PAK Mock Exam-QFIC-QUESTIONS-TOTAL-76

PAK 76 MOCK Problems for SOA QFIC Exam (Fall 2014)
PAK 76 MOCK PROBLEMS for QFIC
(Fall 2014)
Notes
Time yourself 3 minutes per 1 answer point
Total Number of Points in the exam (Morning (60%) and Afternoon (40%)).
These 76 MOCK Problems are included in the PAK EXAM AID.
These 76 MOCK Problems are different from the other MOCK problems (11 from the
SM) and the PAK TEST AID.
Should you find any typos, please kindly contact bell.ouelega@pakstudymanual.com or
at bell.ouelega@gmail.com.
© 2014 PAK EXAM AID 1 SOA QFIC Exam (76 Mock Questions)
PART I: LIST OF MOCK QUESTIONS (1-42) BY KEY CONCEPT
PART II: LIST OF MOCK QUESTIONS (43-76) BY KEY CONCEPT
This question pertains to SOA QFIC Objective 6.

Each question should be answered independently.
1. (6 points) You are requested to develop an investment policy statement (IPS) for the
DB Plan of XYZ Life’s Employees’ Pension Plan. You are focusing on the following seven key
components:
a. Risk objective
b. Return objective
c. Liquidity requirements
d. Time horizon
e. Tax concerns
f. Legal and regulatory factors
g. Unique circumstances
For each component above, outline the key factors.
This question pertains to Investment decisions in the presence of liabilities.

2. (6 points) You are looking at an Employees’ Pension Plan and wants to understand
the source of surplus risk. You receive the following data of the pension plan from an executive
of the plan.
Equity Bond
Mean 12% 4%
Standard deviation 20% 5%
Assumptions
o The annual risk-free rate is 2%.

o The duration of the market index is 8.
o The duration of the liabilities is 17.1
o Total liability of 340.2 million and total assets of 321.4 million.
(a) (2 points) Identify the three main drivers that determine a pension’s plan long-term
performance.
(b) (2 points) Calculate the minimum equity allocation needed to prevent the surplus from
shrinking. Comment on the result.
(c) (2 points) Compare the static and dynamic approaches to evaluate investment decisions in
the presence of liabilities.
This question pertains to Arbitrage theory in stochastic interest rate environment

3. (12 points) Consider a two time period investments:
Assume that the current (𝑡1 ) interest rate is known (𝑟𝑡1 ) and future rates are stochastic evolving
according to the tree below:
Furthermore, assume that there are liquid markets for the following instruments:
1. A saving account with no default risk: At time t one can contract the rate (𝑟𝑡 ), and after
an interval (∆), one is paid (1 + ∆𝑟𝑡 ).
2. A forward contract on an interest rate (𝑳𝒕 ): This interest rate (𝐿𝑡 ) is default free.
3. A short-maturity default-free discount bond with time t price (𝑩(𝒕, 𝒕𝟑 )): This bond
pays off one dollar at time (𝑡3 ).
4. A long maturity default free discount bond with time t price B(t,T): This bond pays a
dollar at maturity date T.
5. A FRA contract written on the (𝑳𝒕𝟐 ) that results in payoff [𝑵 × ∆ × �𝑭𝒕𝟏 − 𝑳𝒕𝟐 �] at
time (𝒕𝟑 ): The payment depends on the rate (𝐿𝑡2 ) that becomes known at time (𝑡2 ), but
the proceeds from the FRA are paid at time (𝑡3 ). The notional amount of this FRA
contract is N=1.
6. An interest rate derivative, say a call option written on 𝑩(𝒕𝟏 , 𝒕𝟑 ): The derivative
expires at time (𝑡3 ) and has the current price (𝐶𝑡1 ).
You are asked to:
1. Define the normalization process.
2. Write the matrix equation implied by the fundamental arbitrage theorem for pricing these
6 assets.
3. What is the proceeds of an investment in the “risk-free” saving account under the
assumption that interest rate will move up?
4. What is the arbitrage-free value of the FRA at contract-time?
5. Define the (𝜓 𝑖𝑗 ) in the matrix and state the no-arbitrage condition in this system?
6. Give the equation for the risk neutral probabilities of this system and the implication
under a no-arbitrage condition.
7. Cite two ways in which the current system differs from the traditional setting (Neftci
Chapter 2: A Primer on the Arbitrage Theorem).
8. Calculate the arbitrage-free value of security 3.
9. Determine the expression for the FRA rate at inception under the no-arbitrage condition.
10. List two drawbacks of the traditional approach to the no-arbitrage (risk adjusted measure)
under this system.
11. Propose a normalization algorithm for pricing the securities in this system.
12. Under the new normalization, calculate the expected value of the future LIBOR rate
(𝑳𝒕𝟐 ).
This question pertains to Fixed Income Securities

4. (5 points) A life insurer’s CFO wants to invest the assets of their traditional life (with
substantial dollar duration mismatch) in the following vehicles:
(i) Zero coupon bond

(ii) Floating bond
(iii) Mortgage-backed (pass-through) securities
(a) (3 points) Describe each type of bond above.
(b) (2 points) Assume they all have the same maturity and rating. Evaluate which type of
bond is suitable for minimizing the duration mismatch between assets and
Liabilities (The block of Traditional Life products).
This question pertains to Fixed Income Portfolio Management.

5. (8 points) It is closed to year-end and your company, a portfolio management

company, plans to renew the contract with its client, BCD family fund. Your company has
managed the fixed-income portfolio for BCD family fund for 5 years and the past returns are
listed below:
Portfolio Benchmark
Period Return Return
1 6.00% 5.80%
2 7.00% 7.40%
3 5.40% 5.00%
4 -2.10% -3.50%
5 -3.90% -2.60%
BCD family fund has a list of criteria to evaluate its portfolio managers in its investment policy
statement. One of them is that the tracking error should be no larger than 1%.
(a) (3 points) Compute the tracking error and comment whether your company satisfy this
criterion.
(b) (2 points) Outline the risk factors attributed to the tracking error.
(c) (3 points) Your student reviewed the market data and found that most of the variances are
attributed to the twist in the yield curve. She suggests creating a portfolio that
mimics the present value distribution of cash flows of the benchmark. Below are
the cash flows of the benchmark.
Time Cash Flow

0.5 50
1.0 60
1.5 70
2.0 80
2.5 90
3.0 110
Assume the yield curve is currently flat at 5%. Calculate the present value distribution of cash
flows of the benchmark. Show all work.
This question pertains to Fixed Income Portfolio Management.

6. (6 points) Your client is looking for a minimum bond-equivalent return of 6.3%. She
has $200 million available to invest and a 5-year investment time horizon. Two bonds are under
consideration:
Bond A: 7% coupon (semi-annual payment) with 6-year maturity and a duration of 5.
Bond B: 7% coupon (semi-annual payment) with 9-year maturity and a duration of 6.8.
The current yield curve is flat at 7% (bond-equivalent).
Yield curve parallel

shift to 10.0% 9.5% 9.0% 8.5% 8.0% 7.5% 7.0%
Bond A Price 173.41 177.53 181.76 186.12 190.61 195.24 200.00
Bond B Price 164.93 170.20 175.68 181.39 187.34 193.54 200.00
(a) (1 point) Your student suggests using bond B for your client because it can create an
immunized portfolio. Comment on your student’s suggestion and determine
which bond should be used.
(b) (1 point) Your client is interested in the contingent immunization approach and wants to
have more details. Describe this strategy.
(c) (2 points) Assume the contingent immunization approach is adopted and bond B is
purchased. Calculate the initial dollar safety margin.
(d) (2 points) Assume the yield curve changes right after you purchase bond B. Determine
how many basis point increases will trigger the implementation of the
immunization strategy. Show all work.
This question pertains to Fixed Income Securities.

7. (6 points) You plan to include the Treasury Inflation Protection Securities (TIPSs) into
your company’s pension portfolio. Your student extracted the data of a 20-year TIPS:
Principal = 1,000
Annual Coupon (Real) = 4%
Annual Inflation = 3%
Consumer Price Index (CPI) = 100 (Base)
(a) (2 points) Describe TIPSs and their advantages.
(b) (2 points) Calculate the annual nominal return and the nominal cash flows at maturity.
Show all work.
(c) (2 points) Discuss the reasons why the inflation-linked bonds (ILBs) are used in the
following three groups:
(i) Pension Plans

(ii) Endowments, Foundations, and Other Eleemosynary Organizations
(iii) Individuals
This question tests RN and RW concept of Valuation and the Vasicek Short Rate model.
8. (13 points) You are performing the stochastic modeling for reserve adequacy testing for
a block of deferred annuities under 1,000 risk neutral scenarios. Your company is based in the
USA.
The term structure of interest rate to be used is the Vasicek model with the following
characteristics:
o The current short rate is 2%.

o The long run mean is 6%
o The instantaneous standard deviation is 10% and
o The rate of adjustment is 0.4
The portfolio of assets consists of complex interest rate products and MBS where you have used
historical data to model prepayment behavior.
(a) (1 point) Discuss the suitability of the one factor Vasicek model to handle the situation.
(b) (1 point) Discuss the suitability of the risk neutral stochastic modeling approach to handle
the situation (Reserve adequacy in the USA).
(c) (1 point) Calculate the yield to maturity (YTM) for 1 and 5 year maturities zero coupon
bonds under the given Vasicek model.
Assume the following RN dynamics for the short rate model:

𝒕
𝜽
𝒓(𝒕) = 𝒓(𝟎)𝒆−𝜶𝒕 + (𝟏 − 𝒆−𝜶𝒕 ) + 𝝈 � 𝒆−𝜶(𝒕−𝒔) 𝒅𝒁(𝒔)
𝜶
𝟎
(d) (2 points) Demonstrate that this is still the RN Vasicek model and find the values of the
parameters (𝛼), (𝜃) and (𝜎).
(e) (2 points) Identify the probabilistic distribution for the short rate process under the
Vasicek model, and calculate its mean and variance.
(f) (3 points) Find the RN dynamics of the ZCB process P(t,T) under the given Vasicek
model.
(g) (1 point) What is the time t instantaneous forward rate f(t,t)?
Consider the following discounted bond price process:
𝑡 → 𝑒𝑥𝑝 �− � 𝑟(𝑠)𝑑𝑠� × 𝑃(𝑡, 𝑇)

0
(h) (2 points) Demonstrate that the given process is a martingale.
This question pertains to Portfolio management of Foundations.

9. (6 points) Uncle Sam is a billionaire and wants to set up a long-lived foundation to

help the country he lives. The main purpose of this foundation is to sponsor the people who do
not have enough money to go to college. Uncle Sam is the only donor and the foundation will
not operate for any other purposes.
(a) (4 points) Identify the types of foundations available and describe the following areas for
each type of foundation:
(i) Description
(ii) Source of funds
(iii) Decision-making authority
(iv) Annual spending requirement
(b) (1 point) Outline the three return objectives for a long-lived foundation.
(c) (1 point) Determine which type of foundation is suitable for Uncle Sam.
This question pertains to Asset allocation.

10. (4 points) Student A and B are arguing which asset they should add to enhance the
portfolio of their company. The company has a risk aversion of 3 and its minimum return is 2%.
The statistical data of the assets is in the following table.
Expected Standard Derivation of

Asset Return Return
A 6% 10%
B 7% 12%
C 8% 15%
Student A: “We should include asset A since its risk-adjusted expected return is the highest
among the three.”
Student B: “We should include asset C since it is the best based on Roy’s safety-first criterion.”
Evaluate your students’ comments and comment which asset is the best one.
This question pertains to Equity Modeling.

11. (10 points) Life insurance company XXX guarantees to repay the initial investment
into Fund ABC (S) of amount $100.00 in five years (T=5), if the proceeds of fund ABC is below
the initial investment ($100.00). You are given the following assumptions:
Assumptions
o The annual risk free rate of interest is 2.00%

o The dynamics of the Fund ABC is described by a GBM of drift rate of 5.5% and the
annual volatility of 25%.
o Ignore all expenses and management charges.
o The company shall hold a reserve equal to the Expected PV of Max(100-S(T),0).
1
o The required capital is the Expected PV of ( �𝑆(𝑇)).
10
You are asked to
(a) (4 points) Identify and describe four different types of volatility specification (in the
context of equity returns)
(b) (2 point) List 5 assumptions from the Black Scholes Merton model and calculate the fair
price of the guarantee.
(c) (1 point) Calculate the reserve for this guarantee.
(d) (3 point) Calculate the capital requirement for this guarantee.
This question pertains to SOA QFIC Section 3: Application of Equity Modeling to VA pricing
12. (5 points) The current management income fees from your company is a flat 1% of
Account Value at the end of each year for the block of VA. Your manager is looking at the
following fees structure:
The expense at the end of the year will be:
𝐸 × 𝑆0
Where:
0.95% 𝑖𝑓 𝑆1 < 𝑆0
𝐸=� 1% 𝑖𝑓 𝑆1 > 𝐾
0.5% 𝑂𝑡ℎ𝑒𝑟𝑤𝑖𝑠𝑒
And
𝑆1 : 𝑇ℎ𝑒 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑆𝑒𝑝𝑎𝑟𝑎𝑡𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑠𝑡 𝑦𝑒𝑎𝑟.
The separate account is modeled by a GBM process with:
𝜇 = 7.5%
𝜎 = 25%
The fund generates no income during the year. The fund’ initial balance is $1,000.00. The
continuously compounded risk-free rate is 4%.
You are asked to:
(a) (2 points) List the advantages and disadvantages of using the GBM in modeling the
returns of the separate account of a VA.
(b) (2 point) Calculate the expected management fees for the one year period under the
current structure
(c) (3 point) Write the equation to determine K such that the expected one-year expense
under the new structure is the same as the expected expense under the old structure.
This question pertains to SOA QFIC Section 3: RN Valuation and option pricing
13. (6 points) A special option pays off a $1 at time 1 if and only if the terminal stock price is
in the interval [a, b].
You are asked to:
(a) (2 points) Explain why risk neutral valuation work, and give two imperfections with risk
neutral valuation.
(b) (2 points) Define complete market and explain (if) why the GBM model results in a
complete market
(c) (2 points) Calculate the value of this special derivative.
This question pertains to Digital Options

14. (8 points) Consider a cash-or-nothing call option and a stock-or-nothing put option on
a non-dividend paying stock.
The current stock price is $50, and the risk-free rate is 5%.
Both options mature in 1 year, and the strike price of the options is $45.
The underlying stock price follows a GBM process with the following:
 The drift is 7% and

 The volatility of the stock is 30%.
The cash amount in the cash-or-nothing option is $60.
You are asked to:
(a) (2 points) Calculate the real world and the risk-neutral probability that the stock-or-
nothing put option is in the money at maturity.
(b) (2 points) Demonstrate that a European call option can be replicated by positions in binary
derivatives.
(c) (2 points) Calculate the value of the cash-or-nothing call option and of the stock-or-
nothing put option.
(d) (1 point) Does the put and call parity property holds for binary options?
(f) (1 point) What is the delta of a cash-or-nothing call?
This question pertains to SOA QFIC Section 3: Jensen inequality, RN/RW valuation
15. (6 points) A reinsurance contract is agreed upon at time t=0. The contract is set so that the
reinsurance company agrees to pay the excess of claims over the deductible (K) at the end of the
year (t=1). Assume that the dynamics of the underlying auto claims distribution follows a GBM
process of drift (𝜇) and volatility (𝜎). The one year rate of interest is (R).
The reinsurer examines two possible approaches to estimate the ceding company premium
(charge) at t=0:
 Approach 1: The ceding company pays a premium at time t=0 equal to the expected
present value of the reinsurance payment due at time 1.
 Approach 2: The ceding company pays a premium at time t=0 equal to the present value
of the maximum of the expected claim (total) over the deductible (K).
Currently, a similar reinsurance treaty resulted to a reinsurance claim of amount 𝑥0
You are asked to:
(a) (2 points) Describe how you will apply the risk neutral valuation principles (derived from
the BSM development) to the valuation of the reinsurance contract.
(b) (2 points) State Jensen’s inequality and compare the ceding company premium under
approaches 1 and 2.
(c) (2 points) Mathematically express the ceding premium under approaches 1 and 2.
This question pertains to Alternative to BSM: BT for pricing index-linked contracts

16. (7 points) A life insurance issues a 3-year maturity single premium equity-linked policies
under which the company guarantees a return of premium compounded at 2% annually on
maturity, and the return on premium on death during the three years term, or the account value,
whichever is the greatest.
The company invests the single premium less an initial charge for the guarantee into an equity
fund (of amount 9500). The charge for the guaranteed is estimated at 5% of the initial premium
(of 10,000).
The three steps binomial tree for the equity process, the guaranteed benefits and the decrement
assumptions are below:
(a) (2 points) Assess whether the calculus for the guaranteed benefit above is appropriate.
(b) (2 points) Build the tree for the option embedded in this contract.
(c) (2 points) Calculate the value of the embedded option, ignoring any discounting rate.
(d) (1 point) Shall the company continue on selling this product?
This question pertains to SOA QFIC Section 1: Markov and Martingale properties
17. (7 points) Suppose your initial wealth at time zero is zero. You take part of a coin tossing
game where if you toss head, you win $1.00 and if you toss face you lose $1.00, with equal
probability (0.5). You repeat this process for an indefinite amount of time.
You are asked to:
(a) (2 points) Clearly distinguish between the Markov property and the Martingale property.
(b) (3 points) Define (a) an Ito process (also give an example), (b) Brownian Motion and (c)
State Ito Lemma.
(c) (2 points) Determine whether the wealth/coin tossing game process above satisfies the
Markov property and/or the Martingale property.
This question pertains to interest rate models feature

18. (9 points) A market risk specialist wishes to model a number of complex interest rate
options some of which involving the correlations of rates of the yield curve. He is considering
the following models:
 Cox Ingersoll and Ross (CIR)
 Hull and White
 Health Jarrow Morton (HJM) and
 Libor Market Model (also called BGM in PW-19)
You are asked to:
(a) (1 point) Define yield curve fitting and comment its usefulness for the CIR model.
(b) (1 point) Define a mean-reverting stochastic process.
(c) (1 point) Explain why a mean-reverting process is not appropriate for modeling bond
prices, but is appropriate for modeling short-term interest rates.
(d) (2 points) Explain the issue associated with using a one factor model to price/value the
type of interest rate complex derivative of this problem.
(e) (4 points) Outline the main features (the risk neutral process, the advantages and
disadvantages) of the above models.
This question pertains to stochastic calculus: Strong Solution to SDE

19. (4 points) Let (𝑋𝑡 ; 𝑡 ≥ 0) be a stochastic process satisfying:

𝑡 𝑡
𝑋𝑡 = 𝑋0 + � 𝜇𝑠 𝑑𝑠 + � 𝜎𝑠 𝑑𝑊𝑠
0 0
Where W is a standard Brownian motion.
Let f be a function, twice partially differentiable with respect to x and once with respect to t.
You are asked to:
(a) (2 points) Find the stochastic differential equation for (𝑓(𝑡, 𝑋𝑡 )).
Consider the SDE:

𝑑𝑋𝑡 = −𝛾𝑋𝑡 𝑑𝑡 + 𝜎𝑑𝑊𝑡
(b) (2 points) Prove that the solution to this SDE is:

𝒕
𝑿𝒕 = 𝑿𝟎 𝒆𝒙𝒑(−𝜸𝒕) + 𝝈 � 𝒆𝒙𝒑[𝜸(𝒔 − 𝒕)] 𝒅𝑾𝒔

𝟎
This question pertains to stochastic calculus and Martingale

20. (6 points) Suppose you are in the Black Scholes economy (all assumptions are true) and
the stock price process at time t is given by:
𝑆𝑡 = 𝑆0 𝑒𝑥𝑝(0.2𝐵𝑡 + 0.2𝑡)
A derivative security written on this stock has the time t value:
𝐶𝑡 = 2 × 𝑒𝑥𝑝(0.6𝐵𝑡 + 0.39𝑡)
And
𝐵𝑡 𝑖𝑠 𝑡ℎ𝑒 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐵𝑟𝑜𝑤𝑛𝑖𝑎𝑛 𝑚𝑜𝑡𝑖𝑜𝑛
(a) (2 points) State the equation for the total differential in traditional/classical algebra
textbook, and discuss whether or not this equation works in the presence of random
variables.
(b) (1 point) What is (or calculate) the value of the constant a such that the expression
(𝑒 𝜎𝐵𝑡 −𝑎𝑡 ) is a martingale:
(c) (2 points) What is the adjusted Wiener process, (𝐵𝑡 + 𝑎 × 𝑡), such that the discounted
values of St and Ct under this adjusted measure are martingales?
(d) (1 point) Calculate the risk free rate
This question pertains to Integrating Interest Rate Modeling and Ito Calculus
21. (8 points) Let the RN dynamics of the short rate be described by the following process:
𝑑𝑟 = (𝜃 − 𝑎𝑟)𝑑𝑡 + 𝜎𝑑𝑧
Denote the time t price of a zero coupon bond price paying off $1 at time T by ZCB(t, T):
(a) (3 points) Identify the given model and describe its dynamics (the meaning of the
coefficients), also list the possible calibration approaches.
(b) (2 points) What is the PDE that an interest rate derivative (under this specific model) must
satisfy?
(c) (2 points) What is the statistical distribution of the short rate r(t) and that of ZCB(t, T) under
this model?
(d) (1 point) What is the mathematical expression for ZCB(t, T)?
This question pertains to an alternative model for equity modeling: The Jump-Diffusion model
22. (14 points) Let the RW dynamics of the stock price be described by the SDE:
𝑑𝑆𝑡 = 𝑎𝑡 𝑆𝑡 𝑑𝑡 + 𝜎𝑡 𝑑𝑊𝑡 + 𝑑𝐽𝑡

You are asked to:
(a) (2 points) Give the name of the above process and explain why it might be considered as an
alternative to the GBM.
(b) (1 point) Is this model and Ito model?
(c) (2 points) Is the market complete under this model? Why or why not?
You are now interested in this process during a finite and small time interval of length h.
(d) (1 point) Calculate the mean of the change in (𝑆𝑡 ) under this model.
(e) (2 point) Write the increments of (∆𝐽𝑡 ) invoking all the relevant terms: The number of
jumps, the average size of jumps,….
(f) (1 point) Can Ito lemma (or a similar) be applied to this process? Why or why not?
The Merton’s jump diffusion model is an example of a fundamental jump diffusion process used
in the market.
(g) (3 point) Differentiate the values of ITM, ATM and OTM options derived under the
Merton’s model and the GBM model?
(h) (2 point) Suggest trading strategies to exploit jumps in the market.
This question pertains to Knowledge and Application of the GBM model

23. (11 points) You are saving funds into a non-dividend paying stock for a 20 years horizon.
The annually compounding rate of the interest (r) is 3%. The stock follows the following process
in the real world measure:
𝑑𝑆𝑡 = 𝑆𝑡 (𝜇𝑑𝑡 + 𝜎𝑑𝑊𝑡 )

Where:
𝑊𝑡 is a standard Brownian motion
µ=0.12
σ=0.25
t is the current time and
The value of the stock (𝑆0 ) can be normalized to 1 without loss of generality.
You are asked:
(a) (2 points) What is the SDE for (i) Log(𝑆𝑡 ) and (ii)𝑒 −𝑟𝑡 𝑆𝑡
(b) (1 point) Is (𝑒 −𝑟𝑡 𝑆𝑡 ) a martingale? Justify
(c) (2 points) What is the statistical distribution of (𝑆20 )? Describe the features of this
distribution as done in the reading (PW-FAQ-Chapter-6).
(d) (2 points) Describe the Levy distribution as an alternative to the distribution in (c).
(e) (2 points) What amount shall be invested at time t=0 in order that the proceeds at time t=20
is of amount $100,000 with a probability of 50%?
(f) (2 points) Calculate (i) the standard deviation of the investment (e) above (ii) The
probability that the investment proceeds is less than $90,000.
This question pertains to the distribution of stock returns under GBM assumption
24. (5 points) You are given the following SDE for a stock process:
𝑑𝑆𝑡 = 𝑆𝑡 (𝜇𝑑𝑡 + 𝜎𝑑𝑊𝑡 )

Where:
𝑊𝑡 is a standard Brownian motion
𝑆0 = 1
Fix a future time T
You are asked:
(a) (2 points) What is the distribution of the annual compounded return over the horizon T?
(b) (1 point) As volatility increases, how does expected return behave?
(c) (1 point) As the level of risk aversion increases, what happens to expected return?
(d) (1 point) Explain the importance of the term (𝜇) in the derivation of the BS PDE
This question pertains to the Greeks and Hedging in the BSM economic system
25. (7 points) You are in the Black Scholes economy. There is only one stock on which two
derivatives instruments are considered. Based on a numerical method (Monte Carlo for instance),
you have estimated the following Greeks for the two European options:
You are also given the following:
You are asked to:
(a) (1 point) Describe each of the Greek in the given table
(b) (1 point) Define model dependent hedging and model independent hedging
(c) (1 point) Explain how delta hedging works?
(d) (1 point) Contrast the use of implied/actual volatility when constrained by mark-to-market
accounting and mark-to-model.
(e) (3 points) Calculate the option value for option 1 and option 2
This question pertains to understanding of stochastic calculus/processes in continuous time

26. (8 points) You are given the following model for an asset price:
𝑑𝑆𝑡 = 𝜇𝑡 𝑑𝑡 + 𝜎𝑡 𝑑𝑊𝑡
Where:
 𝑊𝑡 is a Wiener process
You are asked to:
(a) (2 points) Clearly define a Wiener process with respect to an information set (𝐼𝑡 ) and list the
four most important properties of a Wiener process
(b) (1 point) Is the Wiener process a martingale?
(c) (1 point) What is the main difference between the Wiener process and a standard Brownian
motion?
Suppose that the parameters of the process are made constant and you are now considering:
𝑑𝑆𝑡 = 𝜇𝑑𝑡 + 𝜎𝑑𝑊𝑡
(d) (1 point) Discuss the dependence of the coefficients with the information set (𝐼𝑡 )
(e) (1 point) Calculate the mean and variance of the change in (𝑆𝑡 ) over a small time interval of
length (h).
(f) (2 points) Describe the dynamics of this equation (𝑑𝑆𝑡 = 𝜇𝑑𝑡 + 𝜎𝑑𝑊𝑡 ) and identify the type
of asset that can modeled using it.
This question pertains to understanding of Girsanov Theorem

27. (7 points) You are given the following model for an asset price:
Where:
You are also given the risk free rate of interest (r).
You are asked to:
(a) (2 points) Calculate the SDE followed by the new process (𝑒 −𝑟𝑡 𝑆𝑡 ).
(b) (1 point) Is the process (𝑒 −𝑟𝑡 𝑆𝑡 ) a martingale?
(c) (2 points) Apply Girsanov theorem to link the Wiener process (𝑊𝑡 ) to another one (the goal
is to re-specify the process (𝑑𝑆𝑡 ) under that new measure).
(d) (1 point) What is the process for (𝑒 −𝑟𝑡 𝑆𝑡 ) under the new measure (defined in question (c))?
(e) (1 point) Is it possible to obtain a martingale in this new measure?
28. (6 points) You are given the following model for an asset price in the real world
probability measure:
Where:
Now, assume you are given the present value of a derivative payoff (𝑒 −𝑟𝑡 𝐹(𝑆𝑡 , 𝑡)) that pays off
at some time t.
You are asked to:
(a) (1 point) Use Ito Lemma to develop the SDE for 𝑒 −𝑟𝑡 𝐹(𝑆𝑡 , 𝑡).
(b) (1 point) Is (𝑒 −𝑟𝑡 𝐹(𝑆𝑡 , 𝑡)) a martingale in the real world measure?
(c) (1 point) Use Girsanov theorem to write the process for (𝑒 −𝑟𝑡 𝐹(𝑆𝑡 , 𝑡)) in the risk adjusted
measure
(d) (1 point) Is there a way the process (𝑒 −𝑟𝑡 𝐹(𝑆𝑡 , 𝑡)) can be a martingale in this new measure?
(e) (2 points) Assuming that condition (d) is satisfied, what is the process for (𝑒 −𝑟𝑡 𝐹(𝑆𝑡 , 𝑡))?
29. (6 points) You are given the dynamics of asset returns in the real world probability
measure as follows:
𝑑𝑌𝑡 = 𝜇𝑑𝑡 + 𝜎𝑑𝑊𝑡
Where:
The process for asset prices in this real world probability measure is given by:
𝑆𝑡 = 𝑆0 𝑒 𝑌𝑡
You are asked to:
(a) (1 point) Use Ito Lemma to find the SDE for the asset price.
(b) (1 point) Is the asset price a martingale in the real world probability measure?
(c) (1 point) What distribution is the asset returns in the real world?
Let a new probability measure (𝑃�) such that asset returns follow the SDE:
�𝑡
𝑑𝑌𝑡 = 𝜌𝑑𝑡 + 𝜎𝑑𝑊
(d) (1 point) Find the distribution of asset prices in this new measure (𝑃�).
(e) (1 point) Find the value of (𝜌) so that the present value of the asset prices is a martingale in
this new measure (𝑃�).
(f) (1 point) What is the GBM process for asset prices that ensures that the PV of securities is a
martingale?
30. (7 points) Consider the following SDE which represents the dynamics behavior of some
assets:
𝑑𝑆𝑡 = 𝑎(𝑆𝑡 , 𝑡)𝑑𝑡 + 𝜎(𝑆𝑡 , 𝑡)𝑑𝑊𝑡
Where:
You are asked to:
(a) (1 point) Define the Ito integral from the given SDE.
(b) (1 point) Is the Ito integral a martingale? Justify your answer.
(c) (1 point) When does the Ito integral of a general random function (𝑓(𝑆𝑡 , 𝑡)) exist?
(d) (4 point) Calculate the following expressions:
1.(𝑑𝑊𝑡 )2
2.𝑑𝑊𝑡 × 𝑑𝑡
3.(𝑑𝑆𝑡 )2
𝑇
4.𝐸 �∫0 𝑓(𝑊𝑡 , 𝑡) 𝑑𝑊𝑡 �
This question pertains to understanding of Multivariate Stochastic calculus

31. (6 points) Let P be price of an asset, and M the quantity of that asset at some time.
Assume P and M each follow GBM processes as:
𝑑𝑃
= 𝜇𝑃 𝑑𝑡 + 𝜎𝑃 𝑑𝑊𝑃
𝑃
And
𝑑𝑀
= 𝜇𝑀 𝑑𝑡 + 𝜎𝑀 𝑑𝑊𝑀
𝑀
Where:
 𝑊𝑃 and 𝑊𝑀 are correlated Wiener processes (𝜌).
You are interested in the following quantities:

𝑀
𝑚=
𝑃
and
𝑞 =𝑀×𝑃
(a) (4 points) Derive the SDE for the two quantities m and q.
An investment portfolio contains N such assets where (𝑃𝑖 ) is the price of the ith asset
with dynamics described as that of dP and (𝑀𝑖 (𝑡)) is the position in the ith asset at
time t, following the same dynamics as of (dM). The correlation structure is maintained.
(b) (2 points) Describe the dynamics of the portfolio, and calculate the increment in wealth for
this portfolio.
This question pertains to understanding of Multivariate Stochastic calculus: Multivariate BS

PDE
32. (10 points) You are considering the pricing of a spread option of value (𝑉(𝑡, 𝑆1 , 𝑆2 )),
maturity T, written on the following two assets:
First asset dynamics:

𝑑𝑆1
= 𝜇1 𝑑𝑡 + 𝜎1 𝑑𝑧1
𝑆1
And
Second asset dynamics:

𝑑𝑆2
= 𝜇2 𝑑𝑡 + 𝜎2 𝑑𝑧2
𝑆2
Where the correlation between the two assets is 𝜌.
You are going to derive the Black Scholes PDE for the spread option
You are asked to:
(a) (1 point) What is the boundary condition for the spread option?
You are going to follow the methodology in PW to build the special portfolio as follows:
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = 𝑉(𝑡, 𝑆1 , 𝑆2 ) − ∆1 𝑆1 − ∆2 𝑆2
(b) (2 points) Use Ito Lemma to calculate the increment in the special portfolio over a small
time interval dt.
(c) (1 point) Find appropriate values for (∆1 ) and (∆2 ) such that the increment in the portfolio
has no random term.
(d) (1 point) Derive the expression for the increment of the portfolio (𝑑(𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜)) based on
the answer to question (c).
(e) (2 points) Derive the Black Scholes PDE for this spread option.
(f) (1 point) Discuss whether the same PDE can be used to value the following options a
portfolio call option.
(g) (2 points) Compare the features of the derived two assets BS PDE to those of the one asset
BS PDE
This question pertains to understanding of Interest rate modeling

33. (6 points) Under the real world measure, the price at time t of a ZCB (zero coupon bond)
paying off $1 at time T is given by:
𝑍(𝑡, 𝑇) = 𝑒𝑥𝑝(−𝑎(𝑇 − 𝑡)𝑟𝑡 + 𝑏𝜎 2 (𝑇 − 𝑡)3 )

Where:
𝑎 𝑎𝑛𝑑 𝑏 𝑎𝑟𝑒 𝑎𝑟𝑏𝑖𝑡𝑟𝑎𝑟𝑦 𝑟𝑒𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟𝑠
And
The real world SDE for the short rate (𝑟𝑡 ) is given by:
𝑑𝑟𝑡 = 𝜇𝑟𝑡 𝑑𝑡 + 𝜎𝑑𝑊𝑡

Where:
𝜇>0
And
𝑊𝑡 𝑖𝑠 𝑎 𝑊𝑖𝑒𝑛𝑒𝑟 𝑝𝑟𝑜𝑐𝑒𝑠𝑠
You are asked to:
(a) (1 point) Calculate the yield to maturity (YTM) of this ZCB
(b) (1 point) Calculate the forward rate (F(t,T))
(c) (1 point) Show that the spread between The YTM and the forward rate increases for longer
maturity ZCB
(d) (1 point) Show that as the volatility of the short rate tends to zero, the spread between the
YTM and the forward rate also tends to zero
(e) (2 point) Calculate the volatility of both the ZCB and the forward rate under the real world
measure
This question pertains to understanding of Equity modeling

34. (6 points) You are in the real world measure P. W is a Wiener process and the price of any
stock S is represented by the equation:
1
𝑆(𝑡) = 𝑆(0) × 𝑒𝑥𝑝 ��𝜇 − 𝜎 2 � 𝑡 + 𝜎𝑊𝑡 �
2
The risk free interest rate is constant and denoted by r.
Suppose that the price in the market (risk neutral measure) of any contract which pays (𝑓(𝑆𝑇 )) at
time T is valued at:
𝑃𝑟𝑖𝑐𝑒𝑡 = 𝐸�𝑒 −𝑟(𝑇−𝑡) 𝑓(𝑆𝑇 )𝜑 𝑇 �

Where:
1
𝜑𝑡 = 𝑒𝑥𝑝 �𝛼𝑊𝑡 − 𝛼 2 𝑡�
2
You are asked to:
(a) (1 point) Assess whether or not the quantity (𝜑 𝑇 ) is a martingale
(b) (2 points) Calculate the expected value of 𝑒𝑥𝑝(𝛼𝑊𝑡 )
(c) (2 points) Derive the price at time t=0 of a contract that pays off the underlying asset at time
T.
(d) (1 point) Find the value of 𝛼 such that there is no arbitrage opportunity in trading the
security of question (c)
This question pertains to Application of G.T to interest rate modeling

35. (9 points) You are given the following interest rate model in two different measures:
In the risk neutral measure, the process is given by:
𝑑𝑟(𝑡) = (𝜂 − 𝛾𝑟(𝑡))𝑑𝑡 + �𝛼𝑟(𝑡)𝑑𝑊𝑡

Where:
𝑊 𝑖𝑠 𝑎 𝑊𝑖𝑒𝑛𝑒𝑟 𝑝𝑟𝑜𝑐𝑒𝑠𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑟𝑖𝑠𝑘 𝑛𝑒𝑢𝑡𝑟𝑎𝑙 𝑚𝑒𝑎𝑠𝑢𝑟𝑒
And In an equivalent measure that we call the (𝑄𝑇 ) measure, the process is given by:
𝑑𝑟(𝑡) = (𝜂 − 𝛾𝑟(𝑡) − 𝛾𝛼𝑋(𝑡, 𝑇)𝑟(𝑡))𝑑𝑡 + �𝛼𝑟(𝑡)𝑑𝑊𝑡𝑇

Where:
𝑊𝑡𝑇 𝑖𝑠 𝑎 𝑊𝑖𝑒𝑛𝑒𝑟 𝑝𝑟𝑜𝑐𝑒𝑠𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑛𝑒𝑤 𝑚𝑒𝑎𝑠𝑢𝑟𝑒 (𝑄𝑇 )
And
𝑋(𝑡, 𝑇) = 𝑎 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝑡𝑖𝑚𝑒.
You are asked to:
(a) (1 point) Describe the risk neutral dynamics of this model.
(b) (1 point) Define the expression “equivalent measures”.
(c) (2 points) Explain why mean reverting processes are sometimes used to model (i) interest
rates (ii) volatility of equity returns and (iii) inflation rate.
(d) (2 points) Connect the two Wiener processes (𝑊𝑡𝑇 ) and (𝑊𝑡 )?
(e) (2 point) Demonstrate that the process below (𝑉 𝑇 ) is another Wiener process
𝑑𝑉 𝑇 (𝑡) = 𝑑𝑊(𝑡) + 𝜎𝐵(𝑡, 𝑇)𝑑𝑡

Where:
1
𝐵(𝑡, 𝑇) = �1 − 𝑒 −𝑎(𝑇−𝑡) �
𝑎
And a and σ are positive constant.
(f) (1 point) Describe how you would calculate the time t value of a ZCB maturating at time
t+2.
This question pertains to the importance of Arbitrage opportunities in derivative pricing

Each question should be answered independently. I have included dramatization in the solution.
Please do not use such jokes in your official exam write-ups. The goal is to amuse you as you
progress in your learning, and it shall not be emulated!
36. (10 points) Consider a bank account (B) and an underlying asset (S) with the following:
𝑑𝐵𝑡 = 𝑟𝐵𝑡 𝑑𝑡
𝐵0 = 1
And
𝑑𝑆𝑡 = 𝜇𝑆𝑡 𝑑𝑡 + 𝜎𝑆𝑡 𝑑𝑊𝑡
Where:
𝑊𝑡 𝑖𝑠 𝑎 𝑊𝑖𝑒𝑛𝑒𝑟 𝑝𝑟𝑜𝑐𝑒𝑠𝑠 𝑢𝑛𝑑𝑒𝑟 𝑡ℎ𝑒 𝑅𝑊 𝑚𝑒𝑎𝑠𝑢𝑟𝑒
𝑆0 = 100
You are asked to:
Assume that (𝜇 > 𝑟):
𝑆
(a) (1 point) Is the expression ( 𝑡�𝐵 ) a martingale/submartingale or a supermartingale?
𝑡
(b) (2 points) Show that the economy so-built exhibits an arbitrage opportunity. Comment on
the suitability of this economy system for pricing derivatives.
Assume that (𝜇 < 𝑟)
(c) (2 point) Is there an arbitrage opportunity?
Now let us assume that (𝜇 = 𝑟)
𝑆
(d) (1 point) Is the expression ( 𝑡�𝐵 ) a martingale or a submartingale?
𝑡
(e) (1 point) Is there an arbitrage opportunity?
(f) (3 points) Under what conditions is the expression (𝑒 −𝑟𝑡 𝐹(𝑆𝑡 , 𝑡)) a martingale? Are we now
in the risk neutral measure? Can we price derivative written on this asset?
This question pertains to Application of interest rate modeling

37. (10 points) You are interested in the general risk neutral modeling of short interest rate
dynamics. You observe market information about the discount curve B(t,T) for maturity T where
T takes either of the possible n values:
𝑇1 < 𝑇2 < ⋯ < 𝑇𝑛
“These are just prices of ZCB”
You are asked to:
(a) (1 point) derive the yield curve.
(b) (1 point) derive the discount curve.
(c) (1 point) What is the slope of the yield curve?
(d) (1 point) Take a time s in the future (s>t), what is the best estimate of B(s,T)?
(e) (1 point) Someone throws out the comment: “The yield curve at time t contains all the
relevant information concerning future short rates”. Explain why he or she is right or wrong.
You are looking to use the following interest model to capture the dynamics of short rates:
𝑑𝑟𝑡 = 𝜇𝑟𝑡 𝑑𝑡 + 𝜎𝑟𝑡 𝑑𝑊𝑡
(f) (1 point) Discuss two severe problems with using such models.
(g) (2 points) Describe how you will go about estimating the parameters of this model given
the market information.
(h) (2 points) Propose a new model for which calibrating to the observed market prices is more
realistic.
This question pertains to understanding MBS

38. (11 points) Fannie Mae issued a mortgage pass-through security and the prospectus
supplement stated the following
FANNIE MAE
MORTGAGE-BACKED SECURITIES PROGRAM
SUPPLEMENT TO PROSPECTUS DATED JULY 01, 2004
$464,927,576.00
ISSUE DATE OCTOBER 01, 2005
SECURITY DESCRIPTION FNMS 05.0000 CL-844801
5.00 PERCENT PASS-THROUGH RATE
FANNIE MAE POOL NUMBER CL-844801
CUSIP 31407YRW1
PRINCIPAL AND INTEREST PAYABLE ON THE 25TH OF EACH MONTH

BEGINNING NOVEMBER 25, 2005
POOL STATISTICS
SELLER WELLS FARGO BANK, N.A
SERVICER WELLS FARGO BANK, N.A
NUMBER OF MORTGAGE LOANS 1986
AVERAGE LOAN SIZE $234,312.06
MATURITY DATE 10/01/2035
WEIGHTED AVERAGE COUPON RATE 5.7500%
WEIGHTED AVERAGE LOAN AGE 1 mo
WEIGHTED AVERAGE LOAN TERM 360 mo
WEIGHTED AVERAGE REMAINING MATURITY 359 mo
WEIGHTED AVERAGE LTV 73%
WEIGHTED AVERAGE CREDIT SCORE 729
You are asked to:
(a) (1 point) Cite the different types of agency pass-throughs.
(b) (1 point) Define the Weighted Average Coupon Rate and the Weighted Average Maturity
of a pass-through.
(c) (2 points) Describe the cash flows of a mortgage pass-through security.
(d) (2 points) What does a “pass-through rate of 5%” means and what is the average coupon
rate paid by the borrowers? Are both rates equal?
(e) (1 point) What is the prefix of this security? What is the meaning of this prefix and why is
the prefix important?
(f) (1 point) Why is it that the stated maturity (10/01/2035) of this security is an inappropriate
measure?
(g) (1 point) If an investor purchased $15 million principal of this security (at issued) and, in
some month, the cash flow available to be paid to the security holders (after all fees are
paid) is $12 million, how much is the investor entitled to receive?
(h) (1 point) Every month a pool factor would be reported for this security. If the pool factor
for some month is 0.92, what is the outstanding mortgage balance for the loan pool for that
month?
(i) (1 point) What does a conditional prepayment rate of 8% mean?

39. (5 points) In the context of MBS prepayment modeling, you are asked to:
(a) (3 points) Complete the following table:
CPR Assuming:
Month 100% PSA 70% PSA 320% PSA
1
4
9
27
40
120
340
(b) (2 points) Explain the Burnout effect.

40. (10 points) In the context of MBS prepayment modeling, you are asked to:
A bank originates a pool of 500 30-year mortgages, each averaging $150,000 with an annual
Mortgage coupon rate of 8 percent. The GNMA (Ginnie Mac) credit risk insurance fee is 6
Basis points and the bank servicing fees is 19 basis points.
You are asked to
(a) (1 point) Calculate the present value (the size) of the mortgage pool?
(b) (1 point) Find the monthly mortgage payment of the mortgage pool?
(c) (2 points) For the first two monthly payments, what portion is principal and what portion is
interest payment?
(d) (1 point) What are the expected monthly cash flows to the Ginnie pass-throughs holders?
(e) (1 point) What is the present value of the Ginnie pass-through security, assuming an 8% per
annum convertible monthly?
(f) (1 point) Describe what happens in a month in which prepayment occurs.
(g) (1 point) Describe the difference between the monthly payment from the pool and the
monthly payment to the pass-through investor.
(h) (2 points) If all the mortgages in the pool are prepaid after the second month, what is the
pool WAL?
This question pertains to Brownian Motions and their properties

41. (5 points) Let (𝑊𝑡 ) be a Brownian motion. Consider the following stochastic differential equation:
𝑑𝑋𝑡 = 𝜇(𝑡, 𝑋𝑡 )𝑑𝑡 + 𝜎(𝑡, 𝑋𝑡 )𝑑𝑊𝑡
You are also given the partition:

0 = 𝑡0 ≤ 𝑡1 ≤ ⋯ ≤ 𝑡𝑛 = 𝑡
And another time (s) such that:
𝑡<𝑠
You are asked to perform the following calculations:
This question pertains to Interest Rate modeling

42. (8 points)
You are given the following short rate model:
𝑑𝑟(𝑡) = �𝛼 − 𝛽𝑟(𝑡)�𝑑𝑡 + 𝜎�𝑟(𝑡)𝑑𝑊(𝑡)

Where:
𝑊(𝑡) 𝑖𝑠 𝑎 𝑊𝑖𝑒𝑛𝑒𝑟 𝑝𝑟𝑜𝑐𝑒𝑠𝑠
You are asked to:
(a) (1 point) Determine whether or not the process is mean reverting and identify the long-
term mean reversion and the force of mean reversion.
(b) (1 point) Express (if possible) the value of a ZCB under this model.
Consider the new process defined as:

𝑉(𝑡) = 𝑟(𝑡) × 𝑒 𝛽𝑡
(c) (1 point) Derive the SDE for V(t).
(d) (1 point) Express r(t) in terms of an Ito integral.
(e) (1 point) Calculate the expected value of r(t).
(f) (1 point) State the Isometry property of Ito integral.
(g) (1 point) Calculate the variance of the short rate r(t).
(h) (1 point) What is the limit of this variance when t tends towards infinity?
This question pertains to Equity Modeling/Martingale when the underlying pays dividend
43. (6 points)
A stock pays dividend continuously over time at a rate of (𝐴𝑡 ). Its price at time t (without the
dividend payment) follows a stochastic process with the strong solution:
1
𝑆𝑡 = 𝑆0 × 𝑒𝑥𝑝 ��𝜇 − 𝜎 2 � 𝑡 + 𝜎𝑊𝑡 �
2
Where:
𝑊𝑡 𝑖𝑠 𝑎 𝑊𝑖𝑒𝑛𝑒𝑟 𝑝𝑟𝑜𝑐𝑒𝑠𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑟𝑒𝑎𝑙 𝑤𝑜𝑟𝑙𝑑 𝑚𝑒𝑎𝑠𝑢𝑟𝑒
In addition, the risk free rate of interest is r.
You are asked to:
(a) (1 point) Derive the SDE for the total return index.
For the total return index:
(b) (1 point) Calculate (𝐸𝑡 [𝑑(𝑆𝑡 )]).
(c) (1 point) Calculate (𝑉𝑎𝑟𝑡 [𝑑(𝑆𝑡 )]).
(d) (1 point) Calculate the real world expected value (𝐸𝑡 (𝑆𝑇 )) at some future time T.
(e) (1 point) Calculate the risk neutral expected value (𝐸𝑡 (𝑆𝑇 )) at some future time T.
(f) (1 point) Discuss whether or not the discounted expected value of the total return index is
a martingale in the risk neutral world.
This question pertains to Ito Lemma and Brownian Motions

44. (4 points)
(a) (1 point) Explain the use and significance of Ito’s Lemma for the Valuation of derivatives
based on stochastic processes.
(b) (1 point) Explain what it is meant for a stochastic process to be a martingale under a
probability measure.
Let (𝑊𝑡 ) be a standard Brownian motion in the probability measure (𝑃):
(c) (1 point) Obtain the SDE for the process (𝑌𝑡 = 𝑊𝑡2 − 𝑡) and determine whether it is a
martingale in the probability measure (𝑃).
(d) (1 point) Determine the value(s) of the constant (a), if any, such that the stochastic
process (𝑍𝑡 = 𝑊𝑡4 − 6𝑡𝑊𝑡2 + 𝑎𝑡 2 ) is a martingale in the probability measure (𝑃).
This question pertains to Ito Lemma, Taylor expansion and Ito Integral
45. (7 points)
You are given the following underlying real world process for the stock price:
𝑑𝑆𝑡
= 𝜇𝑡 𝑑𝑡 + 𝜎𝑑𝑊𝑡
𝑆𝑡
Where:
𝑊𝑡 = 𝑎 𝑊𝑖𝑒𝑛𝑒𝑟 𝑝𝑟𝑜𝑐𝑒𝑠𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑟𝑒𝑎𝑙 𝑤𝑜𝑟𝑙𝑑 𝑚𝑒𝑎𝑠𝑢𝑟𝑒
And let �𝑉(𝑆𝑡 , 𝑡)� be a derivative written on the asset S.
(a) (1 point) What are the partial derivatives of 𝑉(𝑆𝑡 , 𝑡) and what is the difference to those of
deterministic calculus?
(b) (1 point) What is the use of partial derivatives of 𝑉(𝑆𝑡 , 𝑡) in finance?
(c) (1 point) Write the Taylor expansion of the derivative 𝑉(𝑆𝑡 , 𝑡) ignoring terms of degree
higher than 2.
(d) (1 point) Compare the Taylor expansion above to Ito’s Lemma, and explain any
differences.
(e) (1 point) Compare the Taylor expansion above to the total differential in deterministic
calculus, and explain any differences.
(f) (1 point) List two uses of Ito Lemma.
(g) (1 point) Calculate the Integral:

𝑡
� 𝑊𝑠 𝑑𝑊𝑠
0
This question pertains to the Doob-Meyer Martingale representation

46. (6 points)
Let (𝑋𝑛 ) be a sequence of independent and integrable random variables with mean zero.
Let their sum be defined as the process:

𝑛
𝑆𝑛 = � 𝑋𝑖
𝑖=1
You are also given a convex/integrable function of real number f.
Finally, consider the new summations:

𝑛
𝑀𝑛 = � 𝑆𝑖−1 𝑋𝑖
𝑖=1
And
𝑛
𝐴𝑛 = � 𝑋𝑖2
𝑖=1
(a) (1 point) Determine whether (𝑆𝑛 ) is a martingale or a submartingale.
(b) (1 point) Assume (𝑋𝑛 ) is a martingale, determine whether (𝑓(𝑋𝑛 )) is a martingale or a

submartingale.
(c) (1 point) Determine whether (𝑀𝑛 ) is a martingale or a submartingale.
(d) (1 point) State the Doob-Meyer decomposition/theorem.
You are also told that you could write the term (𝑆𝑛2 ) as the summation:
𝑆𝑛2 = 2𝑀𝑛 + 𝐴𝑛
(e) (1 point) Determine whether (𝑆𝑛2 ) is a martingale or a submartingale.
(f) (1 point) Determine whether (𝑆𝑛2 − 𝐸[𝑆𝑛2 ]) is a martingale or a submartingale.
This question pertains to the Doob-Meyer representation and the variations of Martingale
47. (6 points)
(a)
Consider the following statement:
<< If continuously observed asset prices contain occasional jumps and trend upwards at the
same time, then we can convert them into martingales by subtracting a process observed at time
t>>
Is the statement true or false? Explain.
(b)
State the first stochastic integral theorem
(c)
Let (𝑊𝑡 ) be a Brownian motion with respect to the information set (𝐼𝑡 ).
Let (𝐻𝑡 ) be a stochastic process with respect to the information set (𝐼𝑡 ).
Show that the solution (𝑀𝑡 ) to the stochastic integral:
𝑑𝑀𝑡 = 𝐻𝑡 𝑑𝑊𝑡
Is another martingale.
(d)
Describe how the above martingale representation can be obtained for a derivative security’s
price.
(e)
Assume (𝑀0 = 0), calculate the following quantities:
1) 𝐸(𝑀𝑡 )
2) (𝑑𝑀𝑡 ) × (𝑑𝑀𝑡 )
3) (𝐸[𝑀𝑡2 ])
4) The limit of the variation of the trajectory of (𝑀𝑡 )
5) The quadratic variation of (𝑀𝑡 )
This question pertains to the Radon Nikodym derivative

48. (6 points)
(a)
Consider the stochastic process (𝑍𝑡 ) such that:
𝑍𝑡 ~𝑁𝑜𝑟𝑚𝑎𝑙(0,1)
Describe how you would transform this process to the new process:
𝑍�𝑡 ~𝑁𝑜𝑟𝑚𝑎𝑙(𝜇, 1)
Let a function of (𝑍𝑡 ) be given by:
1 2
𝜉(𝑍𝑡 ) = 𝑒 𝜇𝑍𝑡−2𝜇
(b)
Calculate:
𝐸[𝜉(𝑍𝑡 )]
(c)
1) Determine whether the stochastic process (𝜉(𝑍𝑡 )) is a martingale.

2) Can 𝜉(𝑍𝑡 ) be a Radon-Nikodym derivative?
(d)
Consider the following normal distributions:
𝑍1𝑡 ~𝑁𝑜𝑟𝑚𝑎𝑙(𝜇1 , 𝜎12 )

And
𝑍2𝑡 ~𝑁𝑜𝑟𝑚𝑎𝑙(𝜇2 , 𝜎22 )
Such that:
𝐶𝑜𝑣(𝑍1𝑡 ; 𝑍2𝑡 ) = 𝜎12
1) Write down the bivariate normal pdf for (𝑍1𝑡 ; 𝑍2𝑡 ) and specify every term.
2) What is the Radon-Nikodym derivative for the bivariate above to a bivariate of a zero
mean vector that preserves the same variance and covariance matrix?
This question pertains to the Radon Nikodym derivative

49. (5 points)
You are given a family of information set (𝐼𝑡 ). You are given a stochastic process (𝑋𝑡 ) that is 𝐼𝑡
measurable.
Consider the following stochastic process:

𝑡 1 𝑡 2
𝜉𝑡 = 𝑒 �∫0 𝑋𝑢𝑑𝑊𝑢 −2 ∫0 𝑋𝑢 𝑑𝑢�
(a) (1 point) Calculate the quantity (𝑑𝜉𝑡 ) under the assumption that the Novikov condition on
(𝑋𝑡 ) is satisfied.
You are told that (𝜉𝑡 ) is the solution to the stochastic equation:
𝑑𝜉𝑡
= 𝑋𝑡 𝑑𝑊𝑡
𝜉𝑡
(b) (1 point) Write (𝜉𝑡 ) with a term involving an Ito integral.
(c) (1 point) Is (𝜉𝑡 ) a martingale?
Suppose the random variable (𝑋𝑢 ) is constant and you have (𝑋𝑢 = 𝛿):
(d) (1 point) Is (𝜉𝑡 ) still a martingale?
(e) (1 point) Calculate the expected value of (𝜉𝑡 )
This question pertains to the Radon Nikodym der. of a discreet (binomial) stochastic process
50. (11 points)
A stochastic process takes values at three different times (0,1 and 2) with different probabilities
(P and Q) as below:
Under measure Q, the probability of an up move from 100 to 120 is the unknown p.
(a) (1 point) Show that for (0 < 𝑝 < 1), both measures (P and Q) are equivalent.
(b) (1 point) Is the process a martingale under the P measure?
(c) (2 points) Determine p such that the stochastic process is a martingale under the Q
measure, and thus build the tree with that value.
(d) (5 points)
Calculate the Values of the discrete Radon-Nikodym derivative for all nodes in the tree (for
moving from P measure to Q measure).
Evaluate the following expressions:
𝑑𝑄
a) 𝐴𝑡 𝑡𝑖𝑚𝑒 𝑡 = 1, 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑢𝑝 𝑛𝑜𝑑𝑒, 𝑐𝑎𝑙𝑐𝑢𝑙𝑎𝑡𝑒 𝐸𝑄 � �
𝑑𝑃
𝑑𝑄
b) 𝐴𝑡 𝑡𝑖𝑚𝑒 𝑡 = 1, 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑢𝑝 𝑛𝑜𝑑𝑒, 𝑐𝑎𝑙𝑐𝑢𝑙𝑎𝑡𝑒 𝐸𝑃 � �
𝑑𝑃
𝑑𝑄
c) 𝐴𝑡 𝑡𝑖𝑚𝑒 𝑡 = 1, 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑑𝑜𝑤𝑛 𝑛𝑜𝑑𝑒, 𝑐𝑎𝑙𝑐𝑢𝑙𝑎𝑡𝑒 𝐸𝑄 � �
𝑑𝑃
𝑑𝑄
d) 𝐴𝑡 𝑡𝑖𝑚𝑒 𝑡 = 1, 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑑𝑜𝑤𝑛 𝑛𝑜𝑑𝑒, 𝑐𝑎𝑙𝑐𝑢𝑙𝑎𝑡𝑒 𝐸𝑃 � �
𝑑𝑃
Is the Radon Nikodym derivative a martingale?
(e) (2 points) Consider a claim X that pays a fixed amount 20 at time t=2 if the tree value at
that time is more than 75, and zero otherwise.
Calculate:
𝐸𝑄 [𝑋] 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡 = 0
This question pertains to Brownian Motions

51. (8 points)
Let (𝑊𝑡 ) be a Brownian motion.
(a)
i. Show that the process (−𝑊𝑡 ) is another Brownian motion.
ii. Show that the process (𝑡𝑊1 ) is another Brownian motion.

𝑡
1
iii. Show that for any strictly positive constant c, the process ( 𝑊𝑐𝑡 ) is another Brownian
√𝑐
motion.
(b)
For three times intervals (0 < 𝑡1 < 𝑡2 < 𝑡3 ), compute the following quantities:
i. 𝐸��𝑊𝑡3 − 𝑊𝑡2 ��𝑊𝑡2 − 𝑊𝑡1 ��
ii. 𝐸��𝑊𝑡3 − 𝑊𝑡1 ��𝑊𝑡2 − 𝑊𝑡1 � 𝑔𝑖𝑣𝑒𝑛 𝑡ℎ𝑎𝑡 𝑊𝑡1 = 1�
iii. 𝐸�𝑊𝑡3 × 𝑊𝑡2 �
(c)
Consider two independent Brownian motions (𝑊𝑡 ) and (𝑉𝑡 ):
Show that the following process is surely a martingale:

𝑡
𝑋𝑡 = (𝑉𝑡 )2 𝑊𝑡 − � 𝑊𝑢 𝑑𝑢
0
This question pertains to Paul Wilmott’s derivation of the BS-PDE

52. (5 points)
You are given the BS-PDE as follows:
Where V is the value of a European option maturing at time T, valued at time t.
(a) (1 point) Show through a proper change of variable(s) that the BS-PDE is equivalent to
the following PDE:
𝜕𝑈 1 2 2 𝜕 2 𝑈 𝜕𝑈
= 𝑆 𝜎 + 𝑟𝑆
𝜕𝜏 2 𝜕𝑆 2 𝜕𝑆
(b) (3 points)
Make the following change of variables:
𝜉 = 𝐿𝑜𝑔(𝑆)
And
1
𝑥 = 𝜉 + �𝑟 − 𝜎 2 � 𝜏
2
And
𝑈 = 𝑊(𝑥)
To show that the BSM is equivalent to a “simpler” stochastic differential equation, involving W
and x.
(c) (1 point)
Describe the steps for showing that the function defined as:
𝑊(𝑥, 𝜏) = 𝜏 −0.5 𝑓(𝜂)

Where
1 𝜂2
𝑓(𝜂) = 𝑒𝑥𝑝 �− �
√2𝜋𝜎 2𝜎 2
And
𝑥 − 𝑥′
𝜂 = 0.5
𝜏
Is a solution to the equation obtained in step (b)
This question pertains to ARCH/GARCH Models for volatility

53. (7 points)
(a) (3 points)
Complete the following table using words and/or equations:
(b) (1 point)
Give three reasons/interests of why practitioners/academics want to forecast volatility
For the ARCH(1) model, you are required to:
(c) (1 point) Specify the mean equation and the volatility model.
(d) (2 points) Show that the unconditional kurtosis of the shock term (𝑎𝑡 ) is greater than
that of the normal distribution.
This question pertains to The HJM approach to interest rate modeling

54. (8 points)
You are given the following RW process for zero coupon bond prices:
𝑑𝑍(𝑡, 𝑇) = 𝜇(𝑡, 𝑇)𝑍(𝑡, 𝑇)𝑑𝑡 + 𝜎(𝑡, 𝑇)𝑍(𝑡, 𝑇)𝑑𝑊(𝑡)

Where:
𝑊(𝑡) 𝑖𝑠 𝑎 𝑊𝑖𝑒𝑛𝑒𝑟 𝑝𝑟𝑜𝑐𝑒𝑠𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑅𝑊
(a) (1 point) Express the RW dynamics of the instantaneous forward rate (f(t,T)) in terms of
the market price of risk.
(b) (1 point) In the risk neutral world, what is the condition for no-arbitrage?
(c) (1 point) Show that in the RN world, the forward rate is a biased estimator of the
instantaneous spot rate.
(d) (1 point) Discuss whether or not in the HJM framework, the instantaneous short rate
process is a Markov process.
(e) (4 points) Derive the no-arbitrage, RN processes for (i) f(t,T) and (ii) r(t) (the time t short
term rate), under the following volatility structures:
1. 𝜎(𝑡, 𝑇) = 𝜎 × (𝑇 − 𝑡)
2. 𝜎(𝑡, 𝑇) = 𝜎(0, 𝑇) = 𝜎(𝑇) = 𝑎 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑇
(f) (1 point- Bonus) Check that the formula derived under (𝜎(𝑡, 𝑇) = 𝜎 × (𝑇 − 𝑡)) are special
cases of the general formula under (𝜎(𝑇)).
This question pertains to Interest rate modeling (Short rates; HJM, LMM and martingale)
55. (10 points)
(a) (3 points)
Complete the following table:
(b) (2 points) Describe the steps for carrying out a MC simulation under the one factor HJM
model. You will assume the following:
𝑣(𝑡, 𝑇) = 𝑇ℎ𝑒 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑣𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦 𝑠𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒
(c) (2 points) Describe the “possible” steps for carrying out a MC simulation for pricing
equity derivatives under the HJM dynamics for interest rates.
Note: the traditional BSM model assumes that interest rates are fixed.
(d) (1 point) Describe a potential issue when using MC simulation/HJM model for pricing
American derivatives.
(e) (2 points)
You are using HJM model for capturing the dynamics of the yield curve. You are conveniently
given the following quantities:
𝐵(𝑡, 𝑇) = 𝑇ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡 𝑜𝑓 𝑎 𝑍𝐶𝐵 𝑝𝑎𝑦𝑖𝑛𝑔 𝑜𝑓𝑓 $1 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑇

𝑓(𝑡, 𝑇) = 𝑇ℎ𝑒 𝑡𝑖𝑚𝑒 𝑡 𝑖𝑛𝑠𝑡𝑎𝑛𝑡𝑎𝑛𝑒𝑜𝑢𝑠 𝑓𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑡𝑖𝑚𝑒 𝑇
𝑟(𝑡) = 𝑇ℎ𝑒 𝑠ℎ𝑜𝑟𝑡 𝑟𝑎𝑡𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡 �𝑑𝑒𝑟𝑖𝑣𝑒𝑑 𝑓𝑟𝑜𝑚 𝑡ℎ𝑒 𝑑𝑦𝑛𝑎𝑚𝑖𝑐𝑠 𝑜𝑓 𝑓(𝑡, 𝑇)�
And
𝐷(𝑡) = 𝑇ℎ𝑒 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑓𝑎𝑐𝑡𝑜𝑟 = 𝑒𝑥𝑝 �− � 𝑟(𝑢)𝑑𝑢�

0
Show that the product:
𝐷(𝑡) × 𝐵(𝑡, 𝑇)
is just another martingale in the risk neutral measure.
This question pertains to Paul Wilmott’s derivation of the LMM model

56. (8 points)
Denote:
𝑍(𝑡, 𝑇𝑖 ) = 𝑇ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡 𝑜𝑓 𝑎 𝑍𝐶𝐵 𝑚𝑎𝑡𝑢𝑟𝑖𝑛𝑔 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑇𝑖
Where you have a clear market horizon of bond price maturity as follows:
𝑇ℎ𝑒 𝑠𝑒𝑡 𝑜𝑓 {𝑇𝑖 } 𝑤ℎ𝑒𝑟𝑒 𝑖 = 1 𝑡𝑜 𝑛, 𝑎𝑛𝑑 𝑡ℎ𝑒 𝑡𝑖𝑚𝑒 𝑠𝑡𝑒𝑝 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 (𝑇𝑖 )𝑎𝑛𝑑 (𝑇𝑖+1 ) 𝑖𝑠 𝜏
Suppose you are now at time (𝑇0 = 𝑡) and the instantaneous forward rate (𝐹(𝑡, 𝑇𝑖 , 𝑇𝑖+1 )) is
denoted by (𝐹𝑖 (𝑡)).
LMM adopts the following process for (𝐹𝑖 (𝑡)):
𝑑𝐹𝑖 (𝑡)
= 𝜇𝑖 𝑑𝑡 + 𝜎𝑖 𝑑𝑋𝑖
𝐹𝑖 (𝑡)
(a) (1 point) Describe each term in the SDE (𝐹𝑖 (𝑡)) and explain if/why it is/is not a GBM
process.
(b) (1 point) Use discrete compounding to write down an equation that expresses (𝑍(𝑡, 𝑇𝑖 ))
and (𝑍(𝑡, 𝑇𝑖+1 )) in terms of the forward rate (𝐹𝑖 (𝑡)).
LMM adopts the following process for (𝑍(𝑡, 𝑇𝑖 )):
𝑖−1
𝑑𝑍(𝑡, 𝑇𝑖 )
= 𝑟𝑑𝑡 + � 𝑎𝑖𝑗 𝑑𝑋𝑗
𝑍(𝑡, 𝑇𝑖 )
𝑗=1
You are asked to:
(c) (1 point) Describe the features of the SDE for (𝑍(𝑡, 𝑇𝑖 )) in terms of: (1) Risk neutrality
(2) GBM appearance (3) Markovness.
(d) (4 points) Derive the LMM model (equation 19.9 on formula sheet for PW-19).
(e) (1 point) Compare the way the PV of cash flows is obtained under the HJM and LMM
MC Simulations.
This question pertains to the one factor extended Vasicek model

57. (5 points)
You are given the following short rate model:
𝑑𝑟(𝑡) = 𝛼�𝜇(𝑡) − 𝑟(𝑡)�𝑑𝑡 + 𝜎𝑑𝑊(𝑡)
The price of a ZCB under this model is given:
𝑃(0, 𝑇) = 𝑒 𝐴(0,𝑇)−𝑟(0)𝐵(0,𝑇)
Where:
𝑇
𝐴(0, 𝑇) = − � 𝜇(𝑠)𝐵(0, 𝑠) 𝑑𝑠 + 𝐻(𝜎, 𝑇)

0
And
𝐻(𝜎, 𝑇) = 𝑎 𝑑𝑒𝑡𝑒𝑟𝑚𝑖𝑛𝑖𝑡𝑖𝑐, 𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑡𝑖𝑎𝑏𝑙𝑒 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑇, 𝑑𝑒𝑝𝑒𝑛𝑑𝑒𝑛𝑡 𝑜𝑛 𝜎
And
𝐵(0, 𝑠) = 𝑎 𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑡𝑖𝑎𝑏𝑙𝑒 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝑡𝑖𝑚𝑒
The initial yield curve is given by the forward rate function:
𝑓(0, 𝑡)
Where:
𝑊(𝑡) 𝑖𝑠 𝑎 𝑊𝑖𝑒𝑛𝑒𝑟 𝑝𝑟𝑜𝑐𝑒𝑠𝑠
You are asked to:
(a) (1 point) Identify and describe the given interest rate model.
(b) (1 point) Is this a Markov model? Justify your answer.
(c) (1 point) Express r(t) in terms of an Ito integral, and calculate its expected value.
(d) (2 points) Assume (𝜇(0) = 0), use yield curve fitting to express (𝜇(𝑡)) in terms of
(𝑓(0, 𝑡)).
This question pertains to HJM model

58. (5 points)
You are given the following model for the instantaneous forward rate (𝑓(𝑡, 𝑇)):
𝑑𝑓(𝑡, 𝑇) = 𝛼(𝑡, 𝑇)𝑑𝑡 + 𝜎(𝑡, 𝑇)𝑑𝑊(𝑡)

You are asked to:
(a) (1 point) Find the corresponding SDE for the short rate process r(t).
(b) (1 point) Is the given process a Markov process? Explain.
Assume we can find a function S such that:
𝜕
𝑆(𝑡, 𝑇) = −𝜎(𝑡, 𝑇)
𝜕𝑇
And
𝛼(𝑡, 𝑇) = −𝜎(𝑡, 𝑇) × 𝑆(𝑡, 𝑇)
(c) (1 point) Identify the given model and reveal the meaning of the function S.
(d) (2 points) Solve the model for the short rate process r(t) under the assumption that:
𝜎
𝑆(𝑠, 𝑡) = − �1 − 𝑒 −𝛼(𝑡−𝑠) �
𝛼
and
Calculate the expected value of r(t) and what can you conclude?.
This question pertains to HJM representation of the Merton’s model

59. (7 points)
You are given the following RN process for the short rate of interest:
𝑑𝑟(𝑡) = 𝜃𝑑𝑡 + 𝜎𝑑𝑊(𝑡)

Where:
𝑊(𝑡) 𝑖𝑠 𝑎 𝑊𝑖𝑒𝑛𝑒𝑟 𝑝𝑟𝑜𝑐𝑒𝑠𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑅𝑁 𝑤𝑜𝑟𝑙𝑑
(a) (1 point) Give two reasons why this model might not be an ideal model for pricing
interest rate contingent claims.
(b) (1 point) The current time is t=0, solve the SDE for r(t) and comment on the Markovian
and Martingale property of this process.
(c) (2 points) Calculate the price of a ZCB paying off a $1 at time t.
(d) (2 points) Derive the SDE for the implied instantaneous short rate.
(e) (1 point) Comment on whether or not the process satisfies the HJM no-arbitrage
condition/framework.
This question pertains to Asset Allocation

60. (6 points)
You have collected the following data for an investor:
Three asset allocations are available to this investor.
You are asked to:
(a) (1 point) Describe the circumstances under which the ALM approach to asset allocation
is appropriate?
(b) (1 point) Define and compare the dynamic and the static approach of ALM for asset
allocation.
(c) (1 point) List four types of investors that prefer the ALM asset allocation to the Asset
only (AO) and state why. Also, list one type of investor that prefers the AO only and state why.
(d) (1 point) Based on the risk-adjusted expected returns for the three asset allocations, which
asset allocation will the investor prefer?
(e) (1 point) Based on the Roy’s safety-first criterion, which asset allocation will the investor
preferred?
(f) (1 point) Which portfolio would you recommend?
This question pertains to HJM representation of the Ho-Lee model

61. (10 points)
You are given the following RN process for the short rate of interest:
𝑑𝑟(𝑡) = 𝜂(𝑡)𝑑𝑡 + 𝜎𝑑𝑊(𝑡)

Where:
𝑊(𝑡) 𝑖𝑠 𝑎 𝑊𝑖𝑒𝑛𝑒𝑟 𝑝𝑟𝑜𝑐𝑒𝑠𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑅𝑁 𝑤𝑜𝑟𝑙𝑑
“Note, the model is pretty similar to the one in MOCK-59, but there is a different trick in
developing the HJM representation, because of the dependence in time and the no-arbitrage
feature of the model. You will see.”
You are asked to:
(a) (1 point) Describe the given model.
(b) (1 point) The current time is t=0, solve the SDE for r(t).
(c) (1 point) What is the bond price PDE for this model?
(d) (2 points) The current time is t=0, calculate the price of a ZCB paying off a $1 at time t
using the equivalence martingale approach.
(e) (1 point) Verify that the price obtained in (d) satisfies the PDE in c.
(f) (1 point) Derive the drift term that ensures that the model fits the initial forward curve.
(g) (2 points) Derive the implied process for the instantaneous forward rate (This is an
arbitrage-free process, derived from f, or otherwise).
(h) (1 point) Is this a HJM representation?
This question pertains to Investment Management: the IPS of a pension fund

62. (4 points)
You are given the following information about the pension fund for corporation XYZ:
The management of the fund is putting together an IPS and is considering two of them below:
For the following components, select the IPS that is best representative of the pension fund:
1. Return requirement
2. Risk tolerance
3. Time horizon and
4. Liquidity
This question pertains to Investment Management: the IPS of a Commercial Bank

63. (6 points)
(a)
1. Determine whether or not the item on panel A below is to be found on the asset or the
liability side of a commercial bank’s balance sheet (USA, not Europe):
Assume a bank's average loan to customers was $100.00 in a year while it earned interest income
of $6.00 and paid interest of $3.00.
2. What is this bank’s net interest margin?
3. Define the interest spread of a bank.
(b) You are given the following information about the balance sheet of a commercial bank:
You are asked to:
(a) (1 point) Calculate the weighted average duration of assets.
(b) (1 point) Calculate the weighted average duration of liabilities.
(c) (1 point) Calculate the leverage adjusted duration gap for the bank
Suppose interest rates decrease from 6% to 4.5%.
(d) (1 point) What is the bank net worth’s dollar change?
This question pertains to Investment Management: the BL optimization model

64. (6 points)
An investor has compiled the following capital market expectations:
Let:
� = 𝑡ℎ𝑒 𝑐𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑚𝑎𝑡𝑟𝑖𝑥 𝑜𝑓 𝑡ℎ𝑒 𝑎𝑠𝑠𝑒𝑡 𝑐𝑙𝑎𝑠𝑠𝑒𝑠
𝛿 = 𝑇ℎ𝑒 𝑟𝑖𝑠𝑘 𝑎𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝑡ℎ𝑒 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
In the context of the BL optimization:
(a) (1 point) Describe the equilibrium returns and give the mathematical equation for
calculating them.
(b) (1 point) Suppose the investor has an average risk tolerance and is constraint to invest
only in the five assets. What would be his optimal asset allocation?
(c) (1 point) Suppose the investor has a below-average risk tolerance and is constraint to
invest only in the five assets. What would be his optimal asset allocation?
The investor has also compiled the following statistics about the total return of the asset classes:
The investor has the following views:
1. The DJGI UK return will be the same as the DJGI Europe/Africa (ex-UK).
2. The DJGI Asia Pacific will outperform the DJGI Japan by 1 percent.
Assume the variance of both views is 0.001.
(d) (1 point) Comment on the investor’s confidence in the two views.
(e) (2 points) incorporate these views and recalculate the BL equilibrium returns with views
This question pertains to Investment Management: Strategic Asset Allocation

65. (6 points)
An investor has a portfolio invested in equities and bonds. The portfolio has a Sharpe Ratio of
0.30. The investor is considering adding international real estate to the portfolio as represented
by the NACREIF (National Council of Real Estate Investment Fiduciaries). The real estate index
has a predicted Sharpe ratio of 0.09. The predicted correlation with the existing portfolio is 0.45.
(a) (1 point) Contrast the elements in the strategic asset allocation process that are relatively
stable to those that frequently change.
(b) (1 point) Compare and contrast the global minimum variance portfolio with the minimum
surplus.
(c) (2 points) Determine whether the investor shall add the international real estate asset class
to the portfolio.
(d) (2 points) Describe how corner portfolio arise and explain how to use them in strategic
asset allocation.
This question pertains to Investment Management: Rebalancing based on Dollar Duration

66. (6 points)
You have constructed a portfolio consisting of three bonds in equal par amounts of $1 million
each. The initial values and durations are shown below:
One year later, the values are:
As a manager, you would like to use dollar duration rebalancing to maintain the portfolio’s initial
dollar duration.
You are asked to:
(a) (1 point) Calculate the initial dollar duration of each of the bond.
(b) (1 point) Calculate the initial dollar duration of the portfolio.
(c) (1 point) Describe the steps involved in rebalancing using the dollar duration.
(d) (2 points) Calculate the rebalancing ratio necessary for the rebalancing.
(e) (1 point) Calculate the cash required for the rebalancing.
This question pertains to Investment Management: Credit derivatives (MIP-6)

67. (4 points)
A portfolio manager purchases a binary credit put option on a bond of company X. The option
pays out only if the credit rating of company X declines below investment grade (BBB).
The option maturity is (T), and the strike price is $1000.00
Answer the following:
(a) (1 point) Suppose that at time T, the credit rating of the company X is BBB and its bonds
are worth $950.00 per bond. What is the payout of the binary credit put option?
(b) (1 point) Suppose that at time T, the credit rating of the company X is BB and its bonds are
worth $920.00 per bond. What is the payout of the binary credit put option?
(c) (1 point) Suppose that at time T, the credit rating of the company X is BB+ and its bonds
are worth $1010.00 per bond. What is the payout of the binary credit put option?
Describe the following credit risk derivatives:
(d) (1 point) Describe the following credit risk derivatives:
1) Credit Default Swap (CDS)

2) Credit Spread Option
3) Credit Forward.
This question pertains to The One Factor Vasicek Model

68. (8 points)
Consider the following model of the short term interest rate:
𝑑𝑟(𝑡) = 𝑎𝑟(𝑡)𝑑𝑡 + 𝜎𝑑𝑍(𝑡)
Where (𝑍(𝑡)) is Brownian motion in the RN world.
(a) (1 point) Describe the model and comment on its suitability for pricing interest rate claims
or modeling interest rate dynamics.
You are also given the Vasicek model as an alternative:
𝑑𝑟(𝑡) = 𝑎[𝜃 − 𝑟(𝑡)]𝑑𝑡 + 𝜎𝑑𝑍(𝑡)
Consider the following stochastic process:
𝑋(𝑡) = 𝑟(𝑡) − 𝜃
You are asked to:
(b) (1 point) Derive the SDE for (𝑋(𝑡))
(c) (2 points) Show that the solution to this SDE (b) is
𝒕
−𝒂𝒕
𝑿(𝒕) = 𝒆 × �𝑿(𝟎) + 𝝈 � 𝒆𝒂𝒔 𝒅𝒁(𝒔)�
𝟎
(d) (1 point) Derive the distribution and the expected value for (𝑋(𝑡))
𝑡
(e) (1 point) Derive the distribution and the expected value for (∫0 𝑋(𝑢)𝑑𝑢)
𝑡
(f) (1 point) Derive the distribution and the expected value for (∫0 𝑟(𝑢)𝑑𝑢)
𝑡
(g) (1 point) Derive the variance of (∫0 𝑋(𝑢)𝑑𝑢)
This question pertains to the dynamics and economics of foreign exchange rates
69. (6 points)
The current market conditions on foreign exchange are summarized below:
You are also given the following economic notions about the FX market:
You asked to:
(a) (1 point) Discuss whether or not foreign exchange rates display mean reversion
(b) (1 point) Discuss the meaning of absolute PPP and whether or not the theory holds in
practical market.
(c) (2 points) Discuss the meaning of RIP and whether or not the theory holds in practical
market.
(d) (1 point) Assume that the Uncovered Interest Rate Parity holds, determine the expected
spot rate in one year time.
(e) (1 point) Use the CIP concept to determine whether or not there is arbitrage opportunity in
this market.
This question pertains to Hedging Foreign Exchange Rate Risk

70. (4 points)
(a)
A USA-based portfolio manager has invested in Yen-denominated Japanese bonds. He is

considering hedging his exposure to FX risk with a forward contract. Assume the following
market conditions:
Furthermore, the portfolio manager expects the Japanese Yen to appreciate against the USA
dollar by 1.30%.
Shall the portfolio manager hedge his or her exposure with a forward contract?
(b)
Assume the spread between USA and German bonds is 250 bps. The duration of the German
bond is 9. If German interest rates should decline, how much of a decline in spread is required to
completely wipe out the quarterly yield advantage for the German investor (62.5 bps)?
This question pertains to Managing an equity portfolio

71. (7 points)
You are evaluating several alternatives for the U.S equity portfolio of your client (a pension
plan). You are considering the following equity managers and the market information/statistics:
Assume that the active returns are uncorrelated.
Assume that the overall equity portfolio benchmark is the Russell 3000.
Active A’s misfit risk is 7.25%.
You want to use a mean-variance optimizer to create an implementation efficient frontier. The
highest risk point on the efficient frontier is a 100 percent allocation to the Long-Short manager.
The active risk of this portfolio is 6.3%.
You asked to:
(a) (1 point) State the three main large-cap styles.
(b) (1 point) Explain the principal benefit of a market-neutral long-short portfolio.
(c) (1 point) Calculate the misfit risk of the highest risk point on the efficient frontier’s
portfolio.
(d) (1 point) Calculate the total active risk for Active A.
You select the following allocation:
For this allocation:
(e) (3 points) Calculate the following quantities:
72. (6 points)
You are responsible for the USA equity portion of your company’s pension fund. You want to
boost the overall alpha in U.S. equities by using an enhanced index fund to replace the core
index fund holding.
Your current holding consists of the following:
By replacing the index manager with an enhanced index fund, the target alpha changes from
2.4% to 2.8%, and the tracking risk changes from 2.75% to 2.9%.
(a) (2 points) List and describe the three major types of equity indexing.
(b) (2 points) List and describe the three major methods of equity portfolio indexation.
(c) (1 point) Does the change represent an improvement? Why?
You need to decide on whether you prefer a stock-based or a synthetic enhanced index
manager.
(d) (1 point) Describe each strategy and list the advantages and disadvantages of each
This question pertains to Fixed Income portfolio management

73. (5 points)
A portfolio manager decided to purchase corporate bonds with a market value of $5 million. To
finance 60 percent of the purchase, the portfolio manager entered into a 30-day repurchase
agreement with the bond dealer. The 30-day term repo rate was 5% per year. At the end of the 30
days, the bonds purchased by the portfolio manager have increased by 0.90% and the manager
decided to sell the bonds. No coupons were received during the 30-day period.
You asked to:
(a) (1 point) Describe the main features of a repurchase agreement and determine if the
following security can be used as collateral (i) A treasury security (ii) A corporate Bond.
(b) (1 point) List four determinants of a repo rate.
(c) (1 point) Compute the 30-day rate of return on the equity and borrowed components of the
portfolio
(d) (1 point) Comment on the effect of the use of leverage on this portfolio rate of return.
(e) (1 point) Discuss why the bond dealer in the above example faces a credit risk even if the
bond dealer holds the collateral.
This question pertains to CMO Deal Structures

74. (7 points)
Consider the following CMO structure backed by 8% collateral:
You asked to:
(a) (1 point) List and describe the most important structures for CMO deal
(b) (2 points) Explain how does a CMO alter the cash flow from mortgages so as to redistribute
the prepayment risk across various tranches in a deal (You will distinguish the two possible
structures as specified in question a)?
(c) (1 point) The last tranche in the given structure is called Z tranche. Describe the main
features of a Z bond
(d) (1 point) Show how tranche C can be transformed into the combination of: (i) 75% Floater
Coupon rate based on LIBOR with a margin of 0.5% and (ii) 25% Inverse Floater based on
LIBOR. Find the correct coupon rate (in terms of the cap rate and the coupon leverage) for the
inverse floater.
Suppose that the structure of this CMO wants to create a notional IO tranche with a coupon rate
of 8%.
(e) (1 point) Calculate the notional amount for this notional IO tranche.
(f) (1 point) Describe the sensitivity of an IO tranche to changes in interest rate.
This question pertains to CMO Deal Structures

75. (7 points)
An issuer is considering the following two CMO structures:
Structure 1: 5 PAC-1 tranches and a support tranche
Structure 2: 5 PAC-1 tranches, one PAC-2 tranche and a support tranche
You are asked to:
(a) (2 points) Describe the features of the following CMO deal tranches:
Targeted Amortization Class (TAC Bond)

Very Accurate Determined Maturity (VADM Bond)
(b) (1 point) Describe the structure 1's support tranche (F) and its workings, and also the
support tranche (G) of structure 2.
(c) (1 point) In structure 2, G is created from tranche F of structure 1. What is the coupon rate
for tranche G (structure 2) given that the combined coupon rates for F and G in structure 2 are
the same as the coupon rate for F in structure 1?
(d) (1 point) What is the effect on the value and average life of tranches A-E by including the
PAC-2 in structure 2?
(e) (1 point) What is the difference in the average life variability of tranche G in structure 2 and
tranche F in structure 1?
(f) (1 point) What is a busted PAC?
This question pertains to projecting MBS Cash Flows

76. (11 points)
An MBS is constructed from a $100 million mortgage pool with the following features:
You built the projected cash flows table as follows:
You are asked to:
(a) (1 point) Calculate the dollar amount of the first-month servicing fees on the MBS pool
(b) (1 point) Calculate the first month mortgage payment
(c) (1 point) Calculate the first month Mortgage Int. Payment ($m)
(d) (1 point) Calculate the first month Mortgage Schedule principal payment ($m)
(e) (1 point) Calculate the prepaid principal in the first month ($m)
(f) (1 point) Calculate the first month total principal payment ($m)
(g) (1 point) Calculate the first month MBS Cash flow ($m)
(h) (1 point) Calculate the Actual Balance at the BEG of month 2
Assume the following:
(i) (1 point) Calculate the SMM rate for month 2
(j) (2 points) Calculate the following quantities (for the last month):

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PAK 76 MOCK Problems for SOA QFIC Exam (Fall 2014)

PAK 76 MOCK PROBLEMS for QFIC

Time yourself 3 minutes per 1 answer point

These 76 MOCK Problems are included in the PAK EXAM AID.

SM) and the PAK TEST AID.

Should you find any typos, please kindly contact bell.ouelega@pakstudymanual.com or

PART I: LIST OF MOCK QUESTIONS (1-42) BY KEY CONCEPT

PART II: LIST OF MOCK QUESTIONS (43-76) BY KEY CONCEPT

This question pertains to SOA QFIC Objective 6.

For each component above, outline the key factors.

This question pertains to Investment decisions in the presence of liabilities.

o The annual risk-free rate is 2%.

This question pertains to Arbitrage theory in stochastic interest rate environment

3. (12 points) Consider a two time period investments:

You are asked to:

1. Define the normalization process.

4. What is the arbitrage-free value of the FRA at contract-time?

8. Calculate the arbitrage-free value of security 3.

This question pertains to Fixed Income Securities

(i) Zero coupon bond

(a) (3 points) Describe each type of bond above.

This question pertains to Fixed Income Portfolio Management.

5. (8 points) It is closed to year-end and your company, a portfolio management

Time Cash Flow

This question pertains to Fixed Income Portfolio Management.

Bond A: 7% coupon (semi-annual payment) with 6-year maturity and a duration of 5.

The current yield curve is flat at 7% (bond-equivalent).

Yield curve parallel

This question pertains to Fixed Income Securities.

(a) (2 points) Describe TIPSs and their advantages.

(i) Pension Plans

o The current short rate is 2%.

Assume the following RN dynamics for the short rate model:

(g) (1 point) What is the time t instantaneous forward rate f(t,t)?

Consider the following discounted bond price process:

𝑡 → 𝑒𝑥𝑝 �− � 𝑟(𝑠)𝑑𝑠� × 𝑃(𝑡, 𝑇)

(h) (2 points) Demonstrate that the given process is a martingale.

This question pertains to Portfolio management of Foundations.

9. (6 points) Uncle Sam is a billionaire and wants to set up a long-lived foundation to

This question pertains to Asset allocation.

Expected Standard Derivation of

This question pertains to Equity Modeling.

o The annual risk free rate of interest is 2.00%

You are asked to

(c) (1 point) Calculate the reserve for this guarantee.

(d) (3 point) Calculate the capital requirement for this guarantee.

The expense at the end of the year will be:

The separate account is modeled by a GBM process with:

You are asked to:

You are asked to:

(c) (2 points) Calculate the value of this special derivative.

This question pertains to Digital Options

 The drift is 7% and

The cash amount in the cash-or-nothing option is $60.

You are asked to:

(f) (1 point) What is the delta of a cash-or-nothing call?

Currently, a similar reinsurance treaty resulted to a reinsurance claim of amount 𝑥0

You are asked to:

This question pertains to Alternative to BSM: BT for pricing index-linked contracts

(d) (1 point) Shall the company continue on selling this product?

You are asked to:

This question pertains to interest rate models feature

 Cox Ingersoll and Ross (CIR)