an
efficient market. [2]

(iv) Outline the claim and test of excessive volatility in stock markets made by
Shiller, along with four criticisms made of the test. [7]
[Total 15]

9 (i) Describe three types of credit risk model. [6]

Assume that a company has fixed debt of £40m with term 10 years, the value of the
equity in the company is £20m and the Merton model for credit risk holds true. The
risk free rate of return is 5% p.a. and there are no other dividends or interest
payments.

(ii) Explain how to calculate the (risk neutral) probability of default. You do not
have to calculate the probability, but should state how each value would be
calculated. [6]

In a particular two state model for credit rating with deterministic transition intensity,
the risk free rate is a constant, r, the recovery rate is δ and the zero coupon bond price
is given by:

⎡ ⎛ −
(T 2 −t 2 ) ⎞ ⎤
B (t , T ) = e − r (T −t ) ⎢1 − (1 − δ) ⎜1 − e 4 ⎟⎥ .
⎢ ⎜ ⎟⎥
⎢⎣ ⎝ ⎠ ⎥⎦

(iii) (a) State the general formula for the zero coupon bond prices in a two state
model for credit ratings.

(b) Deduce the risk-neutral default intensity for the particular two state
model above.
[4]
[Total 16]

END OF PAPER

CT8 A2007—5
Faculty of Actuaries Institute of Actuaries

EXAMINATION
April 2007

Subject CT8 — Financial Economics

Core Technical

EXAMINERS’ REPORT
Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

M A Stocker
Chairman of the Board of Examiners

June 2007

Comments

No comments given.

© Faculty of Actuaries
© Institute of Actuaries
 Subject CT8 (Financial Economics Core Technical) — April 2007 — Examiners’ Report

∂f
1 (i) Θ=
∂t

From the Black-Scholes PDE we have

∂f ∂f 1 ∂2 f
+ rs + σ2 s 2 2 = rf
∂t ∂s 2 ∂s

1
or Θ + rsΔ + σ2 s 2Γ = rf
2

(ii) Deep out of the money, delta and gamma will be close to zero which implies
that theta will equal the risk free rate of return.

2 (i) The expression for the variance of the portfolio can be rewritten as:

V = Σi xi2 Vi + ∑ xi .x j .Cij
i≠ j

(ii) If we assume that equal amounts are invested in each asset, then with N assets
the proportion invested in each is 1/N. Thus:

V = Σi (1/N)2 Vi + ∑ (1/N)(1/N).Cij
i≠ j

Factoring out 1/N from the first summation and (N − 1)/N from the second
yields:

V = 1/N Σi Vi /N + (N − 1)/N ∑ Cij/N(N − 1)

i≠ j

Replacing the summation by averages we have

V = 1/N Vi + (N − 1)/N. Cij

The contribution to the portfolio variance of the variances of the individual

securities goes to zero as N gets very large. However, the contribution of the
covariance terms approaches the average covariance as N gets large. The
individual risk of securities can be diversified away, but the contribution to the
total risk caused by the covariance terms cannot be diversified away.

Page 2
 Subject CT8 (Financial Economics Core Technical) — April 2007 — Examiners’ Report

3 (i) Derivative pays off after two down moves

Derivative price = 0.1448 = A(2,dd) × (1 - p)2 × 1

A(2,dd) = A(1,d)2 = 2.316
Hence p = 0.75

(ii) A(1,u) = 0.7610 = A(0) × exp(-0.05) × q/p

Knowing p, we can get q = 0.6

The alternative approach shown below is possible for (i) and (ii), students
were given full credit for either approach.

(i) and (ii) p and q, the risk neutral probability measure, can be obtained by
solving the equation for the state price deflator (Unit 11 Page 9 of Core
Reading)

A1 = e-rq/p if S1 = S0u
= e-r(1 - q)/(1 - p) if S1 = S0d

This gives p = 0.75 and q = 0.6.

Note if this approach is used it is not necessary to know that the price of the
derivative is 0.1448.

(iii) Price = 0.62 × exp(-.05 × 2) × 1 = 0.3257

The solution to (iii) given above assumes that ud = 1, students who worked on
this basis were given full credit as this is a common presumption in this type
of work. However, some students realized that the strict definition of a
recombining model is that ud = du. In this case

If ud = 1 the solution given above holds i.e. price = 0.3257 (only upper node
pays off)

There is another possible case where ud > 1 (upper and middle nodes both
pay off)

In this case price = 0.62e-0.05×2 + 2 × 0.6 × 0.4e-0.05×2

= 0.3257 + 0.4344
= 0.7601

Page 3
 Subject CT8 (Financial Economics Core Technical) — April 2007 — Examiners’ Report

μ
∫ 0.5 (t − μ)
2
4 (a) SV = Downside semi-variance = f (t ) dt

∞
∞ c ⎤
μ = ∫ tf (t )dt = − ⎥ = 0.75
0.5 2t 2 ⎦ 0.5

SV = c {∫ 0.75 −2
0.5
t dt − 2μ
0.75 −3
∫ 0.5 t dt + μ 2
0.75 −4
∫ 0.5 t dt }
⎧ ⎡ t −2 ⎤
0.75 −3 0.75 ⎫
⎪ 0.75 2⎡ t ⎤ ⎪
= c ⎨−t ] 0.5 − 1.5 ⎢ − ⎥ + 0.75 ⎢ − ⎥ ⎬
⎢⎣ 2 ⎥⎦ 0.5 ⎢⎣ 3 ⎥⎦ 0.5 ⎪
⎩⎪ ⎭

= 0.02083
(in units of (£m)2)

OR

∞ ∞
(t − μ)2 (t − μ) 2
SV = ∫ t4
dt − ∫ t4
dt
0.5 0.75

then, using the same integration steps as above,

SV = 0.1875 – 0.16666

= 0.02083

∞
c
∫ f (t )dt = 3 x
−3
(b) P(R > x) =
x

Pr[S ≤ -t] = Pr[R ≤ 0.7 – t]

= 1 – Pr[R > 0.7 – t]

c
= 1 - (0.7 − t )−3
3

For 5% VaR:

c
Pr[S ≤ -t] = 1 - (0.7 – t)-3 = 0.05
3

⇒ t = 0.1914

Page 4
 Subject CT8 (Financial Economics Core Technical) — April 2007 — Examiners’ Report

5 (i) Cij = ∑∑ βik β jl Cov( I k , Il )

k l

+ ∑ βik Cov( I k , ε j )
k

+ ∑ β jk Cov( I k , εi )
k

= ∑ βik β jk Var( I k ) because of independence of all the other terms.

k

(ii) low covariance if betas are low, i.e. pick stocks with different sensitivities to
the factors

(iii) This is exactly the same as the multi-index model for returns on individual
securities. The contribution of APT is to describe how we can go from a
multi-index model for individual security returns to a equilibrium market
model. Non-mathematically, the argument can be made as follows. Consider a
two index model. The return on the ith security is given by

Ri = ai + bi,1 I1 + bi,2 I2 + ci .

For investors who hold well diversified portfolios the specific risk of each
security, represented by ci can be diversified away so an investor need only be
concerned with expected return, bi,1 and bi,2 in choosing his portfolio.
Suppose we hypothesize the existence of three widely diversified portfolios,
represented by the points (Ei , bi,1, bi,2) in E − b1 − b2 space where i = 1, 2, 3.
These three portfolios define a plane in E − b1 − b2 space with equation

E[Ri] = λ0 + λ1 bi,1 + λ2bi,2 .

A portfolio having any combination of b1 and b2 can be formed by combining

portfolios 1, 2 and 3 in the correct proportions. For example the portfolio P,
obtained by taking one-third each of each of 1, 2 and 3 would have

bP,1 = (b1,1 + b2,1 + b3,1)/3 ,

bP,2 = (b1,2 + b2,2 + b3,2)/3 ,

and E[RP] = λ0 + λ1 bP,1 + λ2bP,2 .

Now, consider what would happen if another portfolio Q existed, with exactly
the same values of b1 and b2 but a higher expected return. Both portfolios
would have the same degree of systematic risk but Q would have a higher
expected return than P. Rational investors would therefore sell P and buy Q,
and this would continue until the forces of supply and demand had brought

Page 5
 Subject CT8 (Financial Economics Core Technical) — April 2007 — Examiners’ Report

portfolio Q onto the same plane as portfolios 1, 2 and 3. Thus, in equilibrium,

all securities and portfolios must lie on a plane in E − b1 − b2 space.

The more general result of APT, that all securities and portfolios have
expected returns described by the L-dimensional hyperplane

Ei = λ0 + λ1 bi,1 + λ2bi,2 + ... + λLbi,L ,

can be derived by a more rigorous mathematical argument.

6 (i) The Hull & White (HW) model does this by extending the Vasicek model in a
simple way. We define the SDE for r(t) under Q as follows

dr (t ) = α(μ(t ) − r (t ))dt + σdW (t )

where μ(t) is a deterministic function of t. μ(t) has the natural interpretation of

being the local mean-reversion level for r(t).

A simple example of a multifactor model is the 2-factor Vasicek model. This

models two processes: r(t), as before, and m(t), the local mean-reversion level
for r(t). Thus

dr (t ) = α r (m(t ) − r (t ))dt + σ r1dW1 (t ) + σ r 2 dW2 (t )

dm(t ) = α m (μ − m(t ))dt + σ m1dW1 (t )

where W1 (t ) and W2 (t ) are independent, standard Brownian motions under the
risk-neutral measure Q. This looks superficially like the Hull & White model,
but the HW model has a deterministic mean-reversion level, whereas here m(t)
is stochastic.

(ii) We will now look at a simple extension of the Vasicek model. Recall the
SDEs for both the Vasicek and CIR models gave us time-homogeneous
models. This means that bond prices at t depend only on r(t) and on the term
to maturity. This results in a lack of flexibility when it comes to pricing related
contracts. For example, on any given date theoretical bond prices will
probably not match exactly observed market prices. We can re-estimate r(t) to
improve the match and even re-estimate the constant parameters α, µ and σ but
we will still, normally, be unable to get a precise match.

A simple way to get theoretical prices to match observed market prices is to

introduce some elements of time-inhomogeneity into the model. The Hull &
White (HW) model does this by extending the Vasicek model in a simple way.

(iii) One factor models have certain limitations which it is important to be familiar
with. First, if we look at historical interest rate data we can see that changes in
the prices of bonds with different terms to maturity are not perfectly correlated

Page 6
 Subject CT8 (Financial Economics Core Technical) — April 2007 — Examiners’ Report

as one would expect to see if a one-factor model was correct. Sometimes we

even see, for example, that short-dated bonds fall in price while long-dated
bonds go up. Recent research has suggested that around three factors, rather
than one, are required to capture most of the randomness in bonds of different
durations.

Second, if we look at the long run of historical data we find that there have
been sustained periods of both high and low interest rates with periods of both
high and low volatility. Again these are features which are difficult to capture
without introducing more random factors into a model. This issue is especially
important for two types of problem in insurance: the pricing and hedging of
long-dated insurance contracts with interest-rate guarantees; and asset-liability
modelling and long-term risk-management.

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

contracts which are more complex than, say, standard European call options.
For example, any contract which makes reference to more than one interest
rate should allow these rates to be less than perfectly correlated.

7 (i) If we were dealing with an ordinary differential equation, integration would

lead to the expression μt + σZt for log(St/S0) and thus to S0 exp(μt + σZt ) for
St. To solve the problem within stochastic calculus, use Itoˆ 's Lemma to
calculate d log St:

1 ⎛ 1 ⎞
dSt + ½ ⎜ − 2 ⎟ ( dSt )
2
d log St =
St ⎜ ⎟
⎝ St ⎠

( )
= μ − ½ σ2 dt + σ dZt .

Written in integral form, this reads

( )
log St = log S0 + μ − ½ σ2 t + σZ t

or, finally,

( )
St = S0 exp ⎡ μ − ½σ2 t + σZt ⎤ .
⎣ ⎦

We see that the process S satisfying the equation above is a geometric

Brownian motion with parameter μ − ½ σ2 . Since log St is normally
distributed, it follows that St has a lognormal distribution with parameters
(μ − ½σ ) t and σ t.
2 2

Should insert the parameters given in the question, i.e. μ = 0.1 and σ = 0.2.

Page 7
 Subject CT8 (Financial Economics Core Technical) — April 2007 — Examiners’ Report

(ii) The properties of the lognormal distribution give us the expectation and
variance of St:

(( ) )
E ( St ) = exp μ − ½σ2 t + ½ σ2t = eμt ,
2
Var( St ) = e 2μt (eσ t − 1)

Need to look at

X = 9000 S1 – 10,000

which will also have a lognormal distribution

(a) 0.049846 × 9,0002 = 4,037,526

(b) Pr[X < 0] = Pr[S1 < 10/9] = Pr[log S1 < log 10/9], then use normal
distribution to get 0.55

(iii) 1021.42 based on Black Scholes

S = 9,000, K = 10,000, other parameters as in question

d1 = -0.1768, d2 = 0.3768, use Black Scholes to get price of call option as

509.12.

Use put call parity (or Black Scholes formula for put option directly) to get
price of put = price of call + 10,000*exp(-0.05) – 9,000 = 1021.42.

8 (i) Attempts to explain this phenomenon gave rise to the efficient markets
hypothesis, which claims that market prices already incorporate the relevant
information. The market price mechanism is such that the trading pattern of a
small number of informed analysts can have a large impact on the market
price. Lazy (or cost conscious) investors can then take a free ride, in the
knowledge that the research of others is keeping the market efficient.

If we assume that there are no arbitrage opportunities in a market, then it

follows that any two securities or combinations of securities that give exactly
the same payments must have the same price. This is sometimes called the
“Law of One Price”.

Arbitrage-free markets can be inefficient.

(ii) One measure of these non-normal features is the Hausdorff fractal dimension
of the price process. A pure jump process (such as a Poisson process) has a
fractal dimension of 1. Random walks have a fractal dimension of 1½.
Empirical investigations of market returns often reveal a fractal dimension
around 1.4.

Page 8
Subject CT8 (Financial Economics Core Technical) — April 2007 — Examiners’ Report

(iii) Even mean reversion can be consistent with efficient markets. After a crash,
many investors may have lost a significant proportion of their total wealth; it
is not irrational for them to be more averse to the risk of losing what remains.
As a result, the prospective equity risk premium could be expected to rise.

(iv) Several observers have commented that stock prices are “excessively volatile”.
By this they mean that the change in market value of stocks (observed
volatility), could not be justified by the news arriving. This was claimed to be
evidence of market over-reaction which was not compatible with efficiency.

The claim of “excessive volatility” was first formulated into a testable

proposition by Shiller in 1981. He considered a discounted cashflow model of
equities going back to 1870. By using the actual dividends that were paid and
some terminal value for the stock he was able to calculate the perfect foresight
price, the “correct equity” price if market participants had been able to predict
future dividends correctly. The difference between the perfect foresight price
and the actual price arise from the forecast errors of future dividends. If
market participants are rational we would expect no systematic forecast errors.
Also if markets are efficient broad movements in the perfect foresight price
should be correlated with moves in the actual price as both react to the same
news.

Shiller found strong evidence that the observed level of volatility contradicted
the EMH. However, subsequent studies using different formulations of the
problem found that the violation of the EMH only had borderline statistical
significance. Numerous criticisms were subsequently made of Shiller’s
methodology, these criticisms covered

• the choice of terminal value for the stock price

• the use of a constant discount rate

• bias in estimates of the variances because of autocorrelation

• possible non-stationarity of the series, i.e. the series may have stochastic
trends which invalidate the measurements obtained for the variance of the
stock price

Although subsequent studies by many authors have attempted to overcome the

shortcomings in Shiller’s original work there still remains the problem that a
model for dividends and distributional assumptions are required. Some
equilibrium models now exist which calibrate both to observed price volatility
and also observed dividend behaviour. However, the vast literature on
volatility tests can at best be described as inconclusive.

Page 9
 Subject CT8 (Financial Economics Core Technical) — April 2007 — Examiners’ Report

9 (i) The three types of credit risk model are:

structural models: these are explicit models of a corporate entity issuing both
debt and equity. They aim to link default events explicitly to the fortunes of
the issuer.

reduced-form models: these are statistical models which use market statistics
(such as credit ratings) rather than specific data relating to the issuer, a nd give
statistical models for their movement.

intensity-based models: these model the factors influencing the credit events
which lead to default and typically do not consider what triggers these events.

(ii) In the Merton model, the company is modelled as having a fixed debt, 40 with
term 10 years and variable assets St. The equity holders can be regarded as
holding a European call on the assets with a strike of 40.

In the current question the value of the option is 20.

Using Black Scholes formula, with (T - t) = 10, K = 40, S0 = 60, r = 0.05,

solve for σ, the implied volatility.
[Candidates need not actually do this calculation]

The assets of the company therefore follow a geometric Brownian motion

under the risk neutral measure with drift r = 0.05 and volatility σ.

Therefore log(S10/ S0) follows a normal distribution with mean 10*(0.05 –

σ2/2) and variance 10* σ2.

The risk neutral probability of default is obtained by calculating the

probability that log(S10/ S0) is less than log(40/60).

(iii) In the two state model for credit rating with deterministic transition intensity,
the formula for the Zero Coupon Bond price is

T
−∫ λ ( s ) ds
B(t, T) = e-r(T-t) (1 – (1 - δ) (1 - e t
)).

It follows that the risk-neutral default intensity is given by

 ( s ) = s/2.
λ

END OF EXAMINERS’ REPORT

Page 10
Faculty of Actuaries Institute of Actuaries

EXAMINATION

13 September 2006 (am)

Subject CT8 Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. Mark allocations are shown in brackets.

4. Attempt all 8 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.

Faculty of Actuaries
CT8 S2006 Institute of Actuaries
1 An investor is contemplating an investment with a return of £R, where:

R = 250,000 100,000N,

and N is a Normal [1, 1] random variable.

Calculate each of the following four measures of risk:

(a) variance of return

(b) downside semi-variance of return
(c) shortfall probability, where the shortfall level is £50,000
(d) Value at Risk at the 5% level
[8]

2 A non-dividend-paying stock has a current price of 800p. In any unit of time (t, t + 1)
the price of the stock either increases by 25% or decreases by 20%. £1 held in cash
between times t and t + 1 receives interest to become £1.04 at time t + 1. The stock
price after t time units is denoted by St.

(i) Calculate the risk-neutral probability measure for the model. [4]

(ii) Calculate the price (at t = 0) of a derivative contract written on the stock with
expiry date t = 2 which pays 1,000p if and only if S2 is not 800p (and
otherwise pays 0). [4]
[Total 8]

3 (i) Explain what is meant by self-financing in the context of continuous-time

derivative pricing, defining all notation used. [4]

(ii) Define the delta of a derivative, defining all notation and terms used other than
those already defined in your answer to (i). [2]

(iii) Explain, in general terms, how delta and self-financing are used in the
martingale approach to valuing derivatives. [5]
[Total 11]

CT8 S2006 2
4 The Wilkie model has been used to produce stochastic simulations of inflation rates.

The following runs were made:

1,000 simulations of one-year

one simulation of 1,000 years

and the standard deviations were calculated.

(i) Explain why you would expect the standard deviations calculated in each run
to be different. [4]

(ii) State the conditions under which the standard deviations in the two runs would
be expected to be the same. [2]

(iii) Discuss the advantages and disadvantages of using economic theory rather
than statistical models to construct and calibrate a stochastic model. [5]
[Total 11]

5 (i) List five desirable characteristics of a model for the term structure of interest
rates. [5]

(ii) State the Stochastic Differential Equation satisfied by the short rate in the
Vasicek model for the term structure of interest rates. [1]

(iii) Comment on the appropriateness of the Vasicek model in the light of your
answer to part (i). [5]
[Total 11]

6 An investor can invest in only two assets with the following characteristics
(annualised):

Asset Expected rate of return Standard deviation

A 10% 20%
B 5% 0%

(i) Show that the efficient frontier for the investor is a straight line passing
through the points (0, 0.05) and (0.1, 0.075) in (standard deviation, expected
return) space. [5]

A third security C becomes available to the investor. It has an annualised expected

return of 6% and an annualised standard deviation of 10%. It is uncorrelated with A
and B.

(ii) Determine the portfolio using only A and C that maximises:

expected return 5%
. [6]
standard deviation

(iii) Using (ii), or otherwise, show that the new efficient frontier using A, B and C
passes through the point (0.1, 0.0769). [6]
[Total 17]

CT8 S2006 3 PLEASE TURN OVER

7 Consider the following two-factor model of security returns:

Ri = i + i1I1 + i2I2 + i

where:

Ri = return on security i
i, i1, i2 are security-specific parameters
I1 and I2 are the changes in the 2 factors on which the model is based
2
i is an independent random normal variate with variance i.

(i) Describe briefly three categories of model that could help in choosing the
factors, I1 and I2. [6]

Suppose the factors I1 and I2 are chosen to be total return indices with I1 based on the
whole market and I2 based on the 50 stocks with the highest dividend yield.

(ii) Explain in detail how the two factors can be transformed into two orthogonal
factors, one of which is the same as the index on which I1 is based. [3]

(iii) Derive an expression for the variance of the returns on the security in terms of
the variances of the changes of the orthogonal factors and i2 . [3]

(iv) Explain in words the expression in (iii). [2]

[Total 14]

8 (i) State the SDE of a non-dividend paying stock price in the Black-Scholes
model, under the EMM defining all symbols used. [2]

(ii) Give the general formula for the price of a derivative security which has a
terminal value of C at time T. [2]

(iii) A special option on a share pays £1 at time T if (and only if) the share price at
time T lies in the interval [a, b].

Prove that the price of such an option is given by:

2
x
ln r T
S0 2
e-rT[ (d(b)) - (d(a)] where d(x) =
T

where S0 = price of underlying stock, r = continuously compounded rate of

return on the risk free asset and = volatility parameter of stock price process.
[5]

CT8 S2006 4
 A fund manager currently charges an annual management fee of 0.5% of the value of
the funds under management at the end of a one-year contract.

The value of the funds under management are governed by the following SDE:

dSt = St( dt + dZt)

where St = value of funds under management

Zt = standard Brownian motion
= 0.08
= 0.25

The funds generate no income during the year.

The continuously compounded risk-free rate is 5% per annum.

The owner of the funds wishes to change the management fee to be performance-
related.

Specifically the fee, KS1 is set so that:

0.1% if S1 S0
K 1% if S1 U
0.5% otherwise

(iv) Calculate the value at time 0 of the management fee under the original fee
structure if S0 = 100. [1]

(v) Calculate U so that the management fee under the performance-related fee
structure has the same value at time 0 as the fixed fee in (iv). [10]

Hint: the fee can be written as a basic fee plus two call options plus two
options of the form in (iii). [Total 20]

END OF PAPER

CT8 S2006 5
Faculty of Actuaries Institute of Actuaries

EXAMINATIONS
September 2006

Subject CT8 — Financial Economics

EXAMINERS’ REPORT

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

M A Stocker
Chairman of the Board of Examiners

November 2006

Comments

No comments are given

© Faculty of Actuaries
© Institute of Actuaries
 Subject CT8 (Financial Economics) — September 2006 — Examiners’ Report

1 (a) Var(R) = 100,0002 Var(N) = 1010

(b) Downside semi-variance of R = 1010 × upside semi-variance of N; the upside

semi-variance of N is ½, so downside semi-variance of R is 5 × 109

(c) P(R < 50,000) = P(N > 2) = 1 − Φ(1) = 1 − .8413 = .1587

(d) If VaR5%(R) = t then P(R ≤- t) = 0.05, so P(250,000 − 100,000N ≤ -t) =

P(N > 2.5 +(t/100,000)) = 5%, hence (since N − 1 is a standard normal r.v)
Φ(1.5 + (t/100,000) = .95, so t = 100,000(1.645-1.5) = £14,500.

2 (i) The pricing measure Q must satisfy:

⎡ 1 ⎤
EQ ⎢ St +1⏐Ft ⎥ = St;
⎣1 + r ⎦

so, if we set

qt = Q(St+1 = 1.25St |Ft),

then

1.04 = 1.25qt + 0.8(1 − qt) ⇔ qt = q = 8/15

Thus the unique pricing measure makes S a multiplicative random walk with
up-jump probability of 8/15.

(ii) The price of the derivative is P = EQ[X/(1 + r)2], where X is the terminal value
of the derivative.

Thus,

P = 1,000Q(S2 ≠ 800)/1.042
= 1,000 × ((8/15)2 + (7/15)2)/1.042
= 464.33p

Page 2
 Subject CT8 (Financial Economics)) — September 2006 — Examiners’ Report

3 (i) Suppose that at time t we hold the portfolio (ϕt, ψt) where ϕt represents the
number of units of St held at time t and ψt is the number of units of the cash
bond held at time t.

We denote the value of the portfolio at time t by V(t).

The portfolio strategy is described as self-financing if dV(t) is equal to

ϕt dSt + ψt dBt: that is, at time t + dt there is no inflow or outflow of money
necessary to make the value of the portfolio back up to V(t + dt).

(ii) Let Ft be the discounted value of a derivative (priced using the EMM) then
since it’s martingale, there is (by martingale representation) a ϕt such that
dFt = ϕtdDt, where D is the discounted price of the underlying. This ϕt is the
derivative’s delta.

(iii) It follows from the above that if we hold ϕt in the underlying asset and
ψt = Ft - ϕtDt in the bond, then the discounted value of our holding is Ft.

The holding is self-financing, since dV(t) = d(ertFt) = rert Ftdt + ert dFt
= rertFtdt + ert ϕtdSt + rert (Ft - ϕtDt) dt = ϕtdSt + ψt dBt.
The final discounted value of our holding is FT, and so we have hedged the
derivative with terminal value of VT.

4 (i) In the Wilkie model, the force of inflation, I(t), over the period t -1 to t is an
autoregressive model of order 1, AR1: It+1 = (1 - α) m + αIt + et, where the et
are iid normal errors.

It follows that it is mean-reverting and the longitudinal distribution from the

1,000 year simulation will converge to stationarity.

Consequently we will get the unconstrained s.d., whereas the s.d. from
repeated one year simulations (cross-sectional) will depend strongly on initial
conditions.

(ii) In a pure random walk environment, the force of inflation would be

independent across the years and (as for any model) across simulations. As a
result, cross-sectional and longitudinal quantities would coincide. This
happens if α = 0.

Page 3
 Subject CT8 (Financial Economics) — September 2006 — Examiners’ Report

(iii) In a statistical model, the model structure is derived from past time series,
together with some intuition regarding what model formulae look reasonable.
However, these statistical models can produce some odd results. It can be
useful to impose additional economic constraints on model behaviour. The
advantage of using more economic theory is that it gives us a more concrete
way of interpreting model output. For example, if we model a market which is
broadly governed by rational pricing rules, we can apply those same pricing
rules to simulated output from a model. This gives us a market-based way of
comparing strategies, and deciding which strategy is most valuable. The
difficulty with this approach is that the model’s optimal strategy may not be
the strategy that managers wish to follow. In this context, a more flexible
judgmental approach may better meet the client’s needs.

5 (i) Arbitrage free

Positive rates
Instantaneous and other rates mean reverting
Ease of computation/pricing of derivatives and bonds
Realistic dynamics/yield curves
Historical fit (with suitable parameter values)
Ease of calibration
Flexibility (to cope with range of derivatives)

(ii) The stochastic differential equation for the short rate r is:

drt = σdBt + α(μ − rt) dt.

(iii) Arbitrage free - yes

Positive rates - no
Instantaneous and other rates mean reverting - yes
Ease of computation/pricing of derivatives and bonds - yes
Realistic dynamics/yield curves - no
Historical fit (with suitable parameter values) - no
Ease of calibration - no
Flexibility (to cope with range of derivatives) - no
-not very good as a model.

6 (i) Since the efficient frontier consists of pairs of points (in (s.d., return)
coordinates) such that no higher return is available for the same or lower s.d.
we see that to get a return of r, greater than or equal to .05, we need a portfolio
of ((r - .05)/.05, 1 –((r - .05)/.05) = (20r – 1, 2 – 20r), this portfolio has a
standard deviation 0.2 (20r -1), hence the efficient frontier is the straight line
(4r – 0.2, r) which does indeed pass through the two specified points.

(ii) A portfolio with x invested in A and (1 – x) invested in C has an expected

return of .06 + .04x and s.d. of √(.04x2 + .01(1 – x)2). Thus we seek x to
maximize (.01 + .04x) / √(.04x2 + .01(1 – x)2). Taking logs and differentiating

Page 4
 Subject CT8 (Financial Economics)) — September 2006 — Examiners’ Report

we see (after a lot of algebra) that the optimal x is 5/9, so the optimal portfolio
is (5/9, 4/9).

(iii) The efficient frontier in the presence of a risk free asset is the tangent to the
efficient frontier (without a risk free asset) which passes through the point in
(s.d., return)-space corresponding to the risk free asset.

Clearly this is the line through (0, .05) with maximal gradient which passes
through some point of the efficient frontier.

Consider the point corresponding to the portfolio in part (ii): it is on the

efficient frontier for the pair A and C, and the line from (0, .05) to it has
gradient
(.01 + .04x) / √(.04x2 + .01(1 – x)2)

Hence the new efficient frontier is a straight line which passes through (0, .05)
and (√(.04(5/9)2 + .01(1 – 5/9)2), .06 + .04 × 5/9).

This is the line y = .05 + .2692x, which clearly passes through (.1, .076926).

7 (i) The three types are:

Macroeconomic factor models

These use observable economic time series as the factors. They could include
factors such as the annual rates of inflation and economic growth, short term
interest rates, the yields on long term government bonds, and the yield margin
on corporate bonds over government bonds. Once the set of factors has been
decided on, a time series regression is performed to determine the sensitivities
for each security in the sample.

Fundamental factor models

Fundamental factory models are closely related to macroeconomic models but

instead of (or in addition to) macroeconomic variables the factors used are
company specific variables. These may include such fundamental factors as:

• the level of gearing

• the price earnings ratio
• the level of R&D spending
• the industry group to which the company belongs

Again, the models are constructed using regression techniques.

Statistical factor models

Statistical factor models do not rely on specifying the factors independently of

the historical returns data. Instead a technique called principal components

Page 5
 Subject CT8 (Financial Economics) — September 2006 — Examiners’ Report

analysis can be used to determine a set of indices which explain as much as

possible of the observed variance.

(ii) Denoting the changes in the two indices by It and Jt, let Kt = Jt - c It, where c
= Cov(It, Jt)/Var(It), then the two factors I and K are orthogonal. We can
check: Cov(It, Kt) = Cov(It, Jt) –c Var(It) = 0. Alternatively, we may regress
index J on index I to obtain J = a + bI + d2, and set K = d2, where a is a
constant and d2 is uncorrelated with I.

(iii) Suppose that Ri = αi + βi,1I + βi,2K + εi, then Var(Ri) = βi,12 Var(I) + βi,22
Var(K) + σi2.

(iv) The interpretation is (as in principal components analysis) that we have a

decomposition of the variance into the portion explained by the behaviour of
the first index, that explained by the second and the residual or unexplained
error or variance.

8 (i) Under the Black Scholes assumptions, the unique risk-neutral measure is Q,
where, under Q,

dSt = rSt dt + σSt dBt,

with B a standard Brownian motion.

(ii) The unique fair price for a derivative security which pays C at time T is

V0 = EQ [e−rTC].

(iii) For the special option, C = 1 if ST is in [a, b], otherwise 0, so

V0 = EQ [e−rT1[a,b](ST)]

= e−rTQ(ST in [a, b])

ST
Because B is a Brownian motion ln is normally distributed (under Q) with
S0
⎛ σ2 ⎞
mean ⎜ r − ⎟⎟ T and standard deviation Tσ .
⎜ 2
⎝ ⎠

x ⎛ σ2 ⎞
ln −⎜r − ⎟T
S0 ⎜⎝ 2 ⎟⎠
Hence Q(ST < x) = Φ(d(x)) where d(x) =
Tσ

Hence V0 = e-rT [Φ(d(b)) - Φ(d(a))]

Page 6
 Subject CT8 (Financial Economics)) — September 2006 — Examiners’ Report

(iv) The value is .5% of the holding, so is .005S0.

(v) Payoff = .001S1 + .004(S1 – S0)+ + .005(S1 – U)+

+ .004 S01( S1 − S0 ) + .005U 1( S1 >U )

Denoting the prices of the four options in the decomposition immediately

above as c1, c2, c3, and c4:
r + ½σ2 r
c1 = S0Φ(d1) – S0e-rΦ(d1 - σ) where d1 = = + ½σ
σ σ

= 100Φ(0.325) – 100e-0.05Φ(0.075)

= 12.33599

⎛S ⎞
ln ⎜ 0 ⎟ + (r + ½σ2 )
= S0Φ(d3) - Ue-0.05 Φ(d3 - σ) where d3 = ⎝ ⎠
U
c2
σ

⎛ σ2 ⎞
−⎜r − ⎟⎟
⎜
c3 = 100[e-0.05(1 - Φ(d4))] where d4 = ⎝ 2 ⎠ = −r + σ
σ σ 2

= 100[0.5040495] = 50.40495

⎛U ⎞ ⎛ σ2 ⎞
ln ⎜ ⎟ − ⎜ r − ⎟⎟
⎜
⎝ S 0 ⎠ ⎝ 2 ⎠
c4 = e-0.05(1 - Φ(d5)) where d5 =
σ

⎛S ⎞ ⎛ σ2 ⎞
− ln ⎜ 0 ⎟ − ⎜ r − ⎟
⎝ U ⎠ ⎜⎝ 2 ⎟⎠
=
σ

= − ( d 3 − σ)

Value = 0.1

+ 12.33599 × .004

+ [100Φ(d3) - Ue-0.05 Φ(d3 - σ)] × 0.005

+ 50.40495 × .004

+ U × e-0.05(1 - Φ{-(d3 - σ)}) × .005

Page 7
 Subject CT8 (Financial Economics) — September 2006 — Examiners’ Report

Value = 0.1 + 12.33599 × 0.04 + 50.40495 × .004

+ 0.5Φ(d3) - Ue-0.05 Φ(d3 - σ) 0.005

+ Ue-0.05 × 0.005 × (1 – (1 - Φ(d3 - σ)))

= 0.35096376 + 0.5Φ(d3) = 0.5

⎛ 0.35096376 ⎞
⇒ d3 = Φ −1 ⎜ 1 − ⎟
⎝ 0.5 ⎠

= -0.52995

100
⇒ ln = -0.52995 × 0.25 – 0.05 – ½0.252
U

⇒ U = 123.83

END OF EXAMINERS’ REPORT

Page 8
Faculty of Actuaries Institute of Actuaries

EXAMINATION

5 April 2006 (am)

Subject CT8 Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. Mark allocations are shown in brackets.

4. Attempt all 9 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.

Faculty of Actuaries
CT8 A2006 Institute of Actuaries
1 An investor can construct a portfolio using only two assets A and B with the
following properties:

A B

Variance of return 24%% 12%%

Correlation coefficient between assets 0.25

(i) Derive a formula for and determine the composition of the investor s
minimum variance portfolio. [3]

(ii) Explain in general terms the benefits of diversification. [3]

[Total 6]

2
Asset
State A B C D Probability of state

1 5% 5% 5% 2% 0.3
2 4% 7% 5% 6% 0.2
3 7% 3% 5% 9% 0.5
Value of asset 10,000 20,000 n/a 10,000

The table above gives the returns on all four assets in an investment market under the
three possible states of the world.

(i) Calculate the market price of risk under CAPM. [4]

(ii) Outline the limitations of CAPM. [3]

[Total 7]

3 (i) State five key defining properties of a standard Brownian motion. [5]

(ii) Outline the advantages and disadvantages of using the continuous time
Lognormal model for stock prices by considering both the theoretical features
of the model and its consistency with empirical evidence. [6]
[Total 11]

CT8 A2006 2
4 (i) List the desirable characteristics of a term structure model. [4]

Under the real world probability measure, P, the price of a zero coupon bond with
maturity T is given by:

B(t, T) = exp(T(T t) rt + 2(T t)3/6)

where rt is the risk free rate of interest at time t.

rt satisfies the following SDE under the real world measure P:

drt = rtdt + dzt

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

(ii) Derive:

(a) the market price of risk and

(b) the SDE for rt under the risk neutral measure Q
[7]
[Total 11]

5 (i) Comment on the implications for an assessment of stock market efficiency of

the necessity for a ban on the management of a company trading in their
company stock particularly during takeover talks. [2]

(ii) Explain why it is not straight forward to identify when the semi-strong form of
stock market efficiency holds. [3]

(iii) Comment on the implications of stock market efficiency for passive and active
fund managers. [2]
[Total 7]

CT8 A2006 3 PLEASE TURN OVER

6 In the Wilkie model, the force of inflation from time t 1 to t, I(t), is modelled as:

I(t) = Qmu + QA[I(t 1) Qmu] + QSD . QZ(t)

where QZ(t) ~ N(0, 1)

and Qmu, QA and QSD are fixed parameters as follows:

Qmu = 0.03
QA = 0.55
QSD = 0.45

(i) Calculate the 95% confidence interval for the force of inflation over the
following year given inflation over the past year was 2.75%. [4]

(ii) Explain an economic justification for using an AR(1) process for inflation. [1]

(iii) Explain whether a model of the form that is used for inflation is also suitable
for share prices. [3]
[Total 8]

7 (i) Describe the advantages of the martingale approach to derivative valuation

compared with an approach based on deriving an appropriate partial
differential equation. [3]

(ii) State and compare the risk-neutral and state price deflator approaches to
valuing derivatives. [4]
[Total 7]

CT8 A2006 4
8 An employer contracts with his staff to give each of them 1,000 shares in one year s
time provided the share price increased from its current level of £1 to at least £1.50 at
the end of the year.

You may assume the following parameters:

risk free interest rate: 4% p.a. continuously compounded

stock price volatility: 30% p.a.
dividend yield: nil

(i) Calculate the value of the contract with each employee by considering the
terms of the Black-Scholes formula, [6]

The employer now wishes to limit the gain to each employee to £2,000.

(ii) Calculate the value of this revised contract. [6]

(iii) An employee has said that he believes the original uncapped contract is worth
£300. He has determined this by saying that he believes there is a 30% chance
of the share price being at least £1.50 therefore 30% £1 = 30p.

(a) Compare the approach taken by the employee and the approach used
in (i).
(b) Comment on the implications of the differences in (iii) (a) if there were
a market in such contracts.
[4]
[Total 16]

CT8 A2006 5 PLEASE TURN OVER

9 Consider a recombining binomial model for the price of a share where:

risk free interest rate r = 4% p.a. (equivalent to 0.016% per trading day)
continuously compounded

volatility = 20% p.a.

initial share price S0 = 100

the ratio of the share price after an up jump compared with the share price before
the jump is given by u = exp( . 250 ½)

There are 250 trading days per year and ignore dividends except where specifically
mentioned.

(i) Calculate the price at time 0 of a European-style put option with a strike price
of 101p that expires in 2 days time. [6]

(ii) (a) Sketch a graph of the delta of a put option against share price with
exercise price 100.
(b) Explain the key features of the graph. [6]

(iii) Derive, using the binomial lattice, the price of a European-style call option
with exercise price 101p expiring in 2 days time. [1]

(iv) (a) State the relationship known as put-call parity .

(b) Prove it from first principles.
[4]

(v) Compare the result of (iii) to the result of (i) using put-call parity. [2]

Assume now that an investor holds a call option and a put option, both with exercise
prices of 101p, that can be exercised at the investor s option at the end of day 1 or the
end of day 2. At the end of day 1, just before the investor is allowed to exercise the
options, the company announces unexpectedly that a dividend of 3p per share will be
paid at the end of day 2 immediately prior to the expiry of the options.

(vi) (a) Construct the binomial lattice of share prices allowing for the dividend
payment.
(b) Explain the conditions under which the holders of the put and call
options will exercise at the end of day 1 after the announcement of the
dividend. [8]
[Total 27]

END OF PAPER

CT8 A2006 6
Faculty of Actuaries Institute of Actuaries

EXAMINATION
April 2006

Subject CT8 Financial Economics

Core Technical

EXAMINERS REPORT

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

M Flaherty
Chairman of the Board of Examiners

June 2006

Comments

Please see individual comments on questions 4 and 6. No other comments given.

Faculty of Actuaries
Institute of Actuaries
 Subject CT8 (Financial Economics Core Technical) April 2006 Examiners Report

2 2
1 (i) Let V = VA A (1 A) VB 2 A (1 A )C AB

V
= VA 2 A 2(1 A )VB (2(1 A) 2 A )C AB
A

Set equal to zero gives

0 = VA 2 A (2 2 A )VB 2(1 2 A )C AB

0= A (V A VB 2C AB ) VB C AB

VB C AB
A =
VA VB 2C AB

In this case

12%% 0.25 (24%% 12%%)½

A =
24%% + 12%% 2 0.25 (24%% 12%%)½

= 28.2%

71.8% of asset B

(ii) As a portfolio is diversified, the return on the portfolio is less exposed to the
specific risk of any one component.

This means that as portfolios are diversified the correlation components

become less important, therefore variance of return is minimised.

2 (i) The market price of risk is (Em r)/ m.

Asset C is the risk free asset therefore r = 5%.

Em = (10,000 (5% 0.3 + 4% 0.2 + 7% 0.5) +

20,000 (5% 0.3 + 7% 0.2 + 3% 0.5) +

10,000 (2% 0.3 + 6% 0.2 + 9% 0.5)) 40,000

= 5.225%

Page 2
 Subject CT8 (Financial Economics Core Technical) April 2006 Examiners Report

2
2 10, 000 5% 20, 000 5% 10, 000 2%
m = 5.225% 0.3 +
40, 000

2
10, 000 4% 20, 000 7% 10, 000 6%
5.225% 0.2 +
40, 000

2
10, 000 7% 20, 000 3% 10, 000 9%
5.225% 0.5
40, 000

= 4.4312 10 5 = 0.66567%2

The market price of risk is (5.225% 5%) / 0.66567%

= 33.8%.

(ii) Empirical studies do not provide strong support for the model.

It does not account for taxes, inflation or where there is no riskless asset.

It does not consider multiple time periods or optimisation of consumption over

time.

3 (i) Credit should be awarded for any five from the following:

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

whenever s < t.

(b) Bt has stationary increments, i.e. the distribution of Bt Bs depends

only on t s.

(c) Bt has Gaussian increments, i.e. the distribution of Bt Bs is N(0, t s).

(d) Bt has continuous sample paths t Bt.

(e) B0 = 0.

(f) Cov(Bs, Bt) = min (s, t) since, for s > t, Cov(Bt, Bt) = t and Cov(Bs Bt,
Bt) = 0.

(g) {Bt, t 0} is a Markov process: this follows directly from the

independent increment property.

(h) {Bt, t 0} is a martingale: 0.1 demonstrates that E ( Bs | Ft ) Bt .

Page 3
 Subject CT8 (Financial Economics Core Technical) April 2006 Examiners Report

(i) {Bt, t 0} returns infinitely often to 0, or indeed to any other level.

(j) If {B1(t), t 0} is defined by

1
B1 (t ) Bct
c

then {B1(t), t 0} is also a standard Brownian motion. (This is the

scaling property of Brownian motion.)

(k) If {B2(t), t 0} is defined by

B2 (t ) tB1/ t

then {B2(t), t 0} is also a standard Brownian motion. (This is the

time inversion property of Brownian motion.)

(ii) Advantages

The mean and variance of return are proportional to the length of the time
interval considered.

Returns over non-overlapping time intervals are independent of each other.

Cannot use past history to identify whether prices are cheap or dear
implying weak form market efficiency consistent with empirical
observations.

Does not permit negative share prices.

Disadvantages

Estimates of volatility vary widely over time periods. This is supported by

implied volatility from option prices.

The model is not mean reverting, which is contradicted by some evidence

of momentum effects and reversion after market crashes.

Does not reflect jumps and discontinuities observed in the market.

Page 4
 Subject CT8 (Financial Economics Core Technical) April 2006 Examiners Report

4 (i)
The model should be arbitrage free.
Interest rates should be positive.
Interest rates should exhibit some element of mean reversion.
The model should be computationally tractable.
Gives a reasonable range of possible yield curves.
Fits historical data.
Can be calibrated to current market data.
Flexible to cope with a range of derivatives.

Comments on question 4(ii):

Please note that there was a typographical error in this question where the first T in the
expression should have been a minus sign.

Candidates who identified this and proceeded on the assumption that there had been a
typographical error were given appropriate credit, as were candidates who noted that the
expression led to inconsistencies. The solution below shows the correct technical
approach applied to the question as it stood. All candidates scripts were assessed to take
into account any additional impact of this error.

(ii) Using Ito s lemma:

dB(t, T) = B(t, T) (-Trtdt ½ 2(T t)2dt + T(T - t) drt + ½T2(T t)2 2dt)

(a) Therefore as the market price of risk is

(t, T) = (m(t, T) rt) / s(t, T)

where dB(t, T) = B(t, T) (m(t, T) dt + s(t, T) dzt)

m(t, T) = T((T t) - 1) rt + ½(T t)2 2(T2 -1)

s(t, T) = (T t) . T

(rt (T (T t ) 2) ½(T t ) 2 2
(T 2 1))
Therefore (t) =
T (T t )

(b) SDE for rt is drt = dzt under the risk neutral measure Q

rt ( (T (T t ) 2) ½(T t ) 2 2
(T 2 1))dt
drt = dzt
T (T t )

Page 5
 Subject CT8 (Financial Economics Core Technical) April 2006 Examiners Report

5 (i) If a market is strong form efficient then senior managers could not make
abnormal profits. The existence of a ban suggests abnormal profits could be
made, which suggests markets are not strong form efficient.

(ii) Different stock exchanges have different disclosure levels therefore different
markets have different levels of efficiency.

Even if information is publicly available, there is a cost and possibly a time

delay to obtain it. This erodes the advantages of obtaining the information.

Individuals do not have access to the management of companies that fund

managers do. They spend time and money interviewing senior management.

(iii) In aggregate, active managers hold the market, which is identical to the
passive manager. Therefore the average active manager should perform in
line with the passive manager.

If markets are inefficient, we would expect active managers with above

average skill to perform better than passive managers.

The existence of active managers suggests a belief that markets are inefficient.

6 (i) Let Q(t) be the inflation index at time t

Q(t 1)
= 1.0275 = eI(t 1)
Q(t 2)

therefore I(t 1) = ln(1.0275)

The 95% confidence interval for I(t) is therefore at the upper level

I(t) = 0.03 + 0.55(ln(1.0275) 0.03) + 0.45 1.96

= 0.910

at the lower level

I(t) = 0.03 + 0.55(ln(1.0275) 0.03) 0.45 1.96

= 0.854

Comments on question 6 (i)

Candidates who used 0.045 as in the original Wilkie calibration (instead of 0.45) were given
appropriate credit.

Page 6
 Subject CT8 (Financial Economics Core Technical) April 2006 Examiners Report

(ii) Inflation in many countries tends to be mean-reverting because central banks

and governments attempt to manage it close to target ranges

(iii) The model used for inflation is not suitable for share prices for the following
reasons:

(1) Strong mean reversion implies prices are predictable so high returns
are possible with little risk through active market timing. This runs
counter to much empirical evidence.

(2) Lots of evidence for share price jumps in market prices that are not
reflected in the model.

(3) Share prices tend to increase rather than mean revert therefore a
stationary process is not suitable.

(4) The model permits negative share prices, which is highly unrealistic.

7 (i) The martingale approach gives much more clarity in the valuation process. By
providing an explicit expectation to evaluate.

It gives the replicating strategy for the derivative.

It can be applied to exotic options where the PDE approach cannot.

(ii)
Risk neutral pricing approach is the same as the martingale approach, i.e.
values are derived from the risk neutral world.

Deflators values the derivative in a real world probability measure with a

stochastic adjustment factor.

The approach is the same as risk-neutral pricing, the only difference is that
calculations are presented using the real world measure and a stochastic
adjustment factor versus a risk neutral measure. Intuitively the deflator
approach can also give information about real world expected outcomes.

Page 7
 Subject CT8 (Financial Economics Core Technical) April 2006 Examiners Report

8 (i) The value of the promise can be thought as part of a call option contract. A
call option consists of a contract to deliver a share in return for the payment of
an exercise, where the share price exceeds the exercise price.

The promise made to the employees is the first part of the call option, the
promise to deliver a share provided the price exceeds a certain level.
Therefore, the first component of the Black Scholes formula gives the value

2
ln s / k r ½
Value = S.N(d1) where d1 = T
T

1
ln 0.04 ½0.32
1.5
= 1,000 N
0.3

= N( 1.0682) 1,000

= £142.70

(ii) Limiting the gain under the contract can be represented by a portfolio of the
above promise less a call option with exercise price of £2.

The value of the call option is therefore

1,000(N(d1) e 0.04 N(d2) * 2) d1 as above

d2 = d1 T

where

d1 = 2.027
d2 = 2.327

The value of the call option is therefore

1,000 0.00215 = £2.15

The value of the revised promise is therefore

£142.70 £2.15 = £140.53

Page 8
 Subject CT8 (Financial Economics Core Technical) April 2006 Examiners Report

(iii) (a) The employee has taken a view about the expected growth in share
price. The result is a value that is not consistent with risk neutral
pricing.

This means that, if there were a market in these contracts the price the
employee has derived is not equal to the price the market would place
on it.

(b) If the employer were willing to buy such promises at their suggested
price, an arbitrageur would sell of £300 and hedge their position at
£142.70. Resulting in substantial risk free profits.

9 (i)
102.562 Put payoff nil

101.273

100 100 101 100 = 1

98.743

97.502 101 97.502 = 3.498

u = exp( . 250 ½) = 1.01273

The risk neutral probability of an upstep is

e0.016% 0.98743
q =
1.01273 0.98743

= 0.50316

The value of the put option is therefore

e 2 0.016%(0.50316(1 0.50316) 2 1 + (1 - 0.50316)2 3.498)

= 1.3635

Page 9
 Subject CT8 (Financial Economics Core Technical) April 2006 Examiners Report

(ii) (a)

0
(2)

Delta

(1)
1.0
0 100 200

(b) Key feature:

Delta is negative as the value of a put option falls when share price
rises.

(1) When the share price is very low the value is almost 100
therefore delta is almost 1.

(2) When share price is high the value is almost nil therefore delta
is almost nil.

(iii) Price of call option

=e 2 0.016%(0.503162 1.562) = 0.3953

(iv) Put call parity means for all time t < T, then

ct + ke r(T t) = pt + s t

ct = call option with exercise price k and expiry T

pt = put option with exercise price k and expiry T

Page 10
Subject CT8 (Financial Economics Core Technical) April 2006 Examiners Report

Consider

A one call plus cash of ke (T t)

B one put plus share

At expiry if ST > K then portfolio A is worth ST as is portfolio B.

If ST K then portfolio A is worth k as is portfolio B.

By the principle of no arbitrage since the payoffs are identical at time T the
value of the portfolios must be identical at time t < T.

(v) Put call parity gives

ct = 1.374 + 100 101e 0.016% 2

= 0.4063

This is not equal to the value above because the binomial model is a discrete
time approximation to a continuous model. Therefore, the difference in value
is due to discretisation error.

(vi) Share price

99.562
9.562
101.273

100 97

98.743

94.502

Call option

If the call option is held to expiry it will be worthless as it will expire

underwater.

If the option holder exercise at day 1 when the share price has risen they will
have a positive gain. Therefore, exercising early, if the share price has risen
will be advantageous.

Page 11
 Subject CT8 (Financial Economics Core Technical) April 2006 Examiners Report

Put option

It is clear that it is not advantageous for the option holder to exercise early as
follows:

If share price is 101.273 then gain = nil.

If the option is held to expiry there is a positive gain.
If the share price is 98.743 the gain is 2.257.
If held to expiry the gain must be at least 101 97 = 4.

END OF EXAMINERS REPORT

Page 12
Faculty of Actuaries Institute of Actuaries

EXAMINATION

8 September 2005 (am)

Subject CT8 Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. Mark allocations are shown in brackets.

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

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.

Faculty of Actuaries
CT8 S2005 Institute of Actuaries
1 An investor is contemplating an investment with a return of £R, where:

R = 300,000 500,000U

where U is a uniform [0, 1] random variable.

Calculate each of the following four measures of risk:

(a) variance of return

(b) downside semi-variance of return

(c) shortfall probability, where the shortfall level is £100,000

(d) Value at Risk at the 5% level [8]

2 A market consists of three securities A, B and C with capitalisations of £22bn, £33bn

and £22bn respectively. Annual returns on the three shares (RA, RB and RC) have the
following characteristics:

Asset Standard deviation

A 40%
B 20%
C 10%

The expected rate of return on the market portfolio is 22.86% p.a.

The correlation between the returns on each pair of distinct securities is 0.5.

The risk-free rate of return is 3.077% p.a. No adjustments to an investor s portfolio

are possible within the year.

(i) Prove that the expected returns on A, B and C are 40%, 20% and 10%
respectively if the CAPM is assumed to hold. [9]

(ii) Derive a single index model (with the index equal to RM, the random return on
the market portfolio) with the same expected returns and variances as in the
CAPM. You are required to calculate the values of all parameters in the model.
[4]

(iii) Prove that this single index model is not completely consistent with the CAPM
model. [3]
[Total 16]

CT8 S2005 2
3 (i) Define in words , , , , , and for an individual derivative. [6]

(ii) Explain how and can be used in the risk management of a portfolio that is
delta-hedged. [4]
[Total 10]

4 (i) State the assumptions underlying the Black-Scholes option pricing formula
and discuss how realistic they are. [6]

An investment bank has written a number, N, of European call options on a non-

dividend paying stock with strike price 200p, current stock price 180p, time to expiry
of six months and an assumed continuously-compounded interest rate of 3% p.a. The
bank is delta-hedging the option position assuming the Black-Scholes framework
holds and currently holds 250,000 shares of the stock and is short £413,057 in cash.

(ii) By using the hedging position and the Black-Scholes formula for the value of
the option, derive two equations satisfied by N and , the bank s assumed
volatility. [3]

(iii) Estimate by interpolation. [5]

(iv) Deduce the value of N. [1]

[Total 15]

5 A binomial model for a non-dividend-paying security with price St at time t is as

follows: the price at time (t + 1) is either St (down-jump) or St (up-jump). £1 held
in cash between times t and t + 1 receives interest to become £(1 + r) at time t + 1.
The parameters satisfy > 1 + r > .

A derivative security with price X has the following payoff at time t + 1:

Xt+1 = b if St+1 = St
= a if St+1 = St

A portfolio of cash (amount y) and stock (value x) at time t exactly replicates the
payoff of the derivative at time t + 1.

(i) Derive expressions for x and y in terms of b, , a, and r. [3]

(ii) Derive an expression for q in terms of (x + y), a, b and r, where q is the

risk-neutral probability of an up-jump. [2]

(iii) Suppose that r = 0%. Two derivatives each have a payoff of a if St+1 = St,
but the first derivative pays 2a and the second 3a if St+1 = St. The price at
time t of the first derivative is 10. Derive an expression, in terms of a, for the
price at time t of the second derivative. [3]
[Total 8]

CT8 S2005 3 PLEASE TURN OVER

6 (i) Explain why, in the absence of arbitrage, the forward price for a forward
contract on one share (over a period where no dividends are payable) is S0ert,
where S0 is the initial price of the share, r is the continuously-compounded
risk-free rate of interest and t is the time to delivery of the contract. [4]

(ii) Determine a fair (forward) price for a forward contract on a share (currently
priced at £10) with delivery in 20 months when the share pays a dividend of
3% of the share price every six months, the continuous risk-free rate is 7% p.a.
and the next dividend is due in one month s time.
[You may assume that dividends are immediately re-invested.] [5]
[Total 9]

7 Consider the following discrete time models for (log) share prices and (log) dividend
yields:

ln St+1 = lnSt + + Zt+1

ln Dt+1 = ln + (lnDt ln ) + Wt+1,

where

St = share price at time t

Dt = dividend yield at time t,

Wt and Zt are both serially uncorrelated standard normal random variables but are
correlated with each other and , , and are positive parameters and 0 < < 1.

The unit of time in this model is a month.

(i) Explain the magnitude and sign of the correlation coefficient you would
expect between Zt and Wt . You do not have to calculate the correlation
coefficient or derive an expression for it. [2]

(ii) State two properties of the dividend yield model and comment on their
realism. [2]

(iii) State three properties of the share price model and comment on them relative
to empirical evidence and, if relevant, the efficient markets hypothesis. [3]
[Total 7]

CT8 S2005 4
8 Suppose that under the unique Equivalent Martingale Measure, Q, for a term structure
model, the SDE satisfied by the instantaneous interest rate r is

drt = ( rt) dt + dZt,

where > 0, and are fixed parameters and, under Q, Z is a standard Brownian
Motion.

The process X is defined by

t
Xt = rt b(T t) r ds,
0 s

where the function b is given by b(s) = (1 e s) / .

The function f is given by f(x, t) = exp(a(T t) x), where a is a differentiable

function.

(i) Apply Ito s formula to f(Xt, t). [6]

[Hint: First show that dXt = Atdt + BtdZt where At = b(T t) and Bt = b(T t)]

(ii) (a) Find a differential equation which the function a must satisfy for
f(Xt, t) to be a martingale.

(b) Determine an additional condition on a which is necessary for a bond

with unit payoff at time T to have a price given by the formula

t
B(t, T) = f(Xt, t) exp r ds . [4]
0 s
[Total 10]

9 The following model has been suggested for the short term interest rate at time t, rt:

drt = rt dt + rt dZt

where and are fixed parameters and Zt is a standard Brownian motion.

(i) Outline three properties of this model and comment on their desirability. [3]

(ii) Outline the properties of the following two models for interest rates:

(a) the one-factor Vasicek model

(b) the Cox-Ingersoll-Ross model
[3]
[Total 6]

CT8 S2005 5 PLEASE TURN OVER

10 (i) Describe four examples of tests that have been done to assess informational
efficiency in stock markets. [4]

(ii) Explain to what extent the results of such tests should affect the assessment of
the validity or otherwise of the efficient markets hypothesis. [3]

(iii) Explain what an efficient portfolio is in the context of modern portfolio

theory, being careful to include a description of what is assumed about
investors. [4]
[Total 11]

END OF PAPER

CT8 S2005 6
Faculty of Actuaries Institute of Actuaries

EXAMINATION
September 2005

Subject CT8 Financial Economics

Core Technical

EXAMINERS REPORT

Faculty of Actuaries
Institute of Actuaries
 Subject CT8 (Financial Economics Core Technical) Sept 2005 Examiners Report

1 (i) Var(R) = 500,0002 Var(U) = 2.5 1011 1/12=2.08333 1010

(ii) Downside semi-variance of R = 2.5 1011 upside semi-variance of U; the

upside semi-variance of U is by symmetry 1/24 so downside semi-variance of
R is 1.04166 1010.

(iii) P(R < 100,000) = P(U > 0.4) = 0.6

(iv) If VaR5%(R) = t then P(R t) = 0.05, so

P(300,000 500,000U t) = P(U > 0.6 + (t / 500,000)) = 5%,

hence (since P(U > x) = 1 x), 0.4 (t / 500,000)) = 0.05, so

t = 500,000 (0.35) = 175,000.

2 (i) The market portfolio is (2/7, 3/7, 2/7), so

RM = (2RA + 3RB + 2RC) / 7.

Thus

Cov(Ri, RM) = [2 Cov(Ri, RA) + 3Cov(Ri, RB) + 2 Cov(Ri, RC)] / 7.

So,

Cov(RA, RM) = [.32 + .12 + .04] / 7 = .06857

Cov(RB, RM) = 0.22/7 = .03143,

and

Cov(RC, RM) = .09/7 = .01286,

and

2
M = [2 Cov(RM, RA) + 3 Cov(RM, RB) + 2 Cov(RM, RC)] / 7 = .03674.

We conclude that A = 1.8664, B = 0.8555 and C = 0.3500.

Finally, solving

ri r0 = i(rM r0), we get rA = 0.4, rB = 0.2 and rC = 0.1.

Page 2
 Subject CT8 (Financial Economics Core Technical) Sept 2005 Examiners Report

(ii) The corresponding single index model is

Ri = (1 i) r0 + i RM + i

where the i s are uncorrelated with each other and with RM, and i has
variance equal to

2 2
Var(Ri) i M ,

so that, setting

2 2 2 2
Var( i) = i, A = 0.0320, B = 0.0131 and C = 0.0055.

(iii) The single index model is not the same as the CAPM model because
the covariances of asset returns are different in the two models: in the
single index model

2
Cov(Ri, Rj) = i j M,

so for example we would obtain

Cov(RA, RB) = 0.0587,

whereas in the CAPM model

Cov(RA, RB) = 0.04.

3 (i) Delta: the rate of change in derivative price with respect to change in the price
of underlying asset.

Gamma: the rate of change of delta with respect to change in the price of
underlying asset.

Theta: the rate of change in the value of the derivative with respect to change
in time to expiration.

lambda: the rate of change in the value of the derivative with respect to change
in the assumed continuous dividend yield on the underlying asset.

rho: the rate of change in the value of the derivative with respect to change in
the risk-free rate of interest.

vega: the rate of change in the value of the derivative with respect to the
(assumed) volatility of the underlying asset.

Page 3
 Subject CT8 (Financial Economics Core Technical) Sept 2005 Examiners Report

(ii) Assuming that the portfolio under management is delta hedged at discrete
times, the two most important Greeks are gamma and vega. Between
rebalancing at the trading times, delta will drift away from zero as the
underlying asset prices move. If the portfolio is gamma-hedged at the discrete
trading times then the amount of such drift will be small (comparable to the
square of the change in underlying price).

The underlying volatilities used in hedging calculations are all estimates. If

these are incorrect then delta hedging may be incorrect, consequently it is
appropriate to attempt to immunise a portfolio against (small) errors in
volatility estimates. Just as in delta hedging, achieving a portfolio vega of
zero achieves this. Consequently, good risk managers will seek to achieve a
(close to) zero vega for the bank s portfolio.

4 (i) No frictions; short-selling permitted; small investor (i.e. does not move the
market ); market is arbitrage-free; stock price is given by

dSt = tSt dt + St dZt

where Z is a standard Brownian motion.

All are, in some sense, implausible. Friction (spreads and commission) is

present; short-selling is available but on very different terms; small investor
not true for an investment bank; stock-market returns are not compatible with
normality (fat tails, jumps); arbitrages occur (for short periods).

(ii) Let N be the number of options written, then N (d1) = 250,000. Now the
value of the bank s portfolio is

1.8 N (d1) 2e .015 N (d2) = 1.8 250,000 413,057 = 36,943

(iii) So (d2) / (d1) = 413,057/ (250,000 2e .015) = 0.8386.

With = 10%: d1 = 1.2425, d2 = 1.3132, (d1) = .1070, (d2) = .0946

so (d2) / (d1) = 0.8841

With = 30%: d1 = .3199, d2 = .5320, (d1) = .3745, (d2) = .2974

so (d2) / (d1) = 0.7941

Page 4
 Subject CT8 (Financial Economics Core Technical) Sept 2005 Examiners Report

Linear interpolation gives an estimate of

10 + 20(.8841 .8386) / (.8841 ) = 20.1%

for the implied volatility.

(iv) Consequently,

N = 250,000 / (d1) = 874126 contracts.

5 (i) Consider an investment of x in the stock and y in cash at time t: the value of
the holding at time t + 1 is

x + y(1 + r),

if there is an up-jump and is

x + y(1 + r),

if there is an down-jump. The value (with t = 0) is supposed to be b in the first

case and a in the second. So, we need to solve:

x + y(1 + r) = b, (1)

x + y(1 + r) = a, (2).

Subtracting (2) from (1) we get:

x = (b a) / ( ) and

y = (a b )/( )(1 + r)
(ii) x + y = Xt = [qb + (1 q)a](1 + r) 1

=> q(b a) + a = (x + y)(1 + r)

=> q = [(x+ y)(1+ r) a] / (b a) (3)

(iii) Using (3), we see from the first derivative that q = (10/a) 1, while, from the
second we see that q = (c2/2a) 1/2, so we deduce that c2 = 20 a.

Page 5
 Subject CT8 (Financial Economics Core Technical) Sept 2005 Examiners Report

6 (i) Consider a portfolio which is, initially, short one forward contract, holds 1
share and is short c in cash. At the delivery date for the forward contract, the
portfolio contains 1 share and is short cert, where r is the risk free rate and t is
the duration of the contract.

So, immediately after delivery the portfolio contains zero shares and is short
cert p in cash, where p is the forward price.

Setting c = pe rt, the portfolio contains nothing. It follows that the portfolio
should have a zero set-up cost so, so p = S0ert.

(ii) Consider a portfolio which is, initially, short one forward contract, holds s
shares and is short c in cash. At each dividend date the dividend is used to buy
more shares. At the delivery date for the forward contract, the portfolio
contains 1.034s shares and is short cert, where r is the risk free rate and t is the
duration of the contract.

So, immediately after delivery the portfolio contains 1.034s 1 shares and is
short cert p in cash, where p is the forward price.

Setting s = 1 / 1.034, and c = pe rt, the portfolio contains nothing. It follows

that the portfolio should have a zero set-up cost so 0 = c 10s, so
p = 10sert = £9.98.

7 (i) We expect a strong negative correlation.

Dividend yield = dividend/price so if there is a strong price rise it s likely to

be accompanied by a decrease in yield.

(ii) Mean-reverting: this is in line with historical evidence in most markets.

Non-negative: dividend yield cannot be negative.

(iii) Not mean-reverting: consistent with weak form EMH. Empirical evidence is
mixed.

Constant volatility: this is inconsistent with empirical evidence

Normal distribution: markets jump and returns have fat tails, so inconsistent
with empirical evidence.

Page 6
 Subject CT8 (Financial Economics Core Technical) Sept 2005 Examiners Report

8 (i) drt = ( rt) dt + dZt

f(Xt, t) = e a (T t) Xt

t
Now Xt = b(T t)rt + r ds
0 s

dXt = b (T t )rt dt b(T t )drt rt dt

(T t ) (T t )
e rt dt 1 e ( rt )dt

(r t )
rt dt 1 e dZt

(T t ) (T t )
1 e dt 1 e dZt

tdt + BtdZt

Using Ito

f f f 1 2f 2
df(Xt, t) = Bt dZt At Bt dt
x t x 2 x2

= f ( X t , t ) Bt dZt f ( X t , t ) a (T t )dt

1
f ( X t , t ) At dt f ( X t , t ) Bt2 dt
2

1 2
f ( Xt , t) a (T t ) At Bt dt Bt dZt
2

(ii) (a) To be a martingale the [ ] term in (i) must be zero:

1 2
a (T t ) = At Bt
2

1 2 2
= b(T t ) b (T t )
2

(b) B(T,T) = 1 ea (0) rT b (0)

=1

a(0) = 0

Page 7
 Subject CT8 (Financial Economics Core Technical) Sept 2005 Examiners Report

9 (i) This means short term interest rates would in the long term increase if >0
geometrically. This is not desirable as it does not reflect reality.
The model also has the following properties:

The change in rate is dependent on the current rate. This is undesirable as

typical rates mean revert.

The model requires constant volatility over time. This is not desirable as
volatility of short term interest rates changes over time.

(ii) (a) Incorporates mean reversion.

Arbitrage free.
Allows negative interest rates.

(b) Incorporates mean reversion.

Arbitrage free.
Volatility high/low when rates high/low.
Does not allow negative interest rates.
More difficult to implement than Vasicek model

10 (i) Over-reaction tests

past winners tend to be future losers (or vice versa)

certain accounting ratios appear to have predictive power (e.g. BV/MV or

E/P)

IPOs and other new offerings have poor subsequent performance

Under-reaction

stock prices react slowly to earnings announcements

abnormal excess returns for parent/subsidiary following a demerger
abnormal negative returns following mergers

(ii) Over-reaction or under-reaction to the arrival of public information would

appear to contradict
the semi-strong form of the EMH since excess returns could be earned.

However, some of the tests (such as accounting ratios) may not allow properly
for risk and the results are therefore not incompatible with the EMH.

Many of these tests appear to be time-period specific.

Page 8
Subject CT8 (Financial Economics Core Technical) Sept 2005 Examiners Report

(iii) Assume that investors are non satiated (always prefer more expected return to
less) and risk averse (in the sense of wanting to avoid volatility of returns).

An efficient portfolio is one with the highest expected return for a given level
of volatility and the lowest volatility for the expected return.

END OF EXAMINERS REPORT

Page 9
Faculty of Actuaries Institute of Actuaries

EXAMINATION

7 April 2005 (am)

Subject CT8 Financial Economics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

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

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

3. Mark allocations are shown in brackets.

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

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

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

In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.

Faculty of Actuaries
CT8 A2005 Institute of Actuaries
1 An investor holds a portfolio consisting of N assets in equal proportions.

Derive an expression for the variance of the portfolio as N gets very large.

[You may assume that all assets have variance less than a certain level Vmax. You may
also assume that the average covariance is c .]
[6]

2 An investor wishes to measure the investment risk presented by an asset which has the
following distribution:

State Return Probability

1 10% 0.5
2 20% 0.3
3 50% 0.2

(i) Evaluate three different measures of investment risk for this asset. Where
necessary, you may assume a benchmark return of 25%. [4]

(ii) (a) State two key properties of Value at Risk (VaR).

(b) VaR is frequently calculated assuming a normal distribution of returns.

State an advantage and a disadvantage of this approach.
[2]
[Total 6]

3 An investor has the choice of the following assets that earn rates of return as follows
in each of the four possible states of the world:

State Probability Asset 1 Asset 2 Asset 3

1 0.2 5% 5% 6%
2 0.3 5% 12% 5%
3 0.1 5% 3% 4%
4 0.4 5% 1% 7%

Market capitalisation 10,000 17,546 82,454

Determine the market price of risk assuming CAPM holds.

Define all terms used. [6]

CT8 A2005 2
4 Let Ri denote the return on security i given by the following multifactor model

Ri = ai + bi,1 I1 + bi,2I2 + + bi,LIL + ci

ai and ci are the constant and random parts respectively of the component of the return
unique to security i.

I 1, IL are the changes in a set of L indices.

bi,k is the sensitivity of security i to factor k.

(i) State the category of the above model where:

(a) index 1 is a price index

index 2 is the yield on government bonds
index 3 is the annual rate of economic growth

(b) index 1 is the level of Research and Development expenditure

index 2 is the price earnings ratio
[2]

(ii) Determine the number of parameters to be estimated in a single index model

and in a multifactor model. [4]
[Total 6]

5 The following unusual model has been proposed for the (real-world) stochastic
behaviour of the short term interest rate:

drt = rt dt + dZt,

where > 0 and are fixed parameters and Z is a standard Brownian motion under
the proposed real-world measure P.

Under the same measure P, a (zero coupon) bond with maturity T has price at time t
B(t, T) = exp( (T t) rt + 2(T t)3/6).

(a) Derive the SDE satisfied by B(t, T).

(b) Determine the market price of risk and deduce the corresponding SDE for r,
under the risk neutral measure Q.
[7]

CT8 A2005 3 PLEASE TURN OVER

6 One particular company over which an investment bank writes European call options
has experienced a severe fall in its share price. However, analysts have not revised
their expectation that the share price will grow to £4 in six months. The table below
shows the share price together with the price of the options.

Date Share price Option price

1 November £3.00 £0.90

2 November £2.00 £0.60

You may assume that the basic Black-Scholes framework is used to price the options.

(i) Explain why the option price has fallen even though the expected return has
increased according to the analysts. [3]

(ii) State any requirements for the option price to have fallen to its level on 2
November. [3]
[Total 6]

7 (i) Outline the approach adopted by Shiller to test for excessive volatility and
state the criticisms of his work. [7]

(ii) State one difficulty of testing the strong form of the efficient market
hypothesis and state the general conclusion of studies carried out on it. [2]
[Total 9]

8 (i) State the martingale representation theorem, including conditions for its
application, defining all terms used. [3]

Let St denote the price of an underlying security at time t; r denotes the risk free rate
of return expressed in continuously compounded form, Bt represents an accumulated
bank account at time t that earns the risk free rate of return.

Let X be any derivative payment contingent on FT, payable at some fixed future time
T, where FT is the sigma algebra generated by Su for 0 u T.

You may assume that, under the equivalent measure Q, the process

Dt = e rt St is a martingale

and that

dSt = Bt(rDtdt + dDt)

(ii) Show that the value of this derivative at time t < T is

Vt = e r(T t) EQ[X Ft] [11]

[Total 14]

CT8 A2005 4
9 (i) Describe the role that the inflation model plays within the Wilkie model. [3]

The Wilkie model proposes an AR(1) process for the continuously compounded rate
of inflation I(t) that can be written as:

I(t) = a + bI(t 1) + (t)

Where (t) ~ N(0, t2) and a and b are constants with 1 < b < 1.

(ii) Derive an expression for the long term average rate of inflation in terms of a
and b. [1]

(iii) Explain why a model of the form above would not be suitable for share prices.
[3]

(iv) Explain why a lognormal model may be used for share prices and state its
weaknesses. [8]
[Total 15]

10 An investment bank has issued a derivative on a share (with share price, S, of 100)
that provides for the following payoff after two months:

F(S) = ln(S 90) if S > 90

= 0 otherwise

You may assume that:

There exists a risk free asset that earns 5% per month, continuously compounded.
The expected effective rate of return on the share is 2% per month.
The monthly standard deviation of the log share price is 10%.

(i) By using a two period recombining model of future share prices, derive the
state price deflators at time 2. The parameters determining the share price
after an up-jump and down-jump should be determined by considering the
standard deviation of the log share price. [9]

(ii) Using the state price deflators from (i) derive the value at time zero of the
option. [3]

The delta of this derivative at time zero is 7% and the gamma is 10%. The bank
which issued the derivative wishes to delta hedge its position in the most efficient
manner. Assume that the share price can also be modelled in continuous time with a
geometric Brownian motion with volatility (diffusion parameter) of 0.1 consistent
with a Black-Scholes framework.

(iii) Determine the delta hedging portfolio, as a combination of the risk free asset,
the underlying share, and a European Call option on the share with term of
3 months and exercise price of 100. [13]
[Total 25]

END OF PAPER

CT8 A2005 5
Faculty of Actuaries Institute of Actuaries

EXAMINATION
April 2005

Subject CT8 Financial Economics

Core Technical

EXAMINERS REPORT

Introduction

The attached subject report has been written by the Principal Examiner with
the aim of helping candidates. The questions and comments are based around
Core Reading as the interpretation of the syllabus to which the examiners are
working. They have however given credit for any alternative approach or
interpretation which they consider to be reasonable.

M Flaherty
Chairman of the Board of Examiners

15 June 2005

Faculty of Actuaries
Institute of Actuaries
 Subject CT8 (Financial Economics Core Technical) April 2005 Examiners Report

1 Let Vi denote the variance of the ith asset.

Cij denote the covariance of the ith and jth assets (i j).

The variance of the investor s portfolio is therefore

1 1
V= 2
Vi Cij
i N i j i N2

1 1
Let V = Vi , and c = Cij
N N ( N 1) i j i

1 ( N 1)
V = V c
N N

As N

1 1 1
V 0 because V Vmax
N N N

1
and Vmax 0 as N
N

therefore V c as N

2 (i) The mean return is 0.1 0.5 + 0.2 0.3 + 0.5 0.2 = 21%

Variance of return

(0.1 0.21)2 0.5 + (0.2 0.21)2 0.3 + (0.5 0.21)2 0.2 2.29%%

Semi variance of return

= (0.1 0.21)2 0.5 + (0.2 0.21)2 0.3 = 0.608%%

Shortfall probability

50% + 30% = 80%

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 Subject CT8 (Financial Economics Core Technical) April 2005 Examiners Report

(ii) (a)
It is a statistical measure of downside risk.
It assesses the potential minimum loss over given time with given
degree of confidence.

(b) Advantage: normal distribution is easy to manipulate to calculate VaRs

based on only two parameters.
Disadvantage: results may be misleading with skewed or fat tailed
distribution.

3 The market price of risk is (Em r)/ m where asset 1 is the risk free asset so r = 5%.

Em = (17,546/100,000) (0.2 5% + 0.3 12% + 0.1 3% + 0.4 1%)

+ (82,454/100,000) (0.2 6% + 0.3 5% + 0.1 4% + 0.4 7%)

= 5.79472%

2
m = 0.2 (0.17546 5% + 0.82454 6% 5.79472%)2

+ 0.3 (0.17546 12% + 0.82454 5% 5.79472%)2

+ 0.1 (0.17546 3% + 0.82454 4% 5.79472%)2

+ 0.4 (0.17546 1% + 0.82454 7% 5.79472%)2

= 0.000045402

= (0.674%)2

market price of risk is (5.79472% 5%) / 0.674%

= 1.179 = 118%

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 Subject CT8 (Financial Economics Core Technical) April 2005 Examiners Report

4 (i) (a) Macroeconomic.

(b) Fundamental.

(ii) The single index model requires the return on the market, plus
for each security: i, i and i .

Therefore 3N + 1 data items are required

The multifactor model requires:

L means of indices (Note: some candidates may assume that they

have 0 mean, which is acceptable.)

L( L 1)
covariances
2

N ai s

NL sensitivities

N standard deviations of ci

L( L 3)
Therefore N ( L 2) data items are required
2

5 (a) B(t, T) = f(rt, t), where

f(x, t) = exp( (T t)x + 2(T t)3 / 6),

so, by Ito s lemma,

dB(t, T) = B(t, T)(( 2(T t)2 / 2 (T t) rt + rt 2(T t)2 / 2)dt

(T t)dZt)

= B(t, T)(( (T t) rt + rt)dt (T t)dZt)

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 Subject CT8 (Financial Economics Core Technical) April 2005 Examiners Report

(b) The market price of risk is

(t, T) = (m(t, T) rt) / S(t, T),

where

dB(t, T) = B(t, T)(m(t, T)dt + S(t, T) dZt ), so (t, T) = / rt

and so under the risk-neutral measure, Q, drt = dWt , where W is a standard

BM under Q.

6 (i) Options are priced by relative valuation techniques (i.e. risk neutral
valuation).

This approach is equivalent to building a hedging strategy for the option and
does not take account of the expected return on the share. Since the hedging
strategy involves holding some shares, the drop in price will result in a drop of
the value of the option even though the expected future share price has
remained the same.

(ii) Unless the option is deep in the money, the drop in price of the option will be
less than proportional to the share price and hence some combination of the
following must also have occurred:

dividends increased
share price volatility decreased
risk free interest rate decreased

7 (i) Shiller used a discounted cashflow model of equities going back to 1870.

A perfect foresight price was determined using actual dividends paid and a
terminal value for the stock.

If markets are rational there would be no systematic forecast errors (i.e. error
between the perfect foresight price and the actual price).

If markets are efficient, the perfect foresight price matches with share price.

Strong evidence was found that contradicted the EMH.

Criticisms of terminal stock price.

Choice of constant discount rate.
Bias in estimates of variance because of autocorrelation.
Non-stationarity of the series.

(ii)

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 Subject CT8 (Financial Economics Core Technical) April 2005 Examiners Report

Researchers require access to information that is not in the public domain.

Studies suggest that it is difficult to out perform with inside information.

8 (i) Suppose Xt is a martingale with respect to a measure P, that is for any t < s

EP[Xs Ft] = Xt

and that the volatility of Xt is always non-zero.

Suppose Yt is another martingale with respect to P.

Then, there exists a unique previsible process t such that

t
Yt = Y0 + s dX s
0

Or equivalently dYt = t dXt

Full credit for either integral or differential form above.

(ii) Let Et = e rTE [X F ] = e rtVt, which is a martingale with respect to Q.

Q t

Using the martingale representation theorem, there exists a unique previsible

process t such that

dEt = tdDt

Let t = Et tDt

Suppose that at time t we hold

tunits of asset St
t of cash Bt

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 Subject CT8 (Financial Economics Core Technical) April 2005 Examiners Report

The value of the portfolio at time t is

t St + tBt = Vt

over the period t to t + dt the change in the value of the portfolio is

tdSt + tdBt

tdSt + tdBt = tBt(rDtdt + dDt) + trBtdt

= Bt[ tdDt + r( tDt + t)dt]

= Bt[ tdDt + rEtdt]

= Bt[dEt + rEtdt]

= BtdEt + EtdBt + dBt dEt

= dVt

Therefore ( t, t) is self financing

VT = EQ[X FT] = X, therefore ( t, t) is replicating so Vt is the value of the

claim.

9 (i) The Wilkie model can be described as a cascade or hierarchical model, with
inflation being the key component. Variations of dividend yields, growth and
interest rates are affected by shocks in the inflation model and moving
averages of past inflation.

(ii) I = a + bI

a
I =
1 b

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 Subject CT8 (Financial Economics Core Technical) April 2005 Examiners Report

(iii)
AR process is stationary, share prices have tended to increase over time.

AR(1) implies a systematic element to the changes in prices which is

inconsistent with high risk and return.

Non-normality, jumps in share prices.

Prices can be negative.

(iv) Log-normal distribution makes the maths for option pricing simple (i.e.
tractable solutions).

Returns in non-overlappng periods are independent, which is consistent, with

the EMH, for example.

It does not allow negative share prices.

Mean and variance are proportional to time period.

Weaknesses:

The variance may not be stable over time.

The mean (drift) may not be constant over time.
Share prices may be considered to be mean-reverting.
Share prices exhibit jumps.

10 (i) u = exp(0.1) = 1.10517

d = 1/1.10517 = 0.904837

122.14 (1)
110.52

100 100 (2)

90.48
81.87 (3)

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Subject CT8 (Financial Economics Core Technical) April 2005 Examiners Report

Since the real world expected return is 2% per month, we can derive the real
world probability of an up-jump

102 = p 110.52 + (1 p) 90.48

(102 90.48)
p= = 57.5%
(110.52 90.48)

The risk neutral probability of an up-jump is

e5% 0.904837
q= = 73.1%
1.10517 0.904837

The state price deflator A2 at time 2 is defined as follows:

Node

2
0.1 q
(1) e = 1.4624
p

0.1 q 1 q
(2) e = 0.72809
p 1 p

2
0.1 1 q
(3) e = 0.36249
1 p

(ii) The value is EP[A2 f (S2)] where S2 is the share price at time 2.

= (57.5%)2 1.4624 log(32.14) + 2 57.5% (1 57.5%) log (10)

0.72809

= 2.4972

(iii) The value of the European call option is

V = 100 (d1) 100e 0.05 3 (d2)

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 Subject CT8 (Financial Economics Core Technical) April 2005 Examiners Report

100
log (0.05 ½0.12 ) 3
Where d1 = 100 = 0.95263
0.1 3

100
log (0.05 ½0.12 ) 3
d2 = 100 = 0.7794256
0.1 3

Therefore value is

100(0.829611) 100e 0.05 x 3 0.7821347

= 15.642

The delta of the European Call option is given by

S 2
log (r ½ )t
= (d1) where d1 = K
t

= 0.95263

= 0.82961

The gamma of the European call option is given by

2
(d1 ) (0.95263) 1 e ½ 0.95263
= = = .
s t 100 0.1 3 2 100 0.1 3

= 1.46%

Clearly the risk free rate has nil delta and gamma.

The underlying share has = 1 and = 0. Therefore, equating

delta 0.07 = 1.x2 + 0.82961x3

gamma 0.10 = 0.0146x3

and value 2.4972 = 1.x1 + 100x2 + 15.642x3

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Subject CT8 (Financial Economics Core Technical) April 2005 Examiners Report

Solving these three equations in three unknowns gives

0.1
x3 = = 6.8493
0.0146

0.07 = x2 + 0.82961 6.8493

x2 = 5.6123

2.4972 = x1 + 100 5.6123 + 15.642 6.8493

x1 = 456.59

Therefore

hold 456.59 in risk free asset

sell 5.6123 of underlying share
hold 6.8493 European Call option

END OF EXAMINERS REPORT

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