CM2A MOCK 7 ACTUATORS EDUCATIONAL INSTITUTE

CM2A
MOCK 7

FINANCIAL ENGINEERING AND

LOSS RESERVING
MOCK EXAM FOR 2023
CA PRAVEEN PATWARI 1 JAI SHREE RAM
CM2A MOCK 7 ACTUATORS EDUCATIONAL INSTITUTE

CM2: MOCK EXAM 7— PAPER A QUESTIONS

1. An insurance company will be required to make a payout of £500 on a particular risk event, which is
likely to occur with a probability of 0.4. The utility for any level of wealth, w, is given by:

U(w) =4,000 + 0.5w

The insurer's initial level of wealth is £6000. Calculate the minimum premium the insurer will require
in order to take on the risk. [3]

2. £200 is invested for 12 years. In any year the yield on the investment will be 3% with probability 0.25,
5% with probability 0.6 and 6% with probability 0.15, and is independent of the yield in any other
year.

(i) Calculate the mean accumulation at the end of 12 years. [2]

(ii) Calculate the standard deviation of the accumulation at the end of 12 years. [4]

[Total 6]

n
3. A portfolio P consists of n assets, with a proportion x i , invested in asset i, i = 1,2,…,n (so that  x i  1 ).
i 1

(i) The annual returns R p on this portfolio can be assumed to conform to the single-index model of

asset returns. Write down an equation defining this model and show that:

   
var R p  p2 var  R M   var p

where  p denotes the component of the portfolio return that is independent of movements in

the market. [3]

 
(ii) Explain why the specific risk, var  p , is sometimes referred to as the 'diversifiable risk', giving

an algebraic justification for your answer. [4]

(iii) Discuss the following statement:

'A portfolio with a beta of zero is equivalent to a risk-free asset.' [2]

[Total 9]

CA PRAVEEN PATWARI 2 JAI SHREE SHYAM

CM2A MOCK 7 ACTUATORS EDUCATIONAL INSTITUTE

4. 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]

5. An investor has decided to model PPB plc shares using the continuous-time lognormal model. Using his-
torical data, the investor has estimated the annual drift and volatility parameters to be 6% and 25% re-
spectively. PPB's current share price is $2.

(i) Calculate the mean and variance of PPB's share price in one year's time. [3]

(ii) Calculate the probability that:

(a) PPB's shares fall in value over the next year.

(b) PPB's shares yield a return of greater than 30% over the next year.

Assume that no dividends are to be paid over the next year. [4]

[Total 7]

6. A company share price is to be modelled using a 5-step recombining binomial tree, with each step in the
tree representing one day. Each day, it is assumed that the share price:

 increases by 2%, or

 decreases by 1%.

CA PRAVEEN PATWARI 3 JAI SHREE SHYAM

CM2A MOCK 7 ACTUATORS EDUCATIONAL INSTITUTE

Assume that the risk-free force of interest is 𝛿 = 5.5% pa and that there are 365 days in a year.

No dividends are to be paid over the next five days.

(i) Calculate the risk-neutral probability of an up-step on any given day. [2]

(ii) Calculate the fair price of a 5-day at-the-money call option on £10,000 worth of shares in this
company.

A special option is available where the payoff after 5 days is:


max S*5  K, 0
where S*5 is the arithmetic average share price recorded at the end of each of the 5 days and K is

the strike price. [5]

(iii) Calculate the fair price of the special option (strike price K  1.06S0 ) on £10,000 worth ofshares

in this company. [4]

(iv) Explain whether an at-the-money special option is likely to have a higher value of vega than a
standard call option. [3]

[Total 14]

7. An investor buys, for a premium of 187.06, a call option on a non-dividend-paying stock whose current
price is 5,000. The strike price of the call is 5,250 and the time to expiry is 6 months. The risk-free rate of
return is 5% pa continuously compounded.

The Black-Scholes formula for the price of a call option on a non-dividend-paying share is assumed to
hold.

(i) Calculate the price of a put option with the same time to maturity and strike price as the call. [2]

(ii) The investor buys a put option with strike price 4,750 with the same time to maturity. Calculate
the price of the put option if the implied volatility were the same as that in (i).

[You need to estimate the implied volatility to within 1% pa of the correct value.] [7]

[Total 9]

CA PRAVEEN PATWARI 4 JAI SHREE SHYAM

CM2A MOCK 7 ACTUATORS EDUCATIONAL INSTITUTE

8. An exotic forward provides a payoff equal to the square root of the share price at maturity time T less
the square root of the delivery price, K.

(i) (a) Assuming that the Black-Scholes assumptions apply, use risk-neutral pricing toderive a
formula for the price at time t of the forward on a non-dividend-paying share.

(b) Derive the corresponding formula for the vega of the forward. [6]

(ii) (a) Explain why an investor might want to vega hedge their portfolio.

(b) Use the result that St   d1   Ker Tt   d 2   0 , where d1 and d 2 are defined as on page 47

in the Tables, to show that the formula for the vega of a European call option is

 call  St   d1  T  t .. [6]

The current price of the share is $1, which is also the delivery price of the forward. The risk-free
force of interest is 5%, the volatility of the underlying share, which pays no dividends, is 20%
and the forward has one year to delivery.

(iii) An investor has a long position in 1,000 exotic forwards. Find the vega-hedged portfolio for this
position involving standard European call options on the underlying share and also the underly-
ing share itself. [8]

[Total 20]

9. To fund an expansion in its operations, a company has just issued 5-year zero-coupon bonds with a total
face value of £10 million, taking its total asset value up to £15 million.

(i) Explain how the value of the bonds can be expressed in terms of a European put option. [3]

(ii) Hence calculate the fair price of a holding of the company bonds with a face value of £100 using the
Black-Scholes model, given that the price of a 5-year zero-coupon government bond is £77.88. As-
sume that the annualised volatility of the company's assets over the 5-year period is 25%. [4]

(iii) Explain what is meant by a credit spread and calculate its value for the company bonds. [3]

[Total 10]

CA PRAVEEN PATWARI 5 JAI SHREE SHYAM

CM2A MOCK 7 ACTUATORS EDUCATIONAL INSTITUTE

10. Claims occur on a portfolio of insurance policies according to a Poisson process with Poisson parameter
 . Claim amounts, X1 , X 2 ,..., are assumed to be identically distributed with moment generating func-

tion M X  t  . The insurer calculates premiums using a loading factor    0  . The insurer's adjustment

coefficient, R, is defined to be the smallest positive root of the equation:

  cr  MX  r 

where c is the insurer's premium income rate.

(i) Using the above equation for R , or otherwise, show that, provided R is small, an approximation to
R is R , where:

2c /   
R̂ 
2  2

where   E  X i  and  2  var  X i  . [4]

(ii) Describe how the adjustment coefficient can be used to assess reinsurance arrangements on the
basis of security. [3]

(iii) The Poisson parameter,  , for this portfolio is 20 and all individual claims are for a fixed amount of
£5,000. The insurer's premium loading factor,  , is 0.15 and proportional reinsurance can be pur-
chased from a reinsurer who calculates premiums using a loading factor of 0.25.

Calculate the maximum proportion of each claim that could be reinsured so that the insurer's secu-
rity, measured by R̂ , is greater than the insurer's security without reinsurance. [9]

[Total 16]

CA PRAVEEN PATWARI 6 JAI SHREE SHYAM