ACTL 3182/ 5109

Asset-Liability and Derivatives Models

Financial Economics for Insurance and Superannuation
Mid Session Exam
September 7, 2015
Time Allowed: 60 minutes
Total Marks: 60 marks
Total Assessment credit: 20%

Read through the following information carefully. You can only go to the
next page when told to do so.
This class test consists of five problems requiring short-written answers.
Marks allocated for each problem are as indicated. You may use your own
calculator for this exam.
Candidates may bring the text FORMULAE AND TABLES FOR ACTUARIAL EXAMINATIONS (ANY EDITION) into the examination. It
must be wholly unannotated.
You can only start writing down your solutions and answers when told to
do so
Answer the problems you are most confident with first.
Anyone writing after time has expired will be given a mark of zero.

GOOD LUCK!

Question 1 [9 marks]

Clearly define (either mathematically, or graphically) and briefly explain the

main differences between the following risk measures:
Variance
Semi-Variance
Value-at-Risk

Question 2 [9 marks]

It is known that CAPM holds, and the market portfolio has an expected
return of 12% and standard deviation of 25%. The expected return of security
1 is 7%, and the expected return of security 2 is 11%. In addition, security 2
has a standard deviation of 22%.
A portfolio investing 50/50 in these two securities is known to have a beta
of 0.6. According to CAPM, what is the specific risk of security 2?

Question 3 [10 marks]

Suppose that stock returns follow the following single factor model
ri = i + i f + i
where f represents the rate of economic growth in the economy.
You may assume that the assumptions behind Arbitrage Pricing Theory
hold. In particular, you may assume that the universe of securities is large, and
that there is a constant S such that 2i S 2 for all stocks i. It is known that,
for assets without residual risk (i.e. stocks with j = 0 then APT states that
E[rj ] = rf + i
where rf is the risk free rate, and is the risk premium associated with the
economic growth.
Define a well diversified portfolio, and hence derive an expected returns
relationship that will be satisfied by any well diversified portfolio.
2

Question 4 [13 marks]

There are N risky assets available for investment. Denote z as the vector of
expected returns for these N assets, and as the associated variance-covariance
matrix. There is no riskless asset available, and an individual is interested in
finding the portfolio that minimizes the variance. Recall that for a portfolio
with weights w the mean of the porfolio is w0 z, and variance is w0 w.
(a) Form the Lagrangian associated to this optimization problem, and hence
find the weights associated to this portfolio. (10 marks)
(b) Briefly explain the importance (or otherwise) of the global minimum variance portfolio to the two fund theorem in mean-variance portfolio optimization. (3 marks)
Note: You may find some of the the following definitions convenient
A = 10 1
B = 10 z
C = z 0 z
F = 10
and recall the following differentiation rules
(w0 w)
= 2w
w
(k0 w)
=k
w
for some n by 1 vector k.

Question 5 [8 marks]

Briefly outline in point form the pros and cons of using a factor model to
specify the parameters in a mean-variance optimization model, as opposed to
using a simple sample moments approach. (Note - no proof is required)

Question 6 [11 marks]

Jane is considering investing into a combination of stocks and bonds. Her

time horizon is one year.
The bond will earn an interest rate of r (effective) over the period
The stock, with current value s, will either be su with probability p and
sd with probability 1 p, with u, d constants satisfying d < 1 + r < u.
Janes decisions can be modelled by the log utility function, i.e. u(W ) = ln(W ).
Let be the units of stock she buys. Her current wealth is w.
(a) Show that her objective is to maximize
p ln s(u (1 + r)) + w(1 + r)) + (1 p) ln(s(d (1 + r)) + w(1 + r))
(7 marks)
(b) The optimal proportion of wealth she should invest in the stock can be
shown to be
(1 + r)E[ S(1)
s ] (1 + r)
((1 + r) d)(u (1 + r))
which is independent of her current wealth. Briefly explain why this result
is not surprising given the assumptions on her preferences. (4 marks)