Cm2 Compiler Setted (1 to 9) With Answers (18.03.23) (1)

CM2- FINANCIAL ENGINEERING AND LOSS RESERVING ACTUATORS EDUCATIONAL INSTITUTE
CM2
FINANCIAL ENGINEERING AND LOSS
RESERVING
PAST EXAM QUESTIONS & SOLUTION
CA PRAVEEN PATWARI 1 JAI SHREE SHYAM

CM2- Financial Engineering and Loss Reserving
INDEX
QUESTIONS
SECTION 1 EFFICIENT MARKETS HYPOTHESIS, INVESTORS AND RISK 3-19
SECTION 2 STOCHASTIC MODELS OF INVESTMENT RETURN 20-28
SECTION 3 PORTFOLIO THEORY AND INVESTMENT MODELS 29-44
SECTION 4 STOCHASTIC CALCULUS AND MODELLING 45-55
SECTION 5 DERIVATIVES AND BINOMIAL TREES 56-77
SECTION 6 BLACK-SCHOLES AND THE 5-STEP METHOD 78-94
SECTION 7 INTEREST RATE AND CREDIT RISK MODELS 95-114
SECTION 8 RUIN THEORY 115-128
SECTION 9 RUN-OFF TRIANGLES 129-142
SOLUTION
SECTION 1 143-159
SECTION 2 160-163
SECTION 3 164-173
SECTION 4 174-179
SECTION 5 180-194
SECTION 6 195-206
SECTION 7 207-222
SECTION 8 223-233
SECTION 9 234-237


SECTION –1
EFFICIENT MARKETS HYPOTHESIS,
INVESTORS AND RISK
FOR THE
2023 EXAMS
COVERING
CHAPTER 1 THE EFFICIENT MARKETS HYPOTHESIS
CHAPTER 2 UTILITY THEORY
CHAPTER 3 STOCHASTIC DOMINANCE AND BEHAVIOURAL FINANCE
CHAPTER 4 MEASURES OF INVESTMENT RISK

1. Subject CT8, April 2010, Question 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 m shares. [10]

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% pa and
the junior one with interest of at 8% pa. Interest is paid on the loans only if the asset sustains no
tosses.
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 uni-
form 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]
3. Subject ST5, September 2010, Question 8
(i) Explain, using the principles of behavioural finance, the types of biases that can affect an inves-
tor's view of the probability of an event occurring that is outside their control, such as an equity
market crash. [4]
(ii) Describe the additional forms of bias that are introduced when an active investor has the discre-
tion to improve an outcome compared with a passive (index) investor. [3]
In a developing country, house prices have been rising rapidly for several years fuelled by loans of up
to 100% of the value of the house. The government has introduced rules that restrict the amount of
borrowing to 50% of the value of the house. Following the restriction in lending, house prices have
started to fall and are expected to do so for the next couple of years.

(iii) Explain the behaviours exhibited by the following people:

(a) An investor who has been successful in the past buying residential property to profit from capi-
tal appreciation, who has decided to continue to buy residential property over the next couple
of years.
(b) An economist who has written a recent article commenting that house prices were always ex-
pected to fall. The economist uses historic data to prove this point. All news articles written
prior to the borrowing restriction only indicated that prices would continue to rise. [5]
A couple have taken advantage of the falling house prices and purchased a new house. As part of the
move they wish to review their house insurance options. They are deciding whether to stay with their
current insurance provider or to move to a new entrant into the market.
Details of the two policies are as follows:
Existing Co New Co
Premium £650 £500
£100 per claim £80 — £120 depending on
Excess payable
profitability of company
Policy schedule Detailed booklet setting Limited information

out all terms and provided on terms and
conditions conditions
The couple have not made a claim in the past and it is unlikely that they will make a claim over the
coming year. The couple decide to take out the policy with Existing Co.
(iv) Outline, with reasons, three possible behaviours which explain wily the couple have stayed with
Existing Co. [5]
[Total 17]
4. Subject CT8, October 2010, Question 1
An investor holds an asset that produces a random rate of return, R, over the course of a year. The dis-
tribution 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 va-
riance 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]
(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]

(i) Outline the three forms of the efficient markets 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]
7. Subject ST5, October 2011, Question 8 (part)
An investment management company is interested in understanding more about what drives perfor-
mance in its portfolios and hires a specialist firm to look at each portfolio manager's track record. The
specialist firm finds the following:
(1) On average, portfolio managers hold on to underperforming stocks for six months longer than
they should.
(2) Portfolio managers often ignore investment analysts' reports when choosing which stocks to
buy and sell.

(3) The underlying stock analysis is often changed by portfolio managers to justify holding onto
stocks.
(i) Explain the type of behaviour exhibited by the portfolio managers for each of the three points
above. [3]
(ii) Suggest actions that could be taken to stop some of the behaviours identified in (i). [5]
[Total 8]
8. Subject CT8, September 2011, Question 3 (part)
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 pur-
chase shares on a non-dividend-paying security with price S t governed by the stochastic differential
equation (SDE):
dSt  St  dt  dZt  ; where:
 Z t is a standard Brownian motion
   12%
   25
 t is the time from now measured in years
 S0  1 .
(i) (a) Derive the distribution of S t .
(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 years' 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]
[Total 10]
9. Subject CT8, April 2012, Question 5 (amended)

Let X be a random variable denoting the rate of return on the fund ABC. The distribution of X is

N ,  2 . 
(i) Define VaR   X  , the Value at Risk at the 100 1    % confidence level, where   0,1 . [1]
(ii) Show that

VaR       1    
where  denotes the cumulative Normal distribution function.
(Hint: Consider the probability that X is less than  VaR  ) [4]
(iii) Derive an expression for TailVaR   X  given that:
TailVaR   E  X | X  VaR   . [4]
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   0.01 . [2]
[Total 11]
The effective risk-free interest rate is 4% pa. Company AA has issued a one-year zero-coupon bond
with a yield of 6% pa and Company BB has issued a one-year zero-coupon bond with a yield of 8% pa.
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, as-
suming 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]

11. Subject CT8, October 2012, Question 10 (part)
Let A and B be two investment portfolios taking values in [a, b] with cumulative probability distribu-
tion functions of returns FA and FR 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]
[Total 3]
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. [Total 10]
13. Subject CT8, September 2013, Question 1
(i) (a) State the expected utility theorem.
(b) State the four axioms from which it can be derived. [5]
(ii) Explain 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  bw . The value of absolute risk aver-
2
sion 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]
(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 along-awaited and publicly negotiated
merger is completed. [3]
[Total 6]
Outline the key findings in behavioural finance. [10]

(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   w 1 |  .
(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]
Consider an asset the annual return, X, on which has probability density function f(x).
(i) Define the 95% Value at Risk for this asset. [1]
(ii) Define the expected shortfall of the return on this asset below 2%. [2]
2
Assume X has a normal distribution with mean µ = 5% and variance   100%% .
(iii) Calculate the 95% 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]


An investor makes decisions using a quadratic utility function,
U  w   a  bw  cw 2 .
(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 proba-
bility (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]
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  dt  dZt 
where:
  =10%
  =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% pa.
(i) Derive the distribution of S t . [2]
(ii) Calculate the amount, A, that the actuary will need to invest in the shares to give a 40% probabil-
ity 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
shareholding 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]
An investor measures the utility of her wealth using the utility function U  w   In  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 probabili-
ty 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 Assets A and B to maximise her expected
utility, using your result from part (iii). [5]
[Total 13]


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 nota-
tion 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  = 6% per annum and variance  2 =
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]
(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]
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]


(i) State the expected utility theorem. [2]
A risk-averse investor makes decisions using a quadratic utility function:
U  w   w  dw 2
(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 game show. 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]
Consider a non-dividend-paying security with price S t at time t. The security price follows the sto-
chastic differential equation:
where:
  = 16% per annum
  = 25% per annum

 S0 = 1.
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% prob-
ability 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]
(i) Define the following terms:
(a) absolute dominance
(b) first-order stochastic dominance
(c) second-order stochastic dominance. [4]
Consider three 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]
 
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. Nega-
tive 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 utility of 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]
Describe the key findings in behavioural finance. [10]
29. Subject CM2, April 2019, Question 1

(i) Describe the three forms of the Efficient Markets Hypothesis. [4]
(ii) Describe the evidence against market efficiency in relation to:
(a) over-reaction of market prices to events
(b) under-reaction of market prices to events. [6]
[Total 10]

(i) Describe the first-order stochastic dominance theorem. [2]
(ii) Describe the second-order stochastic dominance theorem. [2]
Consider two portfolios, 1 and 2, which have normally distributed returns with parameters  1, 1 
and  2 , 2  respectively. Investors in this market meet the assumptions of the dominance theorems.
(iii) Explain which portfolio, if any, dominates the other in the following situations, indicating wheth-
er any dominance is first or second order and why:
(a) 1   2 and 1   2
(b) 1   2 and 1   2
(c) 1   2 and 1   2 [6]
[Total 10]
31. Subject CM2, April 2019, Question 3 (pan)
Consider a lognormal process S t with parameters  and  2 .
(iv) Define the following risk measures algebraically:

(a) Value at Risk at the level p%
(b) expected shortfall below a benchmark level L. [2]
(v) Suggest why it can be difficult to apply Value at Risk to real-world situations at higher percen-
tage levels (for example at the 99% level). [3]
[Total 5]
A portfolio of derivatives is valued today at £1,000,000. The one-day return on the portfolio between
today and tomorrow is normally distributed with parameters   1% and   20% .
(i) Calculate, in respect of the value of the portfolio tomorrow:

(a) the expected value of the portfolio
(b) the variance of the portfolio value
(c) the downside semi-variance of the portfolio value relative to the expected value
(d) the shortfall probability relative to £1,000,000. [5]

(ii) Determine the 99% Value at Risk (VaR) over the one-day period, relative to the expected portfo-
lio value. [3]
(iii) Determine the minimum number of days that would need to pass such that the probability of a
99% one-day VaR event is at least 50%. You should assume that the returns each day are inde-
pendent of each other. [3]
[Total 11]
33. Subject CM2, September 2019, Question 1
Consider a random variable X with probability density function f(x) and mean  .
(i) Define algebraically the following risk measures for X:
(a) shortfall probability below a level L
(b) Value at Risk at the level p
(c) downside semi-variance. [3]
An actuarial student is saving up to buy a car. He currently has £9,000 and he needs £10,000 to buy
the car. There are three options for saving:
 Option 1: A bank account paying a guaranteed 10% per annum interest rate.
 Option 2: An equity fund whose returns are Gaussian with mean 15% pa and standard deviation
15% pa.
 Option 3: A gamble that will return double the original investment with probability 65% or lose
the entire investment otherwise.
Assume that the student can invest his entire savings in only a single investment option.
(ii) Calculate for each of these three investment options, for a one-year time horizon:
(a) the shortfall probability below £10,000
(b) the Value at Risk at the 75% level. [5]
(iii) Recommend, with reasons, an appropriate investment strategy for the student, given the results
in part (ii). [3]
[Total 11]

34. Subject CM2 September 2019, Question 5

A non-dividend paying share is currently priced at $80. Each year the share price will either increase
by 10% or fall by 10% with equal probability. A call option is written on the share with a strike price
of $75 and expiry in two years. The risk-free force of interest is 5% per annum.
(i) Calculate the risk-neutral price of the option using a binomial tree. [4]
An individual has $1,000 to invest. In making his investment choices he uses the utility function
U  w   w 0.5 .
(ii) Calculate the investor's expected utility of wealth at time t = 2 if he invests the entire fund at t = 0
in:
(a) a bank account returning the risk free rate. [1]
(b) the shares. [3]
(c) the call options. [3]
(iii) Explain why the relative appeal of the choices (a), (b) and (c) above is consistent with the form
of the investor's utility function. [2]
[Total 13]


SECTION –2
STOCHASTIC MODELS OF
INVESTMENT RETURN
FOR THE
2023 EXAMS
COVERING
CHAPTER 5 STOCHASTIC MODELS OF INVESTMENT RETURNS

The annual returns, i, on a fund are independent and identically distributed. Each year, the distribu-
tion of 1 + i is lognormal with parameters  = 0.05and  2 = 0.004, where i denotes the annual return
on the fund.
(i) Calculate the expected accumulation in 25 years' time if £3,000 is invested in the fund at the be-
ginning of each of the next 25 years. [5]
(ii) Calculate the probability that the accumulation of a single investment of £1 will be greater than
its expected value 20 years later. [5]
[Total 10]
The annual rates of return from an asset are independently and identically distributed. The expected
accumulation after 20 years of £1 invested in this asset is £2 and the standard deviation of the accu-
mulation is £0.60.
(a) Calculate the expected effective rate of return per annum from the asset showing all the steps in
your working.
(b) Calculate the variance of the effective rate of return per annum. [6]
The annual rates of return from a particular investment, Investment A, are independently and identi-
cally distributed. Each year, the distribution of 1  i t  , where i t is the rate of interest earned in year t,
is lognormal with parameters  and  2 .
The mean and standard deviation of i t are 0.06 and 0.03 respectively.
(i) Calculate  and  2 . [5]
An insurance company has liabilities of £15m to meet in one year's time. It currently has assets of
£14m. Assets can either be invested in Investment A, described above, or in Investment B, which has
a guaranteed return of 4% per annum effective.

(ii) Calculate, to two decimal places, the probability that the insurance company will be unable to
meet its liabilities if:
(a) all assets are invested in Investment B.
(b) 75% of assets are invested in Investment A and 25% of assets are invested in Investment B.
[6]
(iii) Calculate the variance of return from each of the portfolios in (ii)(a) and (ii)(b). [3]
[Total 14]
The annual yields from a fund are independent and identically distributed. Each year, the distribution
of 1 + i is log-normal with parameters  =0.05and  2 = 0.004, where i denotes the annual yield on the
fund.
(i) Calculate the expected accumulation in 20 years' time of an annual investment in the fund of
£5,000 at the beginning of each of the next 20 years. [5]
(ii) Calculate the probability that the accumulation of a single investment of £1 made now will be
greater than its expected value in 20 years' time. [5]
[Total 10]
An individual wishes to make an investment that will pay out £200,000 in twenty years' time. The in-
terest rate he will earn on the invested funds in the first ten years will be either 4% per annum with
probability of 0.3 or 6% per annum with probability 0.7. The interest rate he will earn on the invested
funds in the second ten years will also be either 4% per annum with probability of 0.3 or 6% per an-
num with probability 0.7. However, the interest rate in the second ten year period will be independent
of that in the first ten year period.
(i) Calculate the amount the individual should invest if he calculates the investment using the ex-
pected annual interest rate in each ten year period. [2]
(ii) Calculate the expected value of the investment in excess of £200,000 if the amount calculated in
part (i) is invested [3]
(iii) Calculate the range of the accumulated amount of the investment assuming the amount calcu-
lated in part (i) is invested. [2]
[Total 7]


A cash sum of £10,000 is invested in a fund and held for 15 years. The yield on the investment in any
year will be 5% with probability 0.2, 7% with probability 0.6 and 9% with probability 0.2, and is in-
dependent of the yield in any other year.
(i) Calculate the mean accumulation at the end of 15 years. [2]
(ii) Calculate the standard deviation of the accumulation at the end of 15 years. [5]
(iii) Without carrying out any further calculations, explain how your answers to parts (i) and (ii)
would charge (if at all) if:
(a) the yields had been 6%, 7% and 8% instead of 5%, 7% and 9% per annum, respectively.
(b) the investment had been held for 13 years instead of 15 years. [4]
[Total 11]
An insurance company has just written contracts that require it to make payments to policyholders of
£10 million in five years' time. The total premiums paid by policyholders at the outset of the contracts
amounted to £7.85 million. The insurance company is to invest the premiums in assets that have an
uncertain return. The return from these assets in year t, i t , has a mean value of 5.5% per annum effec-
tive and a standard deviation of 4% per annum effective, 1  i t  is independently and lognormally
distributed.
(i) Calculate the mean and standard deviation of the accumulation of the premiums over the five-
year period. You should derive all necessary formulae. [Note: You are not required to derive the
formulae for the mean and variance of a lognormal distribution.] [9]
A director of the insurance company is concerned about the possibility of a considerable loss from
the investment strategy suggested in part (i). He therefore suggests investing in fixed-interest securi-
ties with a guaranteed return of 4 per cent per annum effective.
(ii) Explain the arguments for and against the director's suggestion. [3]
[Total 12]
An investor is considering investing £18,000 for a period of 12 years. Let i t be the effective rate of in-
terest in the t th year, t  12 . Assume, for t  12 , that i t has mean value of 0.08 and standard deviation
0.05 and that 1  i t is independently and lognormally distributed.
(i) Determine the distribution of S12 where S t is the accumulation of £1 over t years. [5]

At the end of the 12 years the investor intends to use the accumulated amount of the investment to
purchase a 12-year annuity certain paying:
£4,000 per annum monthly in advance during the first four years;
£5,000 per annum quarterly in advance during the second four years;
£6,000 per annum continuously during the final four years.
The effective rate of interest will be 7% per annum in years 13 to 18, and 9% per annum in years 19
to 24, where the years are counted from the start of the initial investment.
(ii) Calculate the probability that the investor will meet the objective. [12]
[Total 17]
A life insurance company is issuing a single premium policy which will pay out £200,000 in 20 years'
time. The interest rate the company will earn on the invested fund throughout the 20 years will be 4%
per annum effective with probability 0.25 or 7% per annum effective with probability 0.75. The insur-
ance company uses the expected annual interest rate to determine the premium.
(i) Calculate the premium. [2]
(ii) Calculate the expected profit made by the insurance company at the end of the policy. [2]
[Total 4]
In any year, the yield on investments with an insurance company has mean j and standard deviation s
and is independent of the yields in all previous years.
(i) Derive formulae for the mean and variance of the accumulated value after n years of a single in-
vestment of 1 at time 0 with the insurance company. [5]
Each year the value of 1  i t  where i t is the rate of interest earned in the t year, is lognormally dis-
th
tributed. The rate of interest has a mean value of 0.04 and standard deviation of 0.12 in all years.
(ii) (a) Calculate the parameters  and  2 for the lognormal distribution of 1  i t  .
(b) Calculate the probability that an investor receives a rate of return between 6% and 8% in
any year. [8]
(iii) Explain whether your answer to part (ii)(b) looks reasonable. [2]
[Total 15]


An individual is planning to purchase £100,000 nominal of a bond on 1 June 2016 which will be re-
deemable at 110% on 1 June 2020. The bond will pay coupons of 3% per annum at the end of each
year.
The individual wishes to invest the coupon payments on deposit until the bond is redeemed. It is as-
sumed that, in any year, there is a 55% probability that the rate of interest will be 6% per annum ef-
fective and a 45% probability that it will be 5.5% per annum effective. It is also assumed that the rate
of interest in any one year is independent of that in any other year.
(i) Derive the necessary formula to determine the mean value of the total accumulated investment
on 1 June 2020. [4]
(ii) Calculate the mean value of the total accumulated investment on 1 June2020. [2]
[Total 6]
An insurance company has just written single premium contracts that require it to make payments to
policyholders of £10,000,000 in five years' time. The total single premiums paid by policyholders
amounted to £8,000,000.
The insurance company is to invest the premiums in assets that have an uncertain return. The return
from these assets in year t, i t , is independent of the returns in all previous years with a mean value of
5.5% per annum effective and a standard deviation of 4% per annum effective. 1  i t  is log no distri-
buted.
(i) Calculate, deriving all necessary formulae, the mean and standard deviation of the accumulation
of the premiums over the five-year period. [9]
A director of the company is concerned about the possibility of a considerable loss from the invest-
ment in the assets suggested in part (i). Instead, the director suggests investing in fixed interest se-
curities with a guaranteed return of 4% per annum effective.
(ii) Set out the arguments for and against the director’s position. [3]
[Total 12]
An individual aged exactly 65 intends to retire in five years' time and receive an annuity-certain. The
annuity will be payable monthly in advance and will cease after 20 years. The annuity will increase at
each anniversary of the commencement of payment at the rate of 3% per annum.
The individual would like the initial level of annuity to be £20,000 per annum.
The price of the annuity will be the present value of the payments on the date it commences using an
interest rate of 7% per annum effective.
(i) Calculate the price of the annuity. [4]
In order to purchase the annuity described in part (i), the individual invests £200,000 on his 65th
birthday in a particular fund.
The investment return on the fund in any given year is independent of returns in all other years and
the annual return is:
 4% with a probability of 60%
 7% with a probability of 40%.
(ii) Calculate, showing all workings, the expected accumulation of the investment at the time of re-
tirement. [3]
(iii) Calculate, showing all workings, the standard deviation of the investment at the time of retire-
ment. [4]
(iv) Determine the probability that the individual will have sufficient funds to purchase the annuity.
[3]
[Total 14]
An individual invests £100 in an asset. The expected accumulation of this asset after 20 years is £200
and the standard deviation of the accumulation after 20 years is £50.
(i) Calculate the expected effective rate of return per annum. [1]
(ii) Calculate the standard deviation of the effective rate of return per annum. [4]
[Total 5]
The annual investment return achieved by an insurance company in year t is i t .
Returns in successive years are assumed to be independent and:
 
In 1  i t  ~ N ,  2 , where   0.08 and   0.15 .

The insurance company has a liability of €800,000 payable at the end of year 10.
The company wishes to invest an amount now so that there is a 95% probability that the accumulated
amount at the end of year 10 will be sufficient to meet this liability.
(i) Calculate the amount of money that the insurance company should invest. [5]
(ii) Explain, without doing any further calculations, how your answer to part (i) would change if
each of the following occurs separately, with all other parameters as in part (i):
(a) The value of  is increased to 0.1.
(b) The value of  is increased to 0.2.
(c) The desired probability of meeting the liability is increased to 99%. [3]
[Total 8]
In a particular investment fund, i t is the effective rate of return in the tth year. Let Sn be the accumula-
tion of £1 invested over a period of n years.
Assume the mean of i t is 0.08, the standard deviation of i t is 0.07 and that 1  t i is independently and
lognormally distributed.
(i) Determine the distribution of S10 . [5]
An investor is considering investing £6,000 in the fund for 10 years.

(ii) Determine the amount of the accumulated value after 10 years such that there is a 97.5% proba-
bility of the investor actually achieving an amount greater than this. [3]
[Total 8]
Consider a model in which the annual rates of return are independent and identically distributed. Let
2
the rate of return each year have mean j and variance s .
Let Sn represent the accumulated amount at time t = n of a single premium of $1 paid at time t= 0.
(i) Derive algebraically an expression for the mean value of Sn . [3]
(ii) Derive algebraically an expression for the variance of Sn . [3]
[Total 6]

Let the random variable log 1  i t  be normally distributed with mean  and variance  2 , where i t is
the rate of interest for year t.
t n
(i) Explain the distribution and parameters for variable Sn   t 1 1  i t  for n>1 including your
reasoning. [3]
Consider the present value of a payment of 1 due at the end of n years denoted by:
1
Vn   tt 1n 1  i t 
(ii) Derive the distribution and parameters of Vn . [5]
[Total 8]


SECTION –3
PORTFOLIO THEORY AND
INVESTMENT MODELS
FOR THE
2023 EXAMS
COVERING
CHAPTER 6 PORTFOLIO THEORY
CHAPTER 7 MODELS OF ASSET RETURNS
CHAPTER 8 ASSET PRICING MODELS

1. Subject CT8, April 2011 Question 2

(i) State the main assumptions of modern portfolio theory. [2]
Three assets have the following characteristics:
Asset i Expected return E i Volatility i
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]
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  M , the standard deviation of the annual return on the market portfolio. Quote any re-
sults 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 mar-
ket portfolio. State any further results that you use. [4]
[Total 7]
(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  R A and R B  have the fol-
lowing 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]
Consider the following three-factor model of security returns:
R i   i  i1l1  i2 l2  i3l3  i , where:
 R i is the return on security i
  i , i1 , i2 and i3 are security-specific parameters
 l1 , l 2 and l3 are the changes in the three factors on which the model is based
2
  i are independent random normal variables, each with variance  .

(i) Describe three categories of model that could be used to help choose the factors l1 , l2 and l3 . [6]
(ii) List examples of the variables that could be used for the factors l1 , l2 and l3 , for two of these
three categories of model. [2]
[Total 8]
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% pa.
(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]
(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]


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]
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 correla-
tion between the returns on the two securities is  .
(i) (a) Determine the values of  which allow the possibility of constructing a zero-risk portfolio,
by calculating the variance of the return on a portfolio with weights x A and x B 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]
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  M , 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]
(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]
(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 part (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]
(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 port-
folio 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]


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 re-
turns 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]
(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%
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 x i denote the weight of Asset i (i =1, 2, 3) in the minimum-variance portfolio with an expected re-
turn of 4%.
(iii) Show, by taking partial derivatives of the Lagrangian function in part (ii), that:
x i  0.45, x 2  0.55, x 3  0.9. [4]
(iv) Comment on how the portfolio would change if short-selling was not allowed. [1]
[Total 11]
(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 x i 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 x A that should be invested in Security A to minimise the portfolio va-
riance. [4]
[Total 9]
Consider a market with N securities, Let x i 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]


In a market where the assumptions of the Capital Asset Pricing Model (CAPM) hold, there is 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]
(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  .
(ii) Determine, in terms of E SA  ,the expected return on the minimum variance portfolio if:
(a) = 0
(b)  =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]

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 (pa) 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]
Let R i denote the return on security i given by the following multifactor model:
R i  a i  bi,1l1  bi,2l2  ...  bi,LlL  ci
where a i and ci are the constant and random parts respectively of the component of the return unique
to security i, l1 ,..., l 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, x B  1.5, x C  0 . [4]
(iii) Construct a portfolio of securities A. B and C that has a factor beta of 2on the first factor and 1 on
the second factor, i.e. the return on the portfolio is:
R P  a P  2l1  l 2  c P [3]
[Total 9]
Let R i 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]
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]


(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 va-
riance vi, as set out below:
Asset i Expected return ri Variance of return v i
A rA = 0.05 v A = 0.16
B rB = 0.07 v B = 0.25
The correlation of returns is C AB  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]
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.
2
An investor uses a utility function that gives rise to an indifference curve V  16R – 200R .
(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]
Describe the difficulties in estimating parameters for asset pricing models. [5]


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% 11% Asset 1 0.00068 0.00102
2 0.3 10% 15% Asset 2 0.00102 0.00181
3 0.1 8% 12%
4 0.4 4% 5%
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]
Consider a market in which the Capital Asset Pricing Model (CAPM) holds. [3]
(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% 11% Asset 1 0.00142 0.00379

2 0.3 15% 30% Asset 2 0.00379 0.01146
3 0.1 18% 25%
4 0.4 20% 40%
(ii) Determine the weight of each asset in the market portfolio to be consistent with
1  0.46,  2  1.36 [3]
(iii) Calculate the Market Price of Risk. [2]

[Total 7]
(i) Define an efficient portfolio in the context of portfolio theory. [1]
(ii) State the two assumptions required in portfolio theory for the existence of an efficient portfolio.
[2]
(iii) Explain what it means if a portfolio is not on the efficient frontier. [1]
Consider a market with just two securities, SA and SB , with expected returns, E A and E B variances,
VA and VB and covariance C AB .
(iv) Derive a formula for the amount, X A , that should be invested in S A to minimise the portfolio va-
riance. [4]
[Total 8]
A market that satisfies the assumptions of the Capital Asset Pricing Model (CAPM) comprises n assets.
Let the random return on asset i be denoted by R i , the expected return by ri , and the corresponding
returns for the market portfolio by R M and rM . Let  i be the proportion of asset i in the market port-
folio.
(i) (a) Define  i , algebraically in this market.
(b) Write down the relationship between these expected returns in this market, including a de-
finition of any additional notation that you use.
(c) Show that  ii  1 [6]

Consider a market where n = 4, that is, there are four assets in the market with the following
attributes:
Asset 1 2 3 4 Risk-free Asset
Expected return 14% r2 r3 r4 3%

(per annum)
Market capitalization £4m £2m £2m £2m
The variance-covariance matrix (in %%) of annual returns on the four assets is as follows:
Asset 1 2 3 4
1 4 1 1 1
2 1 3 1 1
3 1 1 2 1
4 1 1 1 x2
2 8
for some x  0. The variance of the return on the market portfolio is %%.
5
(ii) (a) Calculate the proportions of each asset in the market portfolio.
(b) Calculate 1 ,  2 , 3 and  4 .
(c) Calculate rM , r2 , r3 and r4 . [7]
[Total 13]


SECTION –4
STOCHASTIC CALCULUS AND
MODELLING
FOR THE
2023 EXAMS
COVERING
CHAPTER 9 BROWNIAN MOTION AND MARTINGALES
CHAPTER 10 STOCHASTIC CALCULUS AND ITO PROCESSES
CHAPTER 11 STOCHASTIC MODELS OF SECURITY PRICES

1. Subject CT 8, April 2010, Question 1
Let  X t ; t  0  be a stochastic process satisfying:
t t
X t  X 0    s ds    s dWs
0 0
where W is a standard Brownian motion.

Let f :     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   X t dt  dWt
(ii) Prove that the solution of this stochastic differential equation is given by:
X t  X 0 exp  t     exp    s  t   dWs

t
[6]
0
[Total 8]
2. Subject CT8, April 2010, Question 7 (part)
(ii) Derive the value of a which makes  Bt  at  a martingale when B is a standard Brownian Motion.
[3]
(Note that the whole question is included here, although the last part of it relates to arbitrage.)
Under the real-world measure P, W is a standard Brownian motion and the price of a stock, S, is given
  1  
by St  S0 exp  Wt      2  t  . The continuously-compounded risk-free rate of interest is r and a
  2  
zero-coupon bond with maturity T has price B t  e   . Suppose that in the market any contract
r Tt
which pays f  ST  at time T is valued at:
p t  E e  f  ST  T | Ft 
r Tt
 
where:
 1 
 t  exp  mWt  m 2 t  for t  T for some real number m.
 2 

(i) (a) Prove, using I to's formula, that  t is a martingale.
1 
(b) Show that E exp  mWt    exp  m 2 t  [5]
2 
(ii) (a) Derive an expression for p 0 when f(x) = x
(b) Show that there is an arbitrage in the market unless m   r    |  [5]
[Total 10]
4. Subject CT8, April 2011, Question 1 (part, amended)
(ii) Give the three defining characteristics of a Brownian motion, Z, such that Z0  0 . [2]

(Note that the whole question is included here, although parts of it relate to derivative pricing.)
(i) Describe the lognormal model for security prices. [2]
A security price, S t , is assumed to follow a lognormal model with drift   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 €1,000 if and only if the stock price S1  €2.20 .
They propose to charge €1,000e0.02 p
(iii) Explain whether or not you would buy this option. [4]
Assume now that the value of 4.28% for  has been estimated from observations of the security
price over 10 years using the estimator  '  log  S0   log  S10  / 10
(iv) (a) Specify the distribution of  ' 
(b) Deduce the probability that  '   3% [4]
(v) (a) Explain how your answer to (iii) would change if you knew that   1.28% rather than 4.28%.
(b) Comment on this in the light of your answer to part (iv)(b). [3]
[Total 15]


constant, continuously-compounded risk-free rate of interest is 4% per annum. The investor can pur-
chase shares on a non-dividend-paying security with price S t governed by the stochastic differential
equation (SDE):
where:
   12%
   25%

 S0  1
(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 years' time [4]

(Note that although only parts (ii) and (iii) of this question relate directly to the material in this book-
let, the whole question is included here for completeness. The solution to (i) is included in Booklet 6.)
(i) State the assumptions underlying the Black- choler market. [3]
(ii) State the defining characteristics of Brownian Motion. [2]
(iii) Explain what an examination of past option prices tells us about the assumptions in (i) and (ii).
[4]
[Total 9]
(i) State the four key features of a standard Brownian motion B t . [5]
Consider a stochastic differential equation:

dX t  Yt dB t  A t dt

Where, A t is a deterministic process and Yt is a process adapted to the natural filtration of B t .
(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]
The share price in Santa Insurance Co, S t , is currently 97p and can be modelled by the stochastic dif-
ferential equation:
dSt  0.4St dt  0.5St dB t
where B t is a standard Brownian motion.
(i) (a) Determine d log S t , 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, R t, is also currently at 97p and can be modelled by
the stochastic differential equation:
dR t  0.4R t dt  0.5dB t
Let U t  e0.4t R t .
(ii) (a) Calculate dU t .
(b) Calculate the expectation and variance of the Rudolf Financial Services plc share price in
two years' time. [6]
[Total 12]
Let Wt be a standard Brownian motion.
(i) State the continuous-time lognormal 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  W  .

t
(iii) Derive the values of  and  for which X t defines a standard Brownian motion. [6]
[Total 12]
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, Z 2  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]
(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 (in years) is E S1   200e and the variance is var  S1   40,000e
0.4 0.4
(ii) Determine the parameter values for the corresponding lognormal model. [3]
[Total 7]
Let  X t ; t  0  be a stochastic process satisfying dX t   t dt   t 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, X t  . [2]
Let dX t  X t dt  dWt
(ii) Solve this differential equation, by considering X t  U t et or otherwise. [6]

[Total 8]
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 S t governed by the stochastic differential equation:
where:
  =10%
  = 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% pa.
(ii) Calculate the amount, A, that the actuary will need to invest in the shares to give a 40% probabil-
ity of having savings of at least €20,000 in five years' time. [3]
[Total 5]
State the key arguments against modelling market returns using a Gaussian random walk. [3]

Consider a non-dividend-paying security with price S t at time t. The security price follows the sto-
chastic differential equation:
where:
  =16% per annum
  = 25% per annum
 S0  1 .
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% prob-
ability of having an investment value of at least £100,000 in six years' time. [4]
[Total 8]
The market price, S t , of a traded security satisfies the following stochastic differential equation:
dSt       St dt  St dWt
where Wt is a standard Brownian motion under the probability measure P .
(i) Determine the value of  such that the discounted asset price process S t  e rt St is a martingale
under the given probability measure. [3]
The value of an investment asset follows the equation A  t   exp  Bt  , where Bt follows standard
Brownian motion.

(i) State the defining properties that apply to B t 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]
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  = 12% per annum and  2 = 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 inter-
est. [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 investors 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 investors 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 com-
pounded.
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]
(i) Calculate the mean and the variance of the lognormal distribution. [1]
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  Volatility 
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]
The Ornstein-Uhlenbeck process is the solution to the equation dX t  X t dt  dB t where  and 
are positive parameters.
Derive the solution for X t . [8]

22. Subject CM2, April 2019, Question 3 (part)
Consider a lognormal process S t with parameters  and  2 .
(i) State the mean and variance of S t . [2]
The price of the security at time 0 is S0 = $1,000. The expected price at time 3 is $2,042 and the
standard deviation is $1,290.
(ii) Determine the parameter values for the corresponding lognormal model. [3]
(iii) Calculate the probability that the security price at tine 5, S5 , will fall between $2,000 and $2,500.
[3]
[Total 8]
(i) State the four key features of a standard Brownian motion B t . [4]
Consider a stochastic differential equation dX t  Yt dB t  A t dt where A t is a deterministic

process and Yt is a stochastic process adapted to the natural filtration of B t .
(ii) Write down Ito's lemma for f  t, X t  where f is a suitable function. [1]
 
(iii) Determine df  t, X t  where f  t, X t   exp 4t 2 X t . [2]
[Total 7]


SECTION –5
DERIVATIVES AND BINOMIAL TREES
FOR THE
2023 EXAMS
COVERING
CHAPTER 9 CHARACTERISTICS OF DERIVATIVE SECURITIES
CHAPTER 10 THE GREEKS
CHAPTER 11 THE BINOMIAL MODEL


Consider a stock paying a dividend at a rate  and denote its price at any time t by S t . The dividend
earned between t and T, T  t, is:
 
St e    1 .
 Tt
Let C t 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 de-
noted 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]

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. 151
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]
(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]

Consider a particular stock and denote its price at any time t by S t . This stock pays a dividend D at
time T’.
Let C t and Pt be the price at time t of a European call option and European put option respectively, writ-
ten 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]
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]

Assume that a non-dividend-paying security with price S t 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  e r  d . A financial derivative pays
 if St 1  St u and  if S t 1  S t 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,  and  [4]
(ii) Derive an expression for the risk-neutral probability of the security having value S t u at time t + 1
in terms of (x + y), r,  and  . [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]
(a) List five factors that affect 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.
[Total 5]
constants, continuously-compounded risk-free rate of interest is 4% per annum. The investor can
purchase shares on a non-dividend-paying security with price S t governed by the stochastic differen-
tial equation (SDE):
where:
   12%
   25%
 S0  1 .
(Parts (i) and (ii) are covered in Booklets 4 and 1.)
(b) Calculate the amount A that the investor would need to invest in shares to give a 50:50 prob-
ability of building up a retirement fund of £100,000 in 10 years’ 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 receiv-
ing 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]
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 in-
come stream of £ y per ton payable at six-monthly intervals. A payment has just been made.
Let S t 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]

A non-dividend-paying stock S t 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 anytime 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]
A non-dividend-paying stock has a current price of S0 = 150p and trades in a market which is arbi-
trage 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% pa.
(ii) Calculate the price at time 0 of a non-standard derivative which pays off  S2  100  at the end of
2
two years. [6]

[Total 9]
12. Subject CT8, April 201Z Question 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% pa.

(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]
A non-dividend-paying stock has a current price of S0 = 400p. 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 continuous-
ly-compounded risk-free rate is 6% pa. 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. Oth-
erwise, the derivative pays zero.
Calculate the current price of this non-standard derivative. [8]
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% pa.
(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]

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% pa. 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]
A non-dividend-paying stock has a current price of 300p. Over each of the next two three-month pe-
riods its price will either go up by 30p or down by 30p. Price movements for each period are indepen-
dent 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 mod-
elled 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 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 row 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]
The continuously-compounded risk-free rate of interest is r and a stock with maturity T pays divi-
dends 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]
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]
(Note that we have included the whole question here, although parts of it relate to material covered in
Booklet 6.)

(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%
pa 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 inves-
tor 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. 12]
(iv) (a) Determine an upper and a lower bound on the value of the portfolio at mature.
(b) Deduce bounds for the current put price. [3]
(v) Determine the fair price of the put. [2]
[Total 16]
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% pa.
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]

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% pa.
(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 op-
portunity. [2]
[Total 10]
Consider a non-dividend-paying share with price S t 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% pa.
(ii) Calculate the share price implied by the option prices. [2]
[Total 7]
Part (iii) of this question is covered in Booklet 6.
23. Subject CT8, April 2015, Question 7(i)


(Note that we have included the whole question here, although part (iii) relates to risk-neutral pricing,
which is also covered in Booklet 6)
Consider a non-dividend-paying share with price S t at time t in a market with continuously com-
pounded 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  S0 e rT . [4]
A share is currently worth S0 =£5. The continuously compounded risk-free rate of interest is 3% pa
for 0  t  1 , 5% pa for 1≤ t < 2 and 2% pa 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 timer =1 the share price has in-
creased to £6.
(iii) Calculate the value to the investor of the forward contract at t = 1. [2]
[Total 7]

A non-dividend-paying share currently trades at S0  $10 . An investor is considering buying a Euro-

pean 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% pa.
(i) Determine lower and upper bounds for the price of the call option at time 0. [2]
Consider a stock paying a continuous dividend at a rate  and denote its price at any time t by S t .
Let C t 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]
(Note that we have included the whole question here, although parts (iii) and (iv) relate to risk-
neutral pricing, which is also covered in Booklet 6).
Consider a non-dividend-paying share with price S t at time t (in years) in a market with a continuous-
ly 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  S0 e rT . [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 S t , t and r. [2]

An investor enters into the above forward contract at time t = 0. At timer =1 the risk-free rate of in-
terest 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]
Consider a three-period binomial tree model for the stock price process S t . 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]


Let p t denote the value at time t (measured in years) of a European put option on a non-dividend-
paying stock with price S t . 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 p t in terms of S t and K. [4]
Consider a market with the following two nom-dividend-paying stocks:
Stock Volatility Current price
S1 10% £10
S2 20% £10
The following options are available on those stocks:
Derivative Underlying Strike Term Price
(a) European call S1 £8 1 £2.50
(b) European call S2 £8 1 £2.26
(c) European put S1 £8 1 £1.55
(d) European put S1 £12 1 £1.20
(e) American put 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]
Consider a binomial tree model for the stock price S t . 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 S t  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]
(i) Define the following Greeks algebraically:
(a) delta
(b) vega
(c) theta
(d) gamma. [4]
Consider a call option with price c t at time t (in years) written on an underlying non-dividend-paying
asset with price S t at time t and volatility  .
Using Taylor's expansion, it can be shown that the change in value of the option is approximately giv-
en by:
dc t  delta  dSt  0.5  gamma   dS t   theta  dt  vega  d

2
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]
Consider a three-period binomial tree model for a stock price process S t , 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 pail (ii) would be higher or lower under the real-
world probability measure. [No further calculation is required] [3]
[Total 9]
Consider a European call option with price c t written on an underlying non-dividend-paying security
with price S t 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 un-
changed.] [2]
(ii) Explain each of your statements in part (i). [4]
Consider a European put option with price p t 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 c t and p t . [1]
The call option has value £0.50 at time t = 0, and the put option has value£1.00. Both options are writ-
ten 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]
Consider a one-period binomial tree model for the stock price process S t .
Let S0 = $100 and assume that in three months' time the stock price is either $125 or $105. No divi-
dends 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 Euro-
pean 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]
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% pa. The stock does not pay any divi-
dend. The continuously compounded risk-free rate of interest is 5% pa.
(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]
Consider a three-period binomial tree model for the non-dividend paying stock price process S t , in
which the stock price either rises by u% or falls by d% each period till maturity. Let r denote the con-
tinuously 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. As-
sume 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]
Consider a call option c t and a put option p t written on a non-dividend paying stock S t .
(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 re-
late 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 S8 ?
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]
Consider a binomial tree model for the non-dividend paying stock with price S t . Assume this price ei-
ther rises by 30% or falls by 20% each quarter (3months) 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]
Consider a share with price S t at time t. The continuously compounded risk-free rate is r per annum.
(i) Show that the fair price of a forward contract on S t maturing at time T is K  S0 e rt . [4]
At time t = 0 the share is worth £12. The continuously compounded risk-free rate is 5% per annum.
(ii) Calculate the fair price of a forward contract written on the share at time t = 0 with expiry at
time t = 5. [1]
An investor takes a long position in the forward contract at time 0. At time 1 the share price has fallen
to £10.
(iii) Calculate the value to the investor of the forward contract at time t =1. [3]
At time t = 2 the share unexpectedly pays a one-off dividend.
(iv) Explain, with reasons, how the forward price might change as a result of the one-off dividend. [2]
[Total 10]
(i) Describe six factors that affect the price of a European put option on a dividend-paying share, in-
cluding how they impact the option price. [3]
Consider a European call option currently priced at $15.60, based on an underlying share priced at
$34.55. The option has a delta of 0.5, gamma of $0.10 and a theta of –$0.05day 1 . Two days later the
underlying share price has risen to $35.25.
(ii) Calculate an approximate new value of the call option. [3]
(iii) Explain why a low value of gamma is desirable when using options in a delta-hedged portfolio.
[3]
[Total 9]

Consider a put option p t on a dividend-paying share with strike price K and maturity at time T. The
current time is t and the risk-free rate of interest is r per annum. The share has current price S t , vola-
tility  and dividend yield q.
(i) Write down the impact on the option price of each of the following changes:
(a) An increase in the share price S t .
(b) An increase in the strike price K.

(c) A decrease in time to expiry T–t.
(d) A decrease in the dividend yield q.
(e) A reduction in the risk-free rate r.
(f) An increase in the volatility  . [3]
(ii) Explain which of the changes in (i) move the price of a call option in the same direction as the
price of a put option. [2]
[Total 5]
42. Subject CM2, September 2019, Question 5 part (1)
A non-dividend paying share is currently priced at $80. Each year the share price will either increase
by 10% or fall by 10% with equal probability. A call option is written on the share with a strike price
of $75 and expiry in two years. The risk-free force of interest is 5% per annum.
(i) Calculate the risk-neutral price of the option using a binomial tree. [4]
An individual has $1,000 to invest. In making his investment choices he uses the utility function
U  w   w 0.5 .
Parts (ii) and (iii) of this question are covered in Booklet 1.

Let p t denote the value at time t of a European put option on a non-dividend paying share S t with ma-
turity at time T and a strike price K. The risk-free rate of interest is r.
(i) Derive the lower bound for p t in terms of S t and K. [3]

(ii) Explain how the lower bound would change if p t were an American put option. [2]
The put option p t has the following characteristics:
 Strike price = £100
 Time to expiry 6 months.

The risk-free rate of interest is 4% per annum.
(iii) Calculate an upper bound for the value of the option p t . [2]
(iv) Explain the conditions necessary for the option price to approach the upper bound in part (iii). [2]
[Total 9]


SECTION –6
BLACK-SCHOLES ANDTHE 5-STEP METHOD
FOR THE
2023 EXAMS
COVERING
CHAPTER 15 THE BLACK-SCHOLES OPTION PRICING FORMULA
CHAPTER 16 THE 5-STEP METHOD IN DISCRETE TIME
CHAPTER 17 THE 5-STEP METHOD IN CONTINUOUS TIME

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 com-
pounded risk-free interest rate is 4% pa.
(i) Estimate the stock price volatility to within 0.5% pa 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]
(i) State the Cameron-Martin-Girsanov Theorem. [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 B t  ct is a standard Brownian Motion under the Equivalent
Martingale Measure.
(b) Calculate the risk-free rate of interest. [8]
[Total 11]
(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 underly-
ing 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% pa assuming the Black-Scholes model ap-
plies. [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]
(i) State the six assumptions underlying the Black-Scholes market. [3]

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 1,000 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]
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
$1,000 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 p t . [4]
(ii) Denoting the price just after 1 year by p1 , explain why the fair price p1 at time t = 1 is given by
p1 = max( p1 , 500) if S1  $2 and 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]
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 5,000 of the call options. [2]
[Total 9]

(i) State the assumptions underlying the Black-Scholes market [3]
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% pa and the share price volatility is 18% pa.
(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]
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, S T , is more than a. Let la  x  denote the function which takes the value 1 if x >a and 0 otherwise.
(i) Write down a formula, in terms of expectation, l a , 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    la  x  da . [2]
k
(iii) Find a formula for the price of the special option on S, by differentiating the Black- Scholes for-
mula with respect to K. [3]
Suppose S0  110p , the continuously-compounded risk-free rate is 1% pa, and the volatility of S is
20% pa.
(iv) Calculate the price for a derivative security which pays S1  20p if S1  120p and 0 otherwise. [3]
[Total 10]
11. Subject CT8, October 2012, Question 7 (corrected)
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 0.8557c (where $1 = 100c)
The continuously-compounded risk-free rate is 0.5% pa. 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% pa. [2]
It is known that in three months Universal Widget Inc will embark on a major restructuring. It is an-
ticipated 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]
Note that there was a typo in the original exam paper where the current price of the option was given
as $0.8557 instead of 0.8557c. We have corrected it in this Revision Booklet.
Suppose that at time t we hold the portfolio  a t ,b t ,c t  where a t , b t and c t represent the number of
units held at time t of securities with respective price processes A t , B t and C t . Assume  a t ,b t ,c t  are
previsible. Let Vt be the value of this portfolio at time t.

(i) Explain what it means for  a t ,b t ,c t  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 a t , b t and c t . [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]
In a Black-Scholes market, we consider a special option with strike K and expiry in 2 years on an un-
derlying (non-dividend-bearing) stock with price process S t . Its payoff at maturity is $100 Max
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% pa and the continuously-compounded risk-free rate is 3% pa. The initial stock price is $1.
(i) Calculate Q  Max t 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 sepa-
rately the two cases  Max t 1St   2 and  Max t 1St   2 .
(b) Show that the value of this option at time 1 is $11.348 in the case  Max t 1St   2 .
Hint: S2 / S1 is independent of the values of S t up to time 1 under the EMM.
(iii) Determine, using the result in (i), the fair price at time 0 for the option. [9]
[Total 12]
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% pa. 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 del-
ta- and gamma-hedged portfolio.
(iv) Calculate the investor's new holdings of the put and the stock. [4]
[Total 12]
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 D t  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 ST n S0n 1 at time T, where n is an integer greater than 1.
 
(ii) Show, using part (i), that the price of the derivative at time t is given by D t  ST n S0 n 1 e  
 Tt
for some µ which you should determine. [6]

[Total 9]
Let B be a standard Brownian motion.
(i) Derive the probability density function of max  Bs  s  , where  is a constant, using the for-
0 s  t
mula 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 D T
at time T, defining any terms you use. [3]
Suppose that S has an initial price of S0 = £1.20 and a volatility   30% pa and that the continuously-
compounded risk-free rate is r = 3% pa.

(iii) Calculate the fair price at time zero of the derivative paying £10 at time T=2 if and only if max
max  Bs  s  >£1.44. [4]
0 s  t
[Total 10]
In a Black-Scholes model, the delta of a call option is     d1 
(i) Define delta. [1]
Suppose that the stock price at time zero is S0 = $100, the continuously-compounded risk-free rate is
3% pa and that a European call option written on S with strike price $109.42 and maturity t =1 year
has a delta of   0.42074 .
(ii) Find the implied volatility of the stock to the nearest 1% pa. [3]
An exotic option written on S with strike prices K1 and K 2 and exercise times  and T is defined as
follows:
 The option may be exercised at time  , in which case the holder receives $100 if and only if the
price of the underlying, S , is at least K 1 .
 if the option is not exercised at time  , then the holder will receive an amount c if and only if the
price at expiry T, S T , satisfies St S  K 2 .
(iii) Explain why, if c  $100 , the option will always be exercised at time  when S is at least K 1 . [2]
(iv) Give a formula for the value of the option just after the first exercise time  (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  . [2]
Suppose that K1  $10, K 2 = e 0.09 ,   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]
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% pa 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% pa (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]
Consider a non-dividend-paying share with price S t 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% pa.
(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]
Note that parts (i) and (ii) are covered in Booklet 5.
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% pa
Time to expiry = 3 years
The continuously compounded risk-free rate of interest is 3% pa 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% pa, with everything else except the
option price remaining the same.
(iv) Estimate the new option price. [2]
[Total 8]
A non-dividend-paying share currently trades at S0  $10 . An investor is considering buying a Euro-
pean 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% pa.
(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]
Note that part (i) is covered in Booklet 5.
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 S t 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% pa and the volatility  = 22% pa.
(ii) Determine the values of a and b such that    In S2  a  l b  is a U(0,1) random variable under the
risk-neutral measure, where  is the cumulative distribution function of the standard normal
distribution. [3]

Suppose that a derivative pays D 2  £100    In S2  a  l 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 D 2 at time t=2, but only if D 2 is at least
£25.
(iv) Determine the fair price of this derivative. [3]
[Total 11]
Suppose that at time t a portfolio  t ,  t  is held, where  t represents the number of units of a stock,
with price S t , held at time t and  t is the number of units of a cash bond, with price B t 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]

Note that the rest of this question is covered in Booklet 5.
Consider a non-dividend-paying stock. with price S t , 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  =
0.6179.
(ii) Determine the implied volatility of the stock to the nearest 1 %. [4]
A second stock with price R t is currently priced at R 0 = $30 and has volatility R  15% per an-
num.
An exotic option pays an amount c at time T if S1 / S0  k S and R1 / R 0  k R

(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 corre-
lated. [3]
Assume now that the stock prices are independent. The option has term T =1 year, payoff c = $50 and
strike prices k S  0.8 and k R  0.6 .
(v) Determine the value of the option at time 0. [5]

[Total 15]
The market price, S t , of a traded security satisfies the following stochastic differential equation:
dSt       St dt  St dWt
where Wt is a standard Brownian motion under the probability measure P* .
(i) Determine the value of  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 val-
ue of  obtained in part (i). [3]
[Total 6]
(Part (i) is covered in Booklet 4)
The current price of a non-dividend-paying share is £7 and its volatility is thought to be 40% per an-
num. 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]


(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 S t of a traded security satisfies the following stochastic differential equation:
dSt  St dt  St dWt
where Wt is a standard Brownian motion under the real-world probability measure, and  and 
are constants, with  > 0 .
Let r >0 be the continuously compounded risk-free rate of interest.

(iii) Show, using parts (i) and (ii), that Wt  t is a Brownian motion under the risk-neutral probabili-
  r 
ty measure, if   . [3]

(iv) Calculate the value of  in the case in which   0.04  r and   0.4 . [1]
Another traded asset has a price process satisfying the stochastic differential equation
dA t   0.06  r  A t dt  A t dWt
(v) Determine the value of the volatility coefficient  , using your result from part (iv). [2]
[Total 10]
(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 divi-
dend-paying underlying stock. [Note that you do not have to perform any further calculations]
[3]
[Total 13]
(i) Define a complete market. [1]
The price process of a traded security satisfies the following stochastic differential equation:
where Wt is a Brownian motion under the real-world probability measure P. Let r>0 be the conti-
nuously compounded risk-free rate of interest, with r   .
(ii) Show that the discounted stock price St e rt is not a martingale under the real-world probability
measure P. [3]
(iii) Demonstrate how the discounted asset price St e rt can be a martingale under an equivalent mar-
tingale measure Q. [3]
[Total 7]
The current price of a non-dividend paying stock is £65 and its volatility is 25% per annum. The con-
tinuously 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]


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% pa, the volatility is 20% pa 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]
The price process of a non-dividend paying stock St satisfies the following stochastic differential equa-
tion:
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  t stocks and  t cash bond.
(i)   
Show that d e  rt V  t    t d e  rt St  [3]
 rt
(ii) Determine the conditions under which the discounted value e V  t  is a martingale. [3]
[Total 6]
(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]
(i) List the assumptions underlying the Black-Scholes model of option prices. [3]
Consider a market where the assumptions behind the Black-Scholes model hold.
A non-dividend paying share is currently priced at €30. A put option is available on the share with a
strike price of €32 and one year to expiry. The share has a volatility of 15% and the risk-free rate is
5% per annum.
(ii) Calculate the fair price of the put option. [4]
A call option is also available on the same share, with the same strike price and time to maturity.
(iii) Calculate the fair price of the call option. [1]
(iv) Discuss how the option prices above would change if the share were dividend-paying. [2]
[Total 10]


SECTION –7
INTEREST RATE AND CREDIT RISK
MODELS
FOR THE
2023 EXAMS
COVERING
CHAPTER 18 THE TERM STRUCTURE OF INTEREST RATES
CHAPTER 19 CREDIT RISK


Consider the following stochastic differential equation for the instantaneous risk free rate (also re-
ferred to as the short-rate):
dr  t   a  b  r  t   dt  dWt
Its solution is given by:
r  t   r0 exp  at   b 1  exp  at     exp  at   exp  as  dWs

t
0
You may also use the fact that for T >t:
1  exp  a  T  t    T
t r  u  du  b  T  t    r  t   b   
1  exp  a  T  s   dWs
T
a t

a
(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]
(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]
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]

(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 default table 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.
Assume:
 a continuously compounded risk-free rate of interest of 3% pa
 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]
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 L 2 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]
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 in-
terest, P be the real-world probability measure and Q be 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 part (ii). [5]
(iv) Deduce the form of the distribution of the zero-coupon bond price under this model. [2]
[Total 12]
(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 Q in the Hull-White
model. [1]
(iii) Indicate whether or not the Hull-White model shows the characteristics listed in (i). [4]
[Total 9]
(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), 3 (default).

Transition intensities i, j are constant and as follows:
1,2  1, 1,3  0,  2,1  0.25,  2,3  0.75, 3, j  0 for all j and 1,1   2,2  1
It follows that, if pi  t  is the probability that the economy is in state i at time t then:
dp1  t  dp 2  t 
  p1  t   0.25p 2  t  and  p1  t   p 2  t 
dt 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 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]
(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]


(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  A = 60%, while Company B's have a recovery rate of  B = 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% pa.
(ii) Calculate the implied risk-neutral default intensities  A and  B , assuming that they are con-
stant. [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 $7,900.
(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]
State eight desirable characteristics of a term structure model. [8]

(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]
(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 years' 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% pa 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]
Describe three limitations of one-factor term structure models. [5]
(i) Describe the two-stale 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  = 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% pa.
(ii) (a) Calculate the price per $100 nominal of each bond.
(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]
(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]

(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% pa and the continuously-compounded credit spread on the bond is 4.5% pa.
(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]
Consider the following model for the short rate r:
drt  rt dt  dZ t
where  and  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    rt  dt  dZt
T
(ii) Derive an expression for t r  u  du . [6]
T
(iii) State the distribution of t r  u  du . [1]
[Total 11]


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% pa 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 part (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]
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 as-
sumed to be 50%. The continuously-compounded risk-free rate for one year is 3% pa.
(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). [2]
(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. [3]
[Total 13]


(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  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:
r Tt
    
B  t,T   e   1  1    1  exp  T 3  t 3 | 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% pa. [3]
[Total 11]
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      rt  dt  dWt ; 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 matur-
ity at time T, under the Vasicek model. [3]
In this market the parameters for the Vasicek model are   0.5,   4% and   10% . The short-rate
at time 0, r0 is 2% pa. 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]


(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% pa and the volatility of the company's gross
asset value is assumed to be 30% pa.
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]
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 values of (a), (b), (c) and (d) in the table above. [4]
At time 0, an investor buys £1,000 nominal of zero-coupon bonds maturing at time 2, and £2,000 no-
minal of zero-coupon bonds maturing at time 4. At time 1 interest rate expectations have changed as
set out below.
t F(t –1,1)
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]
(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), Un-
healthy (U) or Defaulted (D). Transition probabilities from state i to state j, pij , are constant.
PHU  0.1
p UH  0.05
p HD  0.02
p UD  0.3
p DJ  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 p D  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]
In the Vasicek model, the short rate of interest under the risk-neutral probability measure is given by:
t
rt    e  kt  r0       e   dWu
 k t u
where k, ,   0 and W is a standard Brownian motion.
Consider the related process:

t
R t   rs ds
0
where rt is the short rate defined above.
(i) Show that R t has a normal distribution with mean and variance given by:
1  e kt
E  R t   t   r0   
k

and:
Var  R t  
2 

t
2 1  e  kt

1  e 2kt

 [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  R t 
 E R t 
P  0, t   e 2
(iii) Show, by using the results from parts (i) and (ii), that:
 B t r0
P  0, t   A  t  e
where:
1  e kt
B t  
k
and:
  2  2 2 
A  t   exp  B  t   t      B  t 
  2k 2  4k 
 
(iv) State the main drawback of the above model for the term structure of interest rates. [1]
[Total 14]
(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,   0 .

(ii) Show, by solving the Vasicek stochastic differential equation. that:
t
 
rt  r0 e  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]
A company has issued zero-coupon bonds payable in five years' time for adnominal 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. [4]
[Hint: consider the delta of an appropriate option.]
(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]
(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   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
(iii) Derive an expression for B(t, T) in terms of the instantaneous forward rate, using the result from
part (ii). [3]
[Total 10]
(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, de-
fining any additional notation used. [2]
[Total 9]
(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  dWt
and a, b,   0 .
Under this model, the short rate rt follows a normal distribution with mean:

E  rt   r0 e  at  b 1  e  at 
and variance:
Var  rt  
2
2a

1  e 2at . 
(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 re-
version. [2]
[Total 11]
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
€10Om, 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]
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  under the probability measure P, and the bond price is:
B t  30e   if the bond has already defaulted by time t, or

 r 3 t
   
B t  e   30 1  e    100e   if the bond has not yet defaulted by time t
 r 3 t  31  3 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  . [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]
Consider a market with the following bonds in issue.
Expiry
Principal Coupon Zero Forward rate
(years) Price
value (annual*) rate r(0,T) f(0,S, T)
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 in-
terest. [2]
[Total 7]
A company is currently financed entirely by equity with 100,000 shares in issue and no debt. The cur-
rent 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 un-
changed 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]


(i) Describe how the Merton model can be used to value the debt issued by a company. [5]
A company has a value of €100m. Its total equity is currently worth €50m, and it has €80m nominal
of debt maturing in ten years. The risk-free force of interest is 4% per annum.
(ii) Calculate the implied volatility of the value of the company to the nearest 1% using the Merton
model. [4]
(iii) Calculate the value of vega for the value of the company's debt under the Merton model. [1]
(iv) Explain why a low value of vega might be desirable when using the Merton model. [2]
[Total 12]


SECTION –8
RUIN THEORY
FOR THE
2023 EXAMS
COVERING
CHAPTER 20 RUIN THEORY


Claims on a portfolio of insurance policies arrive as a Poisson process with annual rate  . Individual
claims are for a fixed amount of 100 and the insurer uses a premium loading of 15%. The insurer is con-
sidering entering a proportional reinsurance agreement with a reinsurer who uses a premium loading of
20%. The insurer will retain a proportion  of each risk.
(i) Write down and simplify the equation defining the adjustment coefficient R for the insurer. [3]
(ii) By considering R as a function of  and differentiating show that:
dR  dR  100R
120  5  120R  100R  100 e [3]
d  d 
dR
(iii) Explain why setting  0 and solving for  may give an optimal value for  . [3]
d
(iv) Use the method suggested in part (iii) to find an optimal choice for  . [4]
[Total 13]
2. Subject CT6, September 2010 Question 2
Claims on a portfolio of insurance policies follow a compound Poisson process with annual claim rate
 .Individual claim amounts are independent and follow an exponential distribution with mean  .
Premiums are received continuously and are set using a premium loading of  . The insurer's initial
surplus is U. Derive an expression for the adjustment coefficient, R, for this portfolio in terms of  and
. [4]
3. Subject CT6, September 2010 Question 8

Claims on a portfolio of insurance policies arrive as a Poisson process with rate  . The claim sizes are
independent identically distributed random variables X1 , X 2 ,... with:
M
P  X i  k   p k for k  1, 2,..., M and  pk  1
k 1
The premium loading factor is  .
(i) Show that the adjustment coefficient R satisfies:
1 2m1
log 1     R 
M m2

 
where mi  E X1i for i  1, 2 [7]
x RM x
[The inequality e Rx  e 1 for 0  x  N may be used without proof.]
M M
(ii) (a) Determine upper and lower bounds for R if   0.3 and X i is equally likely to be 2 or 3 (and
cannot take any other values).
(b) Hence derive an upper bound on the probability of ruin when the initial surplus is U. [3]
[Total 10]
Claims on a portfolio of insurance policies arise as a Poisson process with parameter  . Individual
 
claim amounts are taken from a distribution X and we define mi  E X i for i  1, 2,... . The insurance
company calculates premiums using a premium loading of  .
(i) Define the adjustment coefficient R. [1]
2m1
(ii) (a) Show that R can be approximated by by truncating the m2 series expansion of M X  t  .
m2
(b) Show that there is another approximation to R which is a solution of the equation
m3 y 2  3m 2 y  6m1  0 [6]
Now suppose that X has an exponential distribution with mean 10 and that   0.3 .
(iii) Calculate the approximations to R in (ii) and (iii) and compare them to the true value of R. [6]
[Total 13]
5. Subject CT6 October 2011 Question 4
Claims on a portfolio of insurance policies follow a Poisson process with parameter  . The insurance
company calculates premiums using a premium loading of  and has an initial surplus of U.
(i) Define the surplus process U(t). [1]
(ii) Define the probabilities   U, t  and   U  . [2]
(iii) Explain how   U, t  and   U  depend on  . [2]
[Total 5]

Claim events on a portfolio of insurance policies follow a Poisson process with parameter  . Individu-
al claim amounts follow a distribution X with density:
f  x   0.012 xe 0.01x , x  0
The insurance company calculates premiums using a premium loading of 45%.
(i) Derive the moment generating function M X  t  . [3]
(ii) Determine the adjustment coefficient and hence derive an upper bound on the probability of
ruin if the insurance company has initial surplus U. [5]
(iii) Find the surplus required to ensure the probability of ruin is less than 1% using the upper bound
in (ii). [2]
Suppose instead that individual claims are for a fixed amount of 200.
(iv) Determine whether the adjustment coefficient is higher or lower than in (ii) and comment on
your conclusion. [4]
[Total 14]
7. Subject CT6 April 2012 Question 11
Claims on a portfolio of insurance policies arrive as a Poisson process with parameter 100. Individual
claim amounts follow a normal distribution with mean 30 and variance 52 . The insurer calculates
premiums using a premium loading of 20% and has initial surplus of 100.
(i) Define carefully the ruin probabilities  100  ,  100,1 and 1 100,1 . [3]
(ii) Define the adjustment coefficient R. [1]
(iii) Show that for this portfolio the value of R is 0.011 correct to 3 decimal places. [5]
(iv) Calculate an upper bound for  100  and an estimate of 1 100,1 . [5]
(v) Comment on the results in (iv). [2]
[Total 16]

8. Subject CT6 September 2012 Question 6

Individual claim amounts from a particular type of insurance policy follow a normal distribution with
mean 150 and standard deviation 30. Claim numbers on an individual policy follow a Poisson distri-
bution with parameter 0.25. The insurance company uses a premium loading of 70% to calculate
premiums.
(i) Calculate the annual premium charged by the insurance company. [1]
The insurance company has an individual excess of loss reinsurance arrangement with a retention of
200 with a reinsurer who uses a premium loading of 120%.
(ii) Calculate the probability that an individual claim does not exceed the retention. [2]
(iii) Calculate the probability for a particular policy that in a given year there are no claims which ex-
ceed the retention. [2]
(iv) Calculate the premium charged by the reinsurer. [4]
(v) Calculate the insurance company's expected profit. [2]
[Total 11]
Claims occur on a portfolio of insurance policies according to a Poisson process. Individual claim
amounts are either 1 (with probability 0.7) or 8 (with probability 0.3). The insurance company uses a
premium loading of 60% to calculate premiums and buys excess of loss reinsurance with a retention
of M(1 <M <8) from a reinsurer.
The reinsurer uses a premium loading of 120%.
(i) Calculate the smallest value of M that the insurance company should consider if it wishes to ex-
pect to make a profit on this portfolio. [3]
(ii) Derive the adjustment coefficient equation for the insurance company. [2]
(iii) Calculate the adjustment coefficient (correct to 2 decimal places) if M = 4. [4]
The same reinsurer also offers proportional reinsurance with the same premium loading such that
the reinsurer pays a proportion a of each claim.
(iv) Show that the insurance company may either purchase excess of loss reinsurance with retention
M or proportional reinsurance with
3 8  M 
 for the same premium [2]
31

(v) Determine whether the adjustment coefficient with proportional reinsurance is higher or lower
than that with excess of loss reinsurance when M = 4. [4]
(vi) Comment on the implications of part (v). [2]

[Total 17]
Claims on a portfolio of insurance policies arise as a Poisson process with rate  . The mean claim
amount is  . The insurance company calculates premiums using a loading of  and has an initial sur-
plus of U.
(i) Explain how the parameters  ,  ,  and U affect   U  , the probability of ultimate ruin. [4]
Now suppose that   50,   200 and   30% . There are three models under consideration for the
distribution of individual claim amounts:
A fixed claims of 200

B exponential with mean 200
C gamma with mean 200 and variance 800
Let the corresponding adjustment coefficients be R A , R B and R C .
(ii) Find the numerical value of R B arid show that R B is less than both R A and R C . [7]
n
 x x
(iii) Use the fact that  1    e for large n to show that R A and R C are approximately equal. [2]
 n
[Total 13]
Andy is a famous weight lifter who will be competing at the Olympic Games.
He has taken out special insurance which pays out if he is injured. If the injury is so serious that his ca-
reer is ended the policy pays $1m and is terminated. If he is injured but recovers the insurance pay-
ment is $0.1m and the policy continues.
The insurance company's underwriters believe that the probability of an injury in any year is 0.2, and
that the probability of more than one injury in a year can be ignored. If Andy is injured, there is a 75%
chance that he will recover.

Annual premiums are paid in advance, and the insurance company pays claims at the end of the year.
Assume that this is the only policy that the insurance company writes, and that it has an initial surplus
of $0.1 m.
(i) Define what is meant by   $0.1m,1 and   $0.1m  . [2]
(ii) Calculate the annual premium charged assuming the insurance company uses a premium loading
of 30%. [2]
(iii) Determine   $0.1m, 2  . [4]
[Total 8]
Ruth takes the bus to school every morning. The bus company's ticket machine is unreliable and the
amount Ruth is charged every morning can be regarded as a random variable with mean 2 and non-
zero standard deviation. The bus company does offer a 'value ticket' which gives a 50% discount in re-
turn for a weekly payment of 5 in advance. There are 5 days in a week and Ruth walks home each day.
Ruth's mother is worried about Ruth not having enough money to pay for her ticket and is considering
three approaches to paying for bus fares:
A Give Ruth 10 at the start of each week.
B Give Ruth 2 at the start of each day.
C Buy the 50% discount card at the start of the week and then give Ruth 1 at the start of each day
Determine the approach that will give the lowest probability of Ruth running out of money. [4]

A particular portfolio of insurance policies gives rise to aggregate claims which follow a Poisson
process with parameter   25 . The distribution of individual claim amounts is as follows:
Claim 50 100 200
Probability 30% 50% 20%
The insurer initially has a surplus of 240. Premiums are paid annually in advance.
Calculate approximately the smallest premium loading such that the probability of ruin in the first
year is less than 10%. [7]
14. Subject CT6 September 2014 Question 8 (corrected)

Claims on a portfolio of insurance policies follow a Poisson process with rate  . Individual claim
amounts follow a distribution X with mean  and variance  2 . The insurance company charges a pre-
mium of c per year.
(i) Write down the equation satisfied by the adjustment coefficient R. [1]
(ii) Show that R can be approximated by:
2  c   
R̂  [4]

 2  2 
Now suppose that individual claims follow a distribution given by:
Value 10 20 50 100
Probability 0.3 0.5 0.15 0.05
The insurance company uses a premium loading of 30%. It is considering the following reinsurance
arrangements:
A No reinsurance.
B Proportional reinsurance where the insurer retains 70% of all claims with a reinsurer us-
ing a 20% premium loading.
C Excess of loss reinsurance with retention 70 with a reinsurer using a 40% premium loading.
(iii) Determine which arrangement gives the insurance company the lowest probability of ultimate
ruin, using the approximation in part (ii). [10]
(iv) Comment on your result in part (iii). [2]
[Total 17]
Claims on a certain portfolio of insurance policies arise as a Poisson process with annual rate  . Indi-
vidual claim amounts are independent from claim to claim and follow an exponential distribution with
mean  . The insurance company has purchased excess of loss reinsurance with retention M from a
reinsurer who calculates premiums using a premium loading of  . Denote by X i the amount paid by
the reinsurer on the ith claim (so that X i  0 if the ith claim amount is below M).

(i) Explain why the claims arrival process for the reinsurer is also a Poisson process and specify its
parameter. [3]
(ii) Show that:
t
M Xi  t   1  e  M /   [4]
1  t
(iii) (a) Determine E  Xi  .
(b) Write down and simplify the equation for the reinsurer’s adjustment coefficient. [6]
(iv) Comment on your results to part (iii). [2]
[Total 15]
Claims on a portfolio of insurance policies arrive as a Poisson process with annual rate  . Individual
claims are uniformly distributed between 0 and 50, and the insurance company uses a premium load-
ing of 12%.
(i) Show that the insurance company's adjustment coefficient is 0.0066 to four decimal places. [3]
The insurance company has entered into an excess of loss insurance agreement with a retention
amount of M and with a reinsurer who uses a premium loading of 15%.
(ii) (a) Determine the mean amount per claim paid by the reinsurer as a function of M.
(b) Determine the minimum retention level M min in for the insurance company, assuming that
expected net premium income needs to be greater than expected net claims. [6]
The insurance company manages to negotiate a lower reinsurance premium loading.
(iii) Explain what happens to the minimum retention level M min . Without doing any further calcula-
tions. [2]
[Total 11]
Claims on a portfolio of insurance policies arrive as a Poisson process with parameter  , claim amounts
2
having a Normal distribution with mean  and variance  , and there is a loading  on premiums. The
insurance company has an initial surplus of U.
(i) Explain carefully the meaning of   U  ,   U, t  and   U,1 [3]

(ii) State four factors that affect the size of   U, t  , for a given t. [2]
(iii) Explain, for each factor, what happens to   U, t  when the factor increases. [4]
Sarah, the insurance company's actuary, prefers to consider the probability of ruin in discrete rather
than continuous time.
(iv) Explain an advantage and disadvantage of Sarah's approach. [2]
[Total 11]
Claims on portfolio of insurance policies arise as a Poisson process with parameter  = 125. Individual
claim amounts, X i follow a gamma distribution with parameters   20 and   0.5 .
The insurance company calculates premiums using a premium loading factor of 15% and has an initial
surplus of 300.
(ii) Show that for this portfolio the value of R is 0.00648 correct to three significant figures. [5]
(iii) (a) Calculate an upper bound for   300  .
(b) Calculate an estimate of 1  300,1 , using a Normal approximation. [5]
The parameter  now reduces to 0.4.
(iv) Explain what would happen to the estimate of 1  300,1 , without carrying out any further cal-
culations. [2]
(v) Propose two ways in which the insurance company could reduce 1  300,1 . [2]
[Total 15]
Total annual claim amounts S on a portfolio of insurance policies come from two independent types of
policies:
Type 1, which have claim amounts uniformly distributed between 3,000 and 4.000.
Type 2, which have claim amounts following an Exponential distribution with mean 3,600.

Claims occur according to a Poisson process, with mean 15 per annum for Type 1 claims and mean 25
per annum for Type 2 claims.
The insurance company uses a premium loading factor of 7% and checks for ruin at the end of each
year
(i) Calculate the mean and standard deviation of S. [3]
(ii) Calculate the minimum initial surplus U m required such that the probability of ruin at the end
of the first year is less than 0.015, using a Normal approximation for the distribution of S. [4]
Regulatory reforms mean the insurance company is trying to reduce this probability of ruin to less
than 0.005. The insurance company is therefore purchasing proportional reinsurance from a reinsur-
er, who uses a premium loading factor of 17% in its premiums.
The insurance company retains a proportion  of each claim, and denotes by Sl the aggregate annual
claims it retains net of reinsurance. The insurance company continues to hold initial surplus U m .
(iii) Calculate the maximum proportion  max that the insurance company can retain in order to keep
the probability of ruin less than 0,005, using a Normal approximation for the distribution of Sl . [6]
The insurance company is concerned that  max is too low, reducing its profits, and intends to retain a
higher proportion.
(iv) Suggest other ways in which the insurance company can reduce the probability of ruin. [3]
[Total 16]
On 1 January 2014 an insurance company writes a policy for a European farmer. At the end of each year,
the farmer's crop is assessed, and if it is less than 100 tonnes, it is deemed to have failed. If the crop fails
for two years in a row the insurance policy pays out €1 m and then is immediately terminated.
Premiums are €25k per month, paid in advance, and there are no expenses.
This is the only policy the insurance company writes and it has initial surplus U>0. Denote by   U, t 
the probability of ruin by time t, measured in years; and   U  as the ultimate probability of ruin.
Explain whether the following statements are TRUE or FALSE:
 1
(a)   U,1    U,1 
 2

 1  1
(b)   U, 2     U,3 
 2  3
(c)   U,3    U,4 
(d)   U,4     U  [8]

Claim events on a portfolio of insurance policies follow a Poisson process with parameter  . Individual
claim amounts, X, follow a normal distribution with parameters   500 and  2  200 .
The insurance company calculates premiums using a premium loading factor of 20%.
(i) Show that the adjustment coefficient, r = 0.000708 to three significant figures. [4]
The insurance company's initial surplus is 5,000.
(ii) Calculate an upper bound on the probability of ruin, using Lundberg's inequality. [1]
The insurance company actuary believes that claim amounts are better modelled using an exponential
distribution. You may assume that the mean µ is unchanged, and is now equal to the standard deviation.
(iii) Calculate the new upper bound of the probability of ruin. [5]
(iv) Give a reason why claim amounts on insurance policies are not usually modelled using a normal
distribution, and suggest an alternative distribution, other than the exponential. [2]
[Total 12]
Claims on a portfolio of insurance policies arise as a Poisson process with parameter  , Individual
 
claim amounts are taken from a distribution X and we define mi  E X i for i  1, 2,... . The insurance
company calculates premiums using a premium loading of  .
2m1
(ii) Show that R can be approximated as by truncating the series expansion of M X  t  . [3]
m2
Now suppose that X follows an exponential distribution with parameter  .


(iii) Show that R  . [3]
1 
The insurance company uses a premium loading of 12%, and the mean claim amount is 200.
(iv) Calculate R, commenting on the difference with the approximation to R shown in part(ii). [3]
The initial surplus is 5,000.
(v) Calculate an upper bound for the ultimate probability of ruin. [1]
(vi) Suggest two methods by which the insurance company can reduce the probability of ruin. [2]
[Total 13]
An insurance company offers a special type of policy to actuarial students to cover the cost of celebra-
tions when they qualify. The policy pays a fixed sum of £500 when a student passes his or her final ex-
am. Students pay a premium of £50 at each exam session irrespective of how many exams they are sit-
ting and the last premium is paid in the exam session where the student qualifies.
There are two exam sessions each year, in April and October. Premiums are paid in the month of the
exam. Exam results are published immediately after the exam and the £500 is paid if the student has
qualified.
The insurer has issued three policies on 1 January 2019 to students who are close to qualifying. The
insurer assumes that each student has a 25% chance of qualifying in each future exam session. The in-
surer's initial assets are £750 and this does not earn any interest.
(i) Calculate the insurer's assets after the April 2019 premiums are received. [1]
(ii) Calculate the probability of ruin when the exam results are released. [3]
(iii) Assuming that no students qualified in April 2019:
(a) Calculate the insurer's assets after the October 2019 premiums are received.
(b) Calculate the probability of ruin when the October 2019 exam results are released. [2]
(iv) Assuming that one student qualified in April 2019:
(a) Calculate the insurer's assets after the October 2019 premiums are received.
(b) Calculate the probability of ruin when the October 2019 exam results are released. [2]
(v) Calculate the overall probability of ruin before the end of the year 2019. [3]

(vi) Explain the impact on the ultimate probability of ruin if the insurer issues more policies on the
same terms. [2]
[Total 13]
An insurer writes policies that insure policyholders against losing their mobile phone. Each policy
pays £500 at the end of the year if the policyholder loses their phone during the year.
The insurer has carried out research on mobile phone losses in the general population, which showed
that there is a 10% chance of an individual losing their phone in a one-year period. To allow for ex-
pected claims and a profit margin the insurer sets the annual premium at £125. Premiums are paid at
the start of the policy year.
The insurer writes ten policies and has no assets at the time the policies are written. The insurer as-
sumes that the policies are independent of each other. Discounting and expenses can be ignored.
(i) Calculate the probability that the insurer is still solvent at the end of the year. [3]
After one year the insurer has received two claims.
(ii) State two factors relating to policyholder behaviour which may give rise to the insurer experienc-
ing more claims than expected, explaining for each factor how it may arise in this case. [2]
(iii) Explain how insurers typically reduce the risk posed by the factors identified in part (ii). [2]
At the end of year one, after paying any claims but before receiving any more premiums, the insurer has
assets of £250. All ten policyholders remain with the insurer for another year and all still have a 10%
chance per year of losing their phone.
The insurer decides that premiums for year two will be £x per policy, but with a 25% discount for any
policyholders who did not claim in year one.
(iv) Calculate the base premium, £x, that the insurer should charge to achieve a probability of ruin in
year two of no more than 5%. [4]
[Total 11]


SECTION –9
RUN-OFF TRIANGLES
FOR THE
2023 EXAMS
COVERING
CHAPTER 21 RUN-OFF TRIANGLES


The table below shows the incremental claims paid on a portfolio of insurance policies together with
an extract from an index of prices. Claims are fully paid by the end of development year 3.
Development Year Price index
Accident Year 0 1 2 3 Year (mid year)
2006 103 32 29 13 2006 100
2007 88 21 16 2007 104
2008 110 35 2008 109
2009 132 2009 111
Calculate the reserve for unpaid claims using the inflation-adjusted chain ladder approach, assuming
that future claims inflation will be 3% pa. [11]

An actuarial student has been working on some claims projections but some of her workings have
been lost. The cumulative claim amounts and projected ultimate claims are given by the following ta-
ble:
Accident Development Year Ultimate
Year 0 1 2 3
1 1,001 1,485 1,762 W X
2 1,250 Y 1,820 1,862.3
3 1,302 1,805 2,122.5
4 Z 2,278.8
All claims are paid by the end of development year 3.

It is known that ultimate claims for accident years 2 and 3 have been estimated using the Basic Chain
Ladder method.
(i) Calculate the values of W, X and Y. [5]

For accident year 4 the student has used the Bornhuetter-Ferguson method using an earned pre-
mium of 2,500 and an expected loss ratio of 90%.
(ii) Calculate the value of Z. [4]
(iii) Calculate the outstanding claims reserve for all accident years implied by the completed table. [1]
[Total 10]
The table below shows cumulative claims paid on a portfolio of insurance policies:
Development Year
0 1 2 3
2007 240 281.4 302 305
Accident 2008 260 320 322
Year 2009 270 312.9
2010 276
All claims are fully run off by the end of development year 3.
(i) Calculate the total reserve for outstanding claims using the basic chain ladder technique. [7]
An actuary is considering modelling the future claims assuming that individual development factors
are lognormally distributed with the following parameters:
Development Year
0 to 1 1 to 2 2 to 3
 0.171251 0.035850 0.008787
 0.032148 0.045606 0.046853
(ii) Show that under these assumptions the cumulative development factor to ultimate is also log-
normally distributed. [3]
(iii) Calculate a 99% upper confidence limit for the outstanding claims relating to the 2010 accident
year. [5]
[Total 15]
The table below shows cumulative claims paid on a portfolio of motor insurance policies.
Development Year
Accident Year 0 1 2 3
2007 120 134 146 148
2008 140 180 185
2009 135 149
2010 138
All claims are fully run off by the end of Development Year 3
(i) Calculate the total reserve for outstanding claims using the basic chain ladder technique. [7]
An actuarial student suggests an alternative approach to projecting the claims as follows:
 For each of Development Years 1 to 3 calculate the observed development factor separately for
each accident year.
 Then project claims assuming the development factor for a given year is the maximum of the ob-
served development factors for the relevant accident year.
 For example, for the development factor from Development Year 1 to Development Year 2 we
can observe actual factors for Accident Years 2007 and 2008. To project claims, we assume that
the development factor for Development Year 1 to Development Year 2 is the maximum of the
two observed factors.
(ii) Calculate the increase in the reserve for outstanding claims if claims are projected in this way. [5]
(iii) Discuss why the method in (ii) may not be appropriate. [2]
[Total 14]


The table below shows claims paid on a portfolio of general insurance policies. You may assume that
claims are fully run off after three years.
Development Year
Underwriting Year
0 1 2 3
2008 450 312 117 41
2009 503 389 162
2010 611 438
2011 555
Past claims inflation has been 5% pa. However, it is expected that future claims inflation will be 10% pa.
Use the inflation adjusted chain ladder method to calculate the outstanding claims on the portfolio.
[10]
The table below shows claims paid on a portfolio of general insurance policies. Claims from this port-
folio are fully run off after 3 years.
Development Year
Underwriting year
0 1 2 3
2008 85 42 30 7
2009 103 65 25
2010 93 47
2011 111
(i) Estimate the outstanding claims using the basic chain ladder approach. [7]
You are asked to investigate the fit of the model by applying the development factors from part (i) to
the claims paid in development year 0 and then comparing the fitted claim payments to the actual
payments.
(ii) Construct a table showing the difference between the fitted payments and the actual payments
in the table above. [3]
(iii) Comment on the results of the analysis in part (ii). [2]
[Total 12]
The following table shows incremental claims data from a portfolio of insurance policies for the acci-
dent years 2010, 2011 and 2012. Claims from this type of policy are fully run off after the end of de-
velopment year two.
Incremental Development Year
Claims 0 1 2
2010 2,328 1,484 384
Accident Year 2011 1,749 1,188
2012 2,117
Estimate the total claims outstanding using the basic chain ladder technique. [7]

The tables below show cumulative data for the number of claims and the total claim amounts arising
from a portfolio of insurance policies.
Claim Numbers Total Claim Amounts

Development Year Development Year
0 1 2 0 1 2
2010 87 132 151 2010 43,290 87,430 126,310
2011 117 156 2011 68,900 125,290
2012 99 2012 74,250
Claims are fully run off after two development years.

Estimate the outstanding claims using the average cost per claim method with grossing up factors. [10]


The table below sets out incremental claims data for a portfolio of insurance policies.
Development year
Accident year 0 1 2
2011 1,403 535 142
2012 1,718 811
2013 1,912
Past and projected future inflation is given by the following index (measured to the mid-point of the re-
levant year).
Year Index
2011 100
2012 107
2013 110
2014 113
2015 117
Estimate the outstanding claims using the inflation-adjusted chain ladder technique. [9]

The table below shows the incremental claims incurred for a certain portfolio of insurance policies.
Development year
Accident year 0 1 2
2011 2,233 1,389 600
2012 3,380 1,808
2013 4,996

Cumulative numbers of claims are shown in the following table:
Development year
Accident year 0 1 2
2011 140 203 224
2012 180 230
2013 256
(i) Calculate the outstanding claim reserve for this portfolio using the average cost per claim me-
thod with grossing up factors. [7]
(ii) State the assumptions underlying the calculations in part (i). [3]
[Total 10]
The table below shows cumulative claim amounts incurred on a portfolio of insurance policies.
Development Year
Accident Year
0 1 2 3
2011 1,509 1,969 2,106 2,207
2012 1,542 2,186 2,985
2013 1,734 1,924
2014 1,773
Annual premiums written in 2014 were 4,013 and the ultimate loss ratio has been estimated as 93.5%.
Claims can be assumed to be fully run off by the end of development year 3.
Estimate the total claims arising from policies written in 2014 only, using the Bornhuetter-Ferguson me-
thod. [7]


The run-off triangle below shows cumulative claims incurred on a portfolio of general insurance policies
Development Year
Policy Year 0 1 2 3
2011 1,528 2,034 2,212 2,310
2012 1,812 2,251 2,951
2013 1,693 1,851
2014 2,125
Annual premiums written in 2014 were 4,023 and the ultimate loss ratio has been estimated as 91%.
Claims paid to date for policy year 2014 are 572.
Estimate the outstanding claims to be paid arising from policies written in 2014 only, using the Born-
huetter-Ferguson technique, stating any assumptions that you make. [9]

(i) Explain why insurance companies make use of run-off triangles. [2]
(ii) The run-off triangle below shows incremental claims incurred on a portfolio of general insur-
ance policies.
Development Year
Policy Year 0 1 2 3
2011 4,657 3,440 931 572
2012 6,089 5,275 1,381
2013 5,623 4,799
2014 7,224
Calculate the outstanding claims reserve for this portfolio using the basic chain ladder method. [7]
[Total 9]

The table below shows incremental claim amounts paid on a portfolio of general insurance policies,
where claims are assumed to fully run off after three years.
Development Year
Underwriting Year
0 1 2 3
2012 504 286 110 35
2013 621 302 120
2014 685 340
2015 801
Past and protected future inflation is given by the following index (measured to the mid-point of the
relevant year).
2012 100
2013 103
2014 105
2015 106
2016 105
2017 107
2018 110
Estimate the outstanding claims reserve using the inflation-adjusted chain ladder technique. [12]

(i) Write down the general form of a statistical model for a claims run-off triangle, defining all terms
used. [5]
The table below shows the cumulative incurred claim amounts on a portfolio of insurance policies.
Development Year
Underwriting Year 0 1 3
2014 3,215 6,847 10,078
2015 2,986 7,123
2016 4,167
Claims are assumed to be fully run off after Development Year 2. The estimated loss ratio of both
2015 and 2016 is 91% and the respective premium income in each year is:
Premium Income
2014 11,365
2015 12,012
2016 12,867
The total of claim amounts paid to date is 21,186 from policies written in 2014 to 2016.
(ii) Calculate the outstanding claim reserve for this portfolio using the Bornhuetter-Ferguson me-
thod. [9]
[Total 14]
The table below shows the cost of claims settled per calendar year for a set of car insurance policies,
with figures in €000s.

Development Year
Accident Year 0 1 2
2014 5,419 908 239
2015 6,234 1,088
2016 7,719
The corresponding number of settled claims is as follows:
Development Year
Accident Year 0 1 2
2014 760 98 37
2015 819 93
2016 881
(i) Calculate the outstanding claims reserve for this portfolio, using the average cost per claim me-
thod with grossing up factors. [7]
(ii) State four key assumptions made in part (i). [2]
[Total 9]
The table below shows the cumulative incurred claims by year for a portfolio of general insurance pol-
icies, with all figures in £m. Claims paid to date total 13.5. The ultimate loss ratio is expected to be in
line with the 2013 accident year, and claims are assumed to be fully developed by the end of Devel-
opment Year 3.
Development Year
Accident Year 0 1 2 3 Earned Premiums
2013 3.01 3.38 3.85 4.00 4.32
2014 3.30 3.67 4.15 4.41

2015 3.32 3.86 4.55
2016 3.74 4.68
Calculate the total reserve required to meet the outstanding claims, using the Bornheutter-Ferguson
method. [9]
The cumulative claim amounts incurred on a portfolio of motor insurance policies are as follows:
Development Year
2014 3,907 5,606 6,061 6,145
2015 4,831 7,319 7,470
2016 6,042 8,282
2017 7,061
The cumulative number of reported claims are as follows:
Development Year
2014 435 469 528 534
2015 485 525 541
2016 509 558
2017 544
(i) Estimate the ultimate number of claims, for each accident year, using the chain-ladder technique.
[4]
(ii) Estimate the ultimate average incurred cost per clam, for each accident year, using the grossing-
up method. [5]

(iii) Calculate the total reserve required, using the results from (i) and (ii), assuming that claims paid
to date are 19,544. [2]
[Total 11]
(i) Write down the general form of a statistical model for a claims run-off triangle, defining all terms
used. [5]
The table below shows the cumulative incurred claims on a portfolio of insurance policies.
Development Year
Accident Year 1 2 3
2016 130 180 190
2017 140 185
2018 150
The company decides to apply the Bornhuetter-Ferguson method to calculate the reserves, with the
assumption that the Ultimate Loss Ratio is 80%. Claims are assumed to be fully run off by Develop-
ment Year 3.
The earned premium for 2018 is 300 and the paid claims for 2018 are 100.
(ii) Calculate the reserve in respect of the Accident Year 2018. [6]
[Total 11]

SOLUTION TO PAST EXAM QUESTIONS

SECTION 1
QUESTION 1
‘The efficient markets hypothesis states that the market price is always correct’
EMH states that prices react quickly and accurately to new information, which can be treated as saying
that the prices are 'correct' in the sense that they factor in all the available information.
However, it is important to distinguish between the different types of information that are factored into
the prices. This could be just past price history (the weak form) or all publicly available information
(semi-strong) or all information, including privileged information known only to company directors
(strong form).
If the relevant form of EMH applies, it is not possible to make a risk-adjusted profit based on that cate-
gory of information. For example, if markets are weak-form efficient, then technical analysts should not
be able to benefit from their analyses.
'It is not possible for investors to make money from investing in shares'
This does not mean that it is not possible to make money by investing in shares. In the long-term shares
are generally believed to offer a higher expected return than investing in a risk-free asset. However, if
the market is efficient, it should not be possible to outperform other investors who are working from
the same information and within the same constraints.
However, if additional information is available, higher returns may be possible eg if an investor in a

semi-strong form market has access to insider information (which may be illegal to make use of), this
could provide an advantage.
It may also be possible to pay for more detailed analyses that provide additional information not direct-
ly available to the public. It may also be possible to obtain information more quickly than other inves-
tors, which would give an advantage.
Also, if an investor is prepared to accept a higher level of risk, he or she can obtain higher expected re-
turns, even if the markets are efficient.

There has been considerable research into testing whether the markets are indeed efficient and at what
level, but there are difficulties with such testing.
The weak form can be tested by retrospectively comparing the performance of strategies recommended
by technical analysts with randomly selected portfolios. The problem here is that there will be a wide
range of possible strategies and some are bound to do well purely by chance.
The semi-strong form can be tested by looking for excessive volatility in price movements, as was done
by Shiller in his analysis in 1981. This involved retrospectively comparing the actual price movements
with the theoretical movements according to the model he used.
He found evidence of excessive volatility, which would refute the semi-strong form of EMH. However,
other economists have questioned his model and its assumptions.
The strong form can be tested by comparing the returns obtained by directors who have access to privi-
leged information. However, most markets do not allow insider trading and prevent directors trading
during certain times, which is likely to remove this advantage.
QUESTION 2
Part (i): Variance for the senior loan is var(S) = 110.151 = 10.4952
Variance for the junior loan is var(J) = 388.026 = 19.6982
Part (ii): Shortfall probability for the senior loan is 12.5%
Shortfall probability for the junior loan is 25%
QUESTION 3
Part (i): Issues which might affect an investor's view on the probability of an adverse event include:
 people base perceptions on limited past experience of similar events
 representative heuristics - people find more probable that which they find easier to im-
agine
 availability – people are influenced by the ease with which something can be brought to
mind. This can lead to biased judgements when examples of adverse events are inhe-
rently more difficult to imagine than examples of more positive outcomes.
Part (ii): A key bias for an active investor is overconfidence, i.e. an active investor may 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).
The discrepancy between accuracy and overconfidence increases as the respondent is

more knowledgeable. Accuracy increases to a modest degree but confidence increases
to a much larger degree.
Part (iii):
Sub-part (a): Property investor
Anchoring – the investor is basing his views on his experience of property prices. He
is wedded to past experience, ignoring recent negative experience.
Overconfidence – based on his historic success, the investor is overconfident about

his ability to forecast future trends in property prices.
Sub-part (b): Economist
Hindsight bias – the economist is commenting after the event that the house price
falls could be seen prior to the event, i.e. he is re-evaluating past evidence to prove
that price falls were predictable.
Part (iv): Possible behaviours shown by the couple include:
Regret aversion- by sticking with their existing provider, the couple minimise the chance
that they will regret a decision to move to a new provider if the product or service is not as
good.
Status quo bias - the couple prefer to keep things the way they are, rather than change their
arrangements.
Representative heuristics – as the amount of detail increases, its apparent likelihood may al-
so increase.

QUESTION 4
Part (i): Mean of R is E[R] = 6; Variance of R is var[R] = 244 = 15.622
Part (ii):
Sub-part (a): P (R < 0) = 0.40027; P (S<0) = 0.35045
Sub-part (b): P (R < -10) = 0.12693; P (S < -10) = 0.15285
Part (iii): Just looking at variance, the two assets have the same risk.
Looking at the probability of a shortfall below 0%, the risk is greater for R. This result is
caused by the 80% chance of this return coming from a normal distribution with mean zero.
By contrast, looking at the probability of a shortfall below -10%, the risk is greater for S. It is
the overall spread of S that causes this result because of the 'double hump' nature of R. The
second hump for R is a long way to the right of the benchmark level of -10%.
This highlights the importance of not simply using one risk measure to make an investment
decision. It is usually better to look at various risk measures together to provide a better
profile of the risks being considered.
QUESTION 5
Theory
QUESTION 6
Part (i): Three forms of the EMH
1. Weak form EMH- market prices quickly and accurately incorporate all the information
contained in the past history of security prices.
2. Semi-strong form EMH-market prices incorporate all publicly available information, in-
cluding the past history of prices.
3. Strong form EMH – market prices incorporate all information, including information
available only to insiders as well as all publicly available information.
Part (ii): On the announcement, the share price suddenly dropped by 20%. This suggests that the
share price prior to this didn't incorporate all information.
Company directors (and some other people internal to the company) would have known
prior to the announcement that profits were up by 52% (and not 65% as predicted by ana-
lysts). This suggests that the market is not strong form efficient.
However, the fact that the share price adjusted straight away, once this information become
public, means that there is no evidence to contradict semi-strong and weak form efficiency.
We don't know whether the 20% fall is an accurate reflection of the news. If it turns out to
be an over- or under-reaction, this would contradict semi- strong form efficiency.
QUESTION 7
Part (i): Behaviour (1) – regret aversion, which is where people avoid making a decision which has
a high chance of causing them to later regret the decision. The manager is unwilling to sell
out immediately because of fear that the share will start performing well and he will regret
the decision.
Behaviour (2)– overconfidence. Managers are often more confident in their ability to pre-
dict an uncertain future than they should be. This could cause them to ignore expert advice.
Behaviour (3)– confirmation bias. It is a form of overconfidence and occurs where a man-
ager sifts through the information available to him and searches for the information that
justifies an already existing opinion. He then ignores the other analysis which contradicts
his view.
An alternative here would be framing, namely that the advice he accepts is framed in such a
way that it appeals more to the manager.
Part (ii): Set rules that force managers to sell underperforming stocks before they have underper-
formed for too long.
Educate the managers so that they are aware of their own overconfidence, and therefore
place more weight on other people's analysis and opinions.
Have decisions peer-reviewed to ensure that one person's biases are counteracted by
another person's.
Design and use a model which determines which stocks should be bought and which sold.
Change the remuneration policy such that analysts have a higher proportion of their pay
based on performance. This should focus their attention on avoiding inefficient and biased
processes.
Set up a rule that all shares purchased must have a supporting piece of analyst research.
This will avoid the danger that managers ignore research and back their own opinions.
Introduce a mechanism that presents possible shares to purchase in the form of random scat-
ter diagram. This avoids the danger of a list causing a bias towards the first item on the list.

QUESTION 8
Part (i): St ~ LogNormal [0.08875t, 0.25t2]
A = £41,168
Part (ii): 𝐹10 = 𝟏𝟎𝟎, 𝟎𝟎𝟎𝒆𝟎.𝟐𝟓𝒁𝟏𝟎
Sub-part (a): var (100,000 – F10) = (£127,362)2
Sub-part (b): Pr (F10< 90,000) = 0.44696
Sub-part (c): 99% VaR = £84,104
QUESTION 9
Part (i): VaRα(X) = -t where P(X < t) = α
The one-period Value at Risk with 100 (1 – α)% confidence level is -t, where we are 100 (1 –
α)% sure that the rate of return on the fund will not be worse than t.
Part (ii): Proof
1 2
𝜍 − Φ −1 𝛼
Part (iii): 𝑇𝑎𝑖𝑙𝑉𝑎𝑟𝛼 𝑋 = 𝛼 2𝜋
𝑒 2 − 𝜇
Part (iv): VaR = £168.55m; TailVaR = £198.23m
QUESTION 10
Part (i): pAA = 1.89%; pBB = 3.70%
Part (ii):
Sub-part (a): 95% VaR = -6%; 95% TailVaR = 2%; 95% Conditional TailVaR = 106%
Sub-part (b): 95% VaR = -8%; 95% TailVaR = 4%; 95% Conditional TailVaR = 108%
Sub-part (c): 95% VaR = 46%; 95% TailVaR = 0.074%; 95% Conditional TailVaR = 2%
Part (iii): The 95% VaR measures the potential loss that we expect to exceed only 5% of the time or
less. The answers to Part (ii) show a greater Value at Risk for portfolio (c) compared with
portfolios (a) and (b). This suggests that portfolio (c) is more risky than portfolios (a) and
(b). But portfolio (c) is diversified and so contains less portfolio risk. This illustrates a short-
fall of VaR as a risk measure.
The 95% Conditional TailVaR measures the expected shortfall in the 5% lower tail, given
that a shortfall occurs. The answers to Part (ii) show a much greater Conditional TailVaR for
portfolios (a) and (b) relative to portfolio (c). This is because the distribution of returns is
less skewed in the lower 5% tail.

QUESTION 11
Theory
QUESTION 12
Variance of return
Variance is mathematically tractable, familiar, and widely used and understood. The use of variance
leads to elegant portfolio solutions in a mean-variance portfolio construction framework.
However, variance is a symmetric measure of risk about the mean return, whereas most investors are
likely to be more concerned with downside than upside risk.
It may therefore not be entirely suitable for a portfolio of bonds subject to credit risk, which will have a
negatively skewed return distribution. Also, as defaults are often co-dependent on economic down-
turns, portfolio returns can have fat tails. However, skewness and kurtosis of returns are not captured
by a variance measure.
Variance also measures risk relative to the mean rather than some benchmark level of return chosen by
the investor.
Downside semi-variance of return
Downside semi-variance focuses on downside risk below the mean.
However, in doing so, it completely ignores the variability of returns above the mean. Semi-variance can
be less mathematically tractable than the variance.
Furthermore, if returns on assets are symmetrically distributed semi-variance is proportional to va-
riance.
As with variance of return, semi-variance does not capture skewness or kurtosis.
It again measures risk relative to the mean rather than some benchmark level of return chosen by the
investor.
Shortfall probability
The shortfall probability gives an indication of the possibility of loss below a certain level. As such, it is
easy to understand and may be easy to calculate.
The choice of benchmark level can be chosen to reflect the risk preferences of the individual investor.
The shortfall probability completely ignores returns above the benchmark level, which may be of relev-
ance to the investor.

It also tells you nothing about the extent of the potential downside of returns below the benchmark re-
turn.
Value at Risk (VaR)

VaR provides a statistical measure of downside risk. Subject to regulation, the timeframe and lower-tail
probability can be chosen by the investor.
Bond portfolios subject to credit risk will have a negatively skewed and potentially fat-tailed returns
and so the usefulness of VaR depends on accurately modelling such skewed or fat-tailed distributions of
returns.
However, 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.
VaR ignores all upside above the VaR return and also tells you nothing about the possible extent of the
downside below the VaR return.
Tail Value at Risk (TailVaR)

TailVaR tells you something about how bad returns can be on average when the VaR benchmark level is
exceeded. Subject to regulation, the timeframe and lower-tail probability can be chosen by the investor.
It has the same modelling issues as VaR in terms of sparse data, but captures more information on the
tail of the negatively skewed distribution.
QUESTION 13
Part (i): Theory

Part (ii): Theory
Part (iii): b = -0.1; w < 5
QUESTION 14
Part (i): Theory
Part (ii): Scenario 1 – Assuming that nobody knew the earthquake was going to happen, its effect
could not have been reflected in prices in advance.
The sudden price drop immediately afterwards corresponds to informational efficiency. A

quick adjustment of prices in response to a public news announcement suggests evidence
for the semi-strong form (and by implication the weak form) EMH.

Scenario 2 – If some insiders had known in advance that the merger would complete, then
this would have meant there was information not fully reflected in the share price at that
point, which goes against the strong form EMH.
One possible reason for this might be the existence of rules that ban insider dealing.
Usually the share price would increase as a result of a merger announcement, so the fact
that there's a sudden fall might suggest some other inefficiency in the market, such as a pre-
vious market over reaction.
However, the fall might be due to the terms of the merger being less favourable than antic-
ipated, so a sudden and immediate fall might be in keeping with semi-strong-form EMH, al-
though we don't know whether the size of the fall accurately reflects all known information.
QUESTION 15
Theory
QUESTION 16
Part (i): Theory
Part (ii): Non-satiation can be expressed in terms of a utility function as U’(w) > 0
Risk neutrality can be expressed in terms of a utility function as U”(w) = 0
Part (iii): Theory
Part (iv): As R’(w) = 0, the relative risk aversion is constant.
QUESTION 17
Part (i): 95% VaR = -t where P (X < t) = 5%

2%
Part (ii): Expected Shortfall = −∝
2% − 𝑥 𝑓 𝑥 𝑑𝑥
Part (iii): 95% VaR = 11.45%
Part (iv): Value at Risk (VaR) doesn't give any indication about the extent of any possible loss below
the VaR point. VaR ignores the upside above the lower 5% tail point.
By definition, investment outcomes that occur in the lower tail of a distribution are uncom-
mon in practice. This means that there's an inherent lack of data in this key region with
which to fit a suitable distribution, which reduces the effectiveness of the VaR measure.

QUESTION 18
−𝟐𝒄 −𝟐𝒄𝒘
Part (i): 𝐴 𝑤 = 𝒃+𝟐𝒄𝒘
; 𝑅 𝑤 = 𝒃+𝟐𝒄𝒘
Part (ii): The payoff from the gamble is either a profit or loss of £20. We're told that the gamble
would only be accepted if p ≥ 0.55, which shows that she is risk-averse since she requires
the gamble to be weighted in her favour as compensation for taking the risk.
𝟏𝟕,𝟎𝟖𝟎−𝟐𝟓∗𝑼(𝟏𝟐𝟎) 𝑼 𝟏𝟐𝟎 −𝟔𝟏𝟎 𝟔𝟏𝟎−𝑼(𝟏𝟐𝟎)
Part (iii): 𝑎= 𝟑
;𝑏 = 𝟗
;𝑐 = 𝟑,𝟔𝟎𝟎
Part (iv): Maximum wealth for which the investor is non-satiated is £200
QUESTION 19
Part (i): St ~ lognormal (0.08t, 0.04t)
Part (ii): A = €11,972
Part (iii): X = 10,000 S5 ~ 10,000 x lognormal (0.4, 0.2)
Where, S is the random variable to denote the value of the portfolio at time t = 5.
Sub-part (a): Standard deviation is €7,758
Sub-part (b): 95% VaR is €12,851
QUESTION 20
Part (i): A(w) = 1/w; R(w) = 1
Part (ii): From the results in (i) we can see that the investor exhibits decreasing absolute risk aver-
sion (i.e. A(w) decreases as wealth increases) and constant relative risk aversion (i.e. R(w)
remains constant as wealth increases).
This indicates that the investor is happy to keep a fixed proportion of her wealth in risky as-
sets regardless of the level of wealth. Even though the absolute amount of risky assets
would increase with wealth, the investor is not disturbed by this due to the diminishing ab-
solute risk aversion.
Part (iii): E[U] = 0.75 x ln (100 + 30a) + 0.25 x ln (100 – 6a)
Part (iv): The optimal portfolio is to invest £41.67 in Asset A and £58.33 in Asset B.

QUESTION 21
Part (i): Variance of Return is given by:
∝
−∝
𝜇 − 𝑥 2 𝑓 𝑥 𝑑𝑥; where µ is the mean of the return at the end of the chosen period.
Part (ii): Shortfall probability of the return being below a level L is given by:
𝐿
𝑓 𝑥 𝑑𝑥
−∝
Part (iii): Short fall probability; P (X < -4%) = 0.4174

Part (iv):
Sub-part (a): If an investor bases their investment decisions on risk measured in terms of the va-
riance of returns, then their utility function is characterised completely by the first
two moments of the returns (i.e. the mean and the variance). One example of this is
the quadratic utility function.
Sub-part (b): If an investor bases their investment decisions on risk measured in terms of short-
fall probabilities, then their utility function will exhibit a discontinuity at the re-
quired minimum return. This is because there will tend to be a dramatic shift in such
an investor's utility as their wealth crosses the required benchmark level.
QUESTION 22
Part (i): Theory
Part (ii): Any two of the following:
 All statistical tests need to make assumptions about the markets which may not be valid.
For example, the normality of returns or stationarity.
 Taxes, transactions costs and research costs may make it impossible to effectively ex-
ploit any mispricing arising in the market. Therefore the EMH may only hold net of ex-
penses.
 The EMH doesn’t preclude the possibility of making higher returns by accepting higher
levels of risk. However, the hypothesis doesn't give any framework in which such risk
can be measured or priced.
 Any assumptions made about how security prices are expected to behaviour in response
to the delivery of new information might be invalid.
 Testing strong form EMH requires access to information which, by definition, is only
held in private by some individuals.
 It can be difficult to determine exactly when information becomes public, particularly as

many events are widely rumoured prior to official announcements.
 There is no commonly accepted definition of what constitutes publicly available infor-

mation.
 It's impossible to test all trading strategies that might be employed as a result of tech-
nical analysis.
QUESTION 23
Part (i): Let X denote the return on the asset. The Value at Risk, -t, at confidence level p is then given
by:
P (X < t) = p
Part (ii): Downside semi-variance is defined as:
µ
−∝
𝜇 − 𝑥 2 𝑓 𝑥 𝑑𝑥;
where µ is the expected return from the asset at the end of the chosen period.
Part (iii):
Advantages: It's not uncertainty in general that investors dislike, but the uncertainty of
poor returns that causes concern. Downside semi-variance focuses on this aspect of risk.
Disadvantages: The downside semi-variance measure can become mathematically intract-
able, even for relatively straightforward distributions of returns.
Uncertainty in the returns above the mean level is ignored -which may make this measure
unsuitable for comparing assets.
If the distribution of returns on the asset is symmetrical, then the downside semi-variance is
simply half of the variance. Therefore, this risk measure fails to give any additional informa-
tion about the asset.
It measures downside risk relative to the mean rather than some other benchmark that
might be more relevant to the investor.
Part (iv): 10% VaR is -5 apples
Part (v): Expected Shortfall = 0.159

QUESTION 24
Part (i): Theory
Part (ii): d<0
Part (iii): Utility function only satisfies the condition of non-satiation, and so can only be used to make
financial decisions, over the range of wealth:
−1
−∝ < 𝑤 <
2𝑑
Part (iv): d = - 0.0005

Part (v): If she doesn’t take up the opportunity to exchange, she keeps her prize of $ 250 and has a
certain utility of 218.75.
Conversely, if she takes up the opportunity to exchange, she ends up with either $0 or $600,
each with an estimated probability of 50%. Consequently, her expected utility would be 210.
QUESTION 25
Part (i): St ~ LogN (0.12875t, 0.0625t)
Part (ii): The investor would need to invest about £69,806.
Part (iii):
Sub-part (a): 90% VaR relative to £100,000 is £50,612
Sub-part (b): Expected surplus relative to £100,000 is £30,585.
Part (iv): The calculations suggest that the expected (average) outcome is a large surplus, in which
case the investor would be able to pay off the loan and be left with a substantial cash sum.
However, there is a significant chance of a shortfall, in which case he would have insufficient
funds to repay the loan. In fact, there is a 10% chance of a shortfall of more than £50,612.
Consequently, he might wish to consider taking action, such as changing his investment
portfolio, to reduce the probability of a shortfall.
Part (v): The investor could switch some or all of his funds into an asset or assets with a lower va-
riance of return, albeit at a likely cost in terms of a lower expected return.
Alternatively, by diversifying into a range of assets with less than perfectly correlated re-
turns, he may be able to significantly reduce the risk of a shortfall, without accepting much,
if any, reduction in the expected return.

Although the investor only has £50,000 to invest now, it may be possible to subsequently
reduce the risk of a shortfall by paying off some of the loan from any surplus income.
Finally, it might be possible to reduce the risk of a shortfall by purchasing an appropriate in-
surance product, or perhaps using some form of derivative.
QUESTION 26
Part (i):
Sub-part (a): Absolute dominance exists when one investment portfolio provides a higher return
than another in all possible circumstances.
Sub-part (b): Portfolio A exhibits first-order stochastic dominance over Portfolio B if:
FA(x) ≤ FB(x), for all x, and
FA(x) < FB(x), for some values of x
Sub-part (c): Portfolio A exhibits second-order stochastic dominance over Portfolio B if:
𝑥 𝑥
𝐹
𝑎 𝐴
𝑦 𝑑𝑦 ≤ 𝑎
𝐹𝐵 𝑦 𝑑𝑦, for all x,
With the strict inequality holding for some value of x, where a is the lowest return
that the portfolios can possibly provide.
Part (ii):
Sub-part (a): Asset 2 cannot exhibit either first-order or second-order dominance over as-
set 3.
Sub-part (b and c):
Asset 3 doesn't first-order dominate asset 1.
Asset 1 first-order dominates asset 2.
As first-order stochastic dominance also implies second-order stochastic
dominance, asset 1 also second-order dominates asset 2.
Asset 3 second-order stochastically dominates asset 1.
QUESTION 27
Part (i):
Sub-part (a): Since U’(w) < 0, the investor is non-satiated
Sub-part (b): Since U”(w) < 0, the investor is risk-averse

Part (ii): R(w) = 0.5;

Therefore, the horse racing fan exhibits constant relative risk aversion.
Part (iii): The fan’s expected utility of wealth is maximized by betting £906.84 on horse A and the
remainder (£93.16) on horse B.
Part (iv): Expected utility of wealth is 49.80
Part (v): The fan’s initial utility is 61.25
So, the maximum expected utility of wealth is less than the initial utility of wealth.
This is because the winning pay-outs are less than would be required based on the inves-
tor's estimated probabilities of each horse winning.
Based on expected utility, the investor would be better off not betting at all.
QUESTION 28
Theory
QUESTION 29
Theory
QUESTION 30
Part (i): Theory
Part (ii): Theory
Part (iii):
Sub-part (a): Portfolio 2 first-order stochastically dominates Portfolio 1 because the cumulative
distribution function (CDF) of Portfolio 2 is always less than or equal to that for
Portfolio 1, and in some cases strictly less.
Sub-part (b): Portfolio 1 second-order stochastically dominates Portfolio 2 because the CDFS of
Portfolios 1 and 2 cross, indicating that neither portfolio first-order stochastically
dominates the other. However, the integral of the CDF of Portfolio 1 is always less
than or equal to that for Portfolio 2, and in some cases strictly less.
Sub-part (c): The outcome is not clear cut. Portfolio 1 will appeal to a non-satiated investor whe-
reas Portfolio 2 will appeal to a risk-averse investor. Depending on the relative sizes
of the means and standard deviations, the conclusion could vary.

QUESTION 31
Part (iv): Theory
Part (v): It can be difficult to fit an appropriate distribution to model tail events. This is because, by
definition, tail events are extreme and unlikely, meaning that data with which to fit a distri-
bution (that is accurate in the tails) is sparse.
Hence, the parameters of the fitted distribution are likely to be heavily influenced by the
core data. This may mean that the fitted distribution may underestimate the probability of
tail events and hence underestimate the VaR.
QUESTION 32
Part (i): Let i1 be the random variable denoting the one-day investment return. Then,
i1 ~ N (0.01, 0.22)
Sub-part (a): Expected return = £1.01m
Sub-part (b): Variance = (£200,000)2
Sub-part (c): For a symmetrical distribution, such as the normal distribution, the downside semi-
variance of the portfolio value (relative to the expected value) is half the variance,
i.e. £20,000m.
Sub-part (d): Shortfall probability = 0.48006
Part (ii): Loss relative to the expected portfolio value is £465,260
Part (iii): 69 is the minimum number of days required
QUESTION 33
Part (i): Theory
Part (ii):
Sub-part (a): Shortfall probability for:
Option 1 = 100%; Option 2 = 39.77%; Option 3 = 35%
Sub-part (b): VaR for
Option 1 = -£900; Option 2 = -£439.43; Option 3 = £9,000
Part (iii): The two risk measures are not conclusive, and each suggests that a different investment
would be best.
The bank account delivers nearly enough money with no risk, so the student might be better
to invest wholly in the bank account and wait to buy the car.
If the student can split his investment, he could invest mostly in the bank account and a little
in the shares or the gamble.
If the student only needs £10,000, he need only invest £1,000 in the gamble. The student
could also find other investments with a different risk/return profile.
As a risk measure the shortfall probability assumes that all the student cares about is reach-
ing £10.000. He may want to consider the size of any shortfall or surplus.
QUESTION 34
Part (ii):
Sub-part (a): Expected Utility, E[U] = 33.24
Sub-part (b): Expected Utility, E[U] = 31.54
Sub-part (c): Expected Utility, E[U] = 19.46
Part (iii): A utility function of the form w0.5 exhibits risk aversion because U"(w) = -0.25w1.5<0 so their
utility function implies that they are a risk-averse investor.
Investing in the bank account is risk-free and so it is consistent that this approach should
provide the highest expected utility. Buying the shares is a riskier strategy and buying the
call options are riskier still.
We would therefore expect shares to provide a lower expected utility than cash and for the
call options to provide the lowest expected utility of the three.
Risk-averse investors require compensation for taking on additional risk and so the real-
world probability of a price increase p should be greater than the risk-neutral probability q.
However, here p = 0.5 and q = 0.7564 so the investor is not getting sufficient compensation
to take on risk.

SECTION 2
QUESTION 1
Part (i): Expected accumulation = £158,037
Part (ii): Required probability = 0.444
QUESTION 2
Part (a): Expected rate of return pa, E(S20) = 0.035265
Part (b): Variance of the effective rate of return pa, s2 = 0.004628
QUESTION 3
Part (i): (1 + it) ~ log N (0.0578686, 0.000800676)
Part (ii):
Sub-part (a): The probability that the company will not meet its liabilities is 1
Sub-part (b): The probability that the liabilities will not be meet is 0.77
Part (iii): Variance of return of portfolio in (ii)(a) is 0
Variance of return of portfolio in (ii)(b) is 0.00050625
QUESTION 4
Part (i): Expected accumulation = £180,499
Part (ii): Required probability = 0.44377
QUESTION 5
Part (i): Amount to be invested = £69,858.26

Part (ii): Expected value in excess of £200,000 is £1,336.55
Part (iii): Range = £70,976.85
QUESTION 6
Part (i): Mean accumulation = £27,590.32

Part (ii): Standard deviation = £1,263.84

Part (iii):
Sub-part (a): If the yields had been 6%, 7% and 8%, the value of j would still have been 7%, so the
mean accumulation would be the same. However, the individual yield values are less
spread out, so the standard deviation of the accumulation would be reduced.
Sub-part (b): If the term had been 13 years instead of 15, the mean accumulation would be re-
duced, since the investment has a shorter time in which to grow. The standard devi-
ation of the accumulation would also have been reduced, since the spread of possi-
ble outcomes would be narrower if the term of the investment is shorter.
QUESTION 7
Part (i): Mean accumulation = £10,260,000
Standard deviation = £871,100
Part (ii): If there was a guaranteed return of 4% then the accumulated value would be:
7.85(1.04)5 = 9.5507, i.e. £9,551,000 (4 SF).

This is less than the insurance company has to pay out (£10m) so therefore there is definite-
ly going to be a loss.
However, even though the expected accumulation under the strategy in part (i) is higher
than the payout, that value is not guaranteed. The standard deviation of just under £900,000
means that the accumulation could be much higher than the mean (of £10.26m) but it could
also be much lower leading to a higher loss than investing in the fixed-interest securities.
QUESTION 8
Part (i): S12 ~ lognormal (0.910686, 0.025693)
Part (ii): Probability of meeting the objective is about 81%
QUESTION 9
Part (i): P = £59,490.99
Part (ii): E(Profit) = £5,246.54
QUESTION 10
Part (i): E(Sn) = (1 + j)n; var(Sn) = [s2 + (1 + j)2]n – (1 + j)2n

Part (ii):
Sub-part (a): σ2 = 0.013226; µ = 0.032608
Sub-part (b): Required probability = 0.06185
Part (iii): Since the mean value for the rate of interest is 4%, and we are looking for the probability
that the rate lies between 6% and 8%, we are looking for a probability in the upper tail of
the distribution. Since this range does not include the mean, we would expect the probabili-
ty to be relatively small. A value of 6.2% perhaps does not look unreasonable here.
QUESTION 11
𝑗
Part (i): E (R + A1 + A2 +……+ An) = R + C𝑠𝑛|
Part (ii): Mean value of the total accumulated investment is £123,080
QUESTION 12
Part (i): Mean = £10,455,680; Standard deviation = £887,706

Part (ii): The fixed interest securities will give a guaranteed accumulation after 5 years of:
8,000,000 x 1.045 = £9,733,223
This is less than the £10,000,000 required so we are making a guaranteed loss.
The risky investment leads to an expected profit. However, this profit is uncertain due to the
large standard deviation of returns. So, it could be better or it could be worse and also make
a loss.
QUESTION 13
Part (i): Price of the annuity = £276,639
Part (ii): Expected accumulation = £257,697
Part (iii): Standard deviation = £8,051.74
Part (iv): Probability = 0.01024
QUESTION 14
Part (i): Expected effective rate of return per annum is 3.526%
Part (ii): Standard deviation of rate of return is 5.704% pa

QUESTION 15
Part (i): The company should invest approximately €784,350
Part (ii):
Sub-part (a): Increasing the value of µ will increase the expected annual investment return and so
the amount required at time 0 (to meet the liability with probability 95%) will de-
crease.
Sub-part (b): Increasing the value of σ will increase the volatility of the annual investment return,
which implies that the amount required at time 0 (to meet the liability with proba-
bility 95%) will increase.
Sub-part (c): If the probability of meeting the liability is increased from 95% to 99%, then the risk
of not meeting the liability must be reduced. This can only be achieved by investing a
greater amount now.
QUESTION 16
Part (i): S10 ~ Log N (0.74865, 0.041922)
Part (ii): Required amount is approximately £8,492
QUESTION 17
Theory
QUESTION 18
Part (i): Theory
Part (ii): Vn ~ lognormal (-nµ, nσ2)

SECTION 3
QUESTION 1
Part (i): Main assumptions of modern portfolio theory:
1. Investors select their portfolios on the basis of the expected return and the variance of
that return only over a single time horizon.
2. The expected returns, variances of returns and covariances of returns are known.
3. Investors are non-satiated.
4. Investors are risk-averse.
Part (ii):
Sub-part (a): L = -µ (x1 + x2 +x3 -1)
Sub-part (b): x1 = 0.7125; x2 = 0.075; x3 = 0.2125
QUESTION 2
Part (i): σM = 20%
Part (ii): rB = 5%
Part (iii): Cov (RA, RM) = 140%%; Cov (RB, RM) = 340%%; Cov (RC, RM) = 540%%
QUESTION 3
Part (i): A portfolio is efficient if an investor cannot find a better one in the sense that it has either a
higher expected return and the same (or lower) variance of returns or a lower variance of
returns and the same (or higher) expected return.
Part (ii):
Sub-part (a):xA = 0.5; xB = 0.5
Sub-part (b): Expected return = 8%
QUESTION 4
Theory

QUESTION 5
Part (i): The expected return on the market is 9% pa
Part (ii): MC4 = 6.5; β1 = 0.625; β2 = 0.5; β3 = 0.875; β5 = 1.25
Part (iii): βP = 0.792
Part (iv): The Capital Market Line is the straight line denoting the efficient frontier in E - σ space. This
is a straight line passing through the risk-free asset and the market portfolio and so the
risky part of all efficient portfolios must comprise risky assets in the same proportions as in
the market portfolio.
Since this is not the case for Portfolio P, this portfolio cannot lie on the Capital Market Line.
QUESTION 6
Part (i): Three main assumptions of mean-variance portfolio theory
 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.
 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.
Part (ii): Theory
Part (iii): A portfolio is efficient if an investor cannot find a better one in the sense that it has either a
higher expected return and the same (or lower) variance or a lower variance and the same
(or higher) expected return.
QUESTION 7
Part (i): The two risky assets, A and B, have the same market capitalisation and so the market portfo-
lio consists of 50% in Asset A and 50% in Asset B.
𝟎.𝟓(𝑽𝑨 +𝑪𝑨𝑩 ) 𝟎.𝟓(𝑽𝑩 +𝑪𝑨𝑩 )
Part (ii): VM = 0.25 (VA + VB +2CAB); βA = ; βB =
𝑽𝑴 𝑽𝑴
Part (iii): EA = 20%; EB = 16%

Part (iv): xR = -0.25; xM = 1.25
Part (v): σP = 17.68%
QUESTION 8
Part (i):
Sub-part (a): ρ = -1 and 𝑥𝐴 − 𝑥𝐵 2 = 0
ρ = +1 and 𝑥𝐴 + 𝑥𝐵 2 = 0
Sub-part (b): The most efficient risk-free portfolio will occur when ρ = -1 with xA = 0.58579 and xB
= 0.41421
Sub-part (c): Expected return =𝑬𝑨 𝟐
Part (ii):
Sub-part (a): If the portfolio weights are unlimited, this will be maximized when xA = -∞, in which
case Ep = +∞
Sub-part (b): Ep = 3EA
Part (iii): Ep = 11/9EA
QUESTION 9
Part (i): EM = 4.6%; σM = 0.92466%
Part (ii): Market price of risk is 1.730
Part (iii):
Method 1: βA = 1.2865; βB = 1.5205; βC = 0.5848; βD = 1.1111; βE = 0
Method 2: βA = 1.25; βB = 1.5625; βC = 0.46875; βD = 1.25; βE = 0
Part (iv): Most of the assumptions of the basic model can be attacked as unrealistic. For example, the
assumption that all investors use the same means, standard deviations and covariances of
investment returns.
Empirical studies do not provide strong support for the model. For example, returns are not
found to be consistent with the security market line relationship.
It is difficult to test the predictions of the model since, in theory, account has to be taken of the
entire investment universe open to investors, not just capital markets. For example, an impor-
tant asset of most investors is their human capital (i.e. the value of their future earnings).

QUESTION 10
Part (i): Theory
Part (ii): Theory
Part (iii): The specific risk can be diversified away by increasing the number of securities.
Part (iv):
Sub-part (a): Although many studies have found that incorporating more factors into the model
(for example industry indices) leads to a better explanation of the historical data,
correlation with the market is the largest factor in explaining security price varia-
tion.
Sub-part (b): There is little evidence that multi-factor models are significantly better at forecast-
ing the future correlation structure.
QUESTION 11
Part (i): Theory
Part (ii): The single-index model is purely empirical (i.e. a statistical model) and is not based on any
theoretical (or economic) relationships between β i and the other variables, as is the case
with CAPM.
Part (iii): α1 = 5.75%; α2 = 5.2%
Part (iv): The greater number of factors used in a multi-factor model compared with the single-index
model leads to a better fit to historical data.
However, correlation with the market is the most significant factor in explaining security
price variation and there is little evidence that multi-factor models are significantly better at
forecasting the future.
QUESTION 12
Part (i): Theory
Part (ii): σP = 3.5% pa
Part (iii): Amount of money invested in market portfolio is £2.1m which requires a cash (i.e. the risk-
free asset) borrowing of £0.9m

QUESTION 13
Part (i): Shares in Company S have a higher expected return and a lower variance of returns than
shares in Company M and so would be preferred.
Part (ii): The assumption that 'investors make their decisions purely on the basis of expected return
and variance' can be relaxed.
Part (iii): E = 9.5%; σ = 3.579%
Part (iv): xS = 0.655; xM = 0.345
Part (v): Whenever M is delivering strong profits, S will make more sales and so will have increased
profits too. So, the correlation between the returns of each company will increase. This will
increase the variance of returns on portfolios composed of M and S.
The minimum-variance portfolio will contain a higher proportion of Company S shares than
before.
QUESTION 14
Part (i): Main assumptions of mean-variance portfolio theory:
Investors select their portfolios on the basis of expected return and variance of return over
a single time horizon.
The expected returns, variance 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.
Part (ii):
𝑊𝑃 = 16𝑥12 + 144𝑥22 + 64𝑥32 + 48𝑥1 𝑥3 − 𝜆 2𝑥1 + 4𝑥2 + 3𝑥3 − 𝐸 − 𝜇(𝑥1 + 𝑥2 + 𝑥3 − 1)
Where λ and µ are the Lagrangian multipliers.
Part (iii): µ = -100.8 and λ = 64.8
x1 = -0.45; x2 = 0.55; x3 = 0.9
Part (iv): If short-selling is not allowed, then the minimum-variance portfolio deduced in part (ii) is
no longer available because x1<0.
Asset 2 has the highest individual expected return, therefore any positive combination of
the three assets cannot exceed this. Furthermore, E 2 = 4%, so without short-selling the only
way to achieve a portfolio return of 4% is to invest wholly in Asset 2.
QUESTION 15
Part (i): Theory
Part (ii): Theory
Part (iii): Theory
Part (iv): Theory

𝑉𝐵 −𝐶𝐴𝐵
Part (v): Minimum occurs when:𝑥𝐴 =
𝑉𝐴 −2𝐶𝐴𝐵 +𝑉𝐵
QUESTION 16
Part (i): The variance of the return on the portfolio, V, is given by:
𝑛 2 𝑁 𝑁
𝑉= 𝑖=1 𝑥𝑖 𝑉𝑖 + 𝑖=1 𝑗 =1 𝑥𝑖 𝑥𝑗 𝐶𝑖𝑗
𝑗 ≠1
Where Cij is the covariance between the returns on securities i and j.
Part (ii): In E – V 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 variance.
Part (iii): Theory
Part (iv): Theory
QUESTION 17
Part (i): Market portfolio consists of 30% Asset 2 and 70% Asset 3.
Part (ii): Market price of risk = 3.35
Part (iii):
Method 1: β2 = 1.40; β3 = 0.83
Method 2: β2 = -1.59; β3 = 2.11
Part (iv): The CAPM is limited for the following reasons:
 Empirical studies do not provide strong support for the model.
 The conclusions drawn from the CAPM are difficult to test because the market portfolio
includes the entire universe of risky assets, including human capital, and not just finan-
cial securities. It is therefore difficult to identify and invest in.

 It is based on unrealistic assumptions, for example:
 All investors have the same time horizon, currency, estimates of the means, variances
and covariances of asset returns, and can lend and borrow unlimited amounts at the
same risk-free rate. Markets for risky assets are generally not perfect.
 The model does not account for tax, inflation, multiple time periods or the optimisation
of consumption over time.
QUESTION 18
Part (i): Main assumptions of mean-variance portfolio theory
 All expected returns, variances and covariances of pairs of assets are known.
 Investors make their decisions purely on the basis of expected return and variance of
that return over a single time period.
 Investors are non-satiated. For a given level of risk, investors will always prefer a port-
folio with a higher expected return to one with a lower return.
 Investors are risk-averse. For a given level of return, investors will always prefer a port-
folio with lower expected variance to one with higher variance.
Part (ii): E[SP] = E[SA] (0.25 + 0.75xA)
Sub-part (a): E[SP] = 0.4 x E[SA]
Sub-part (b): E[SP] = -0.5 x E[SA]
Part (iii):
Sub-part (a): V[SP] = 0
Sub-part (b): With a variance of zero, the minimum variance portfolio is also a risk-free portfolio.
QUESTION 19
Part (i): The market portfolio is composed of Security A and Security B in equal proportions.
Part (ii): βA = 1.25; βB = 0.75

QUESTION 20
Part (i):
Sub-part (a): The given indices (price index, yield on government bonds and the annual rate of
economic growth) are all macroeconomic factors. Therefore, this is a macroeconom-
ic model.
Sub-part (b): The given indices (R&D expenditure, price earnings ratio and the level of gearing)
are all company-specific factors. Therefore, this is a fundamental model.
Part (ii): E[RP] = xA (0.03 + E[I1] – 4E[I2]) +xB (0.05 + 3E[I1] + 2E[I2]) +xC (0.1 + 1.5E[I1] + 1.5E[I2])
Sub-part (a): E[RP] = 0.06 + 1.83E[I1] – 0.17E[I2]
Sub-part (b): E[RP] = 0.06 + 4E[I1] + 5E[I2]
Part (iii): xA = 1/8; xB = 3/8; xC = 1/2
QUESTION 21
Part (i): In a two-factor model, the return on security i, denoted by Ri, is modelled as:
𝑅𝑖 = 𝑎𝑖 + 𝑏𝑖,1 𝐼1 + 𝑏𝑖,2 𝐼2 + 𝑐𝑖
Part (ii): Theory
QUESTION 22
Part (i): xA = 0.5; xB = 0.5
Part (ii): βA = 1.2; βB = 0.8
Part (iii): Theory
QUESTION 23
Part (i): An efficient portfolio is one such that there is no other portfolio that offers a higher ex-
pected return for the same or lower variance of return, or a lower variance of return for the
same or higher expected return.
An inefficient portfolio is a portfolio that isn't efficient.
Part (ii): Investors are never satiated. At a given level of risk or variance, 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 risk or variance to one with higher risk or variance.

Part (iii): V = 0.49a2 – 0.58a + 0.25
Part (iv): V = 1,225R2 – 142.5R + 4.2225
Part (v): a = 0.1497 or 1.2889
Part (vi): Assuming that the investor is fully-invested, then the solution with a = 1.2889 implies a
holding in asset B of-0.2889. In other words, you need to short- sell asset B.
If short-selling isn't allowed, then it will not be possible to attain this particular portfolio.
Consequently, the only attainable point where the efficient portfolio and indifference curve
intersect is the other one found, which has a weight of 0.1497 in A and 0.8503 in B.
QUESTION 24
Theory
QUESTION 25
Part (i): Theory
Part (ii): βM = 1
Part (iii): β1 = 0.7072; β2 = 1.1952
Part (iv): r = 13.279%
QUESTION 26
Part (i): Theory
Part (ii): x1 = 0.4; x2 = 0.6
Part (iii): Market price of risk is 1.897
QUESTION 27
Part (i): An efficient portfolio is one that cannot be bettered in terms of a higher expected return (for
a given or lower standard deviation of returns) or a lower standard deviation of returns (for
a given or higher expected return).
Part (ii): The two assumptions are:
 non-satiation - investors prefer more to less.
 risk aversion - investors dislike risk.

Part (iii): If a portfolio is not on the efficient frontier then it is inefficient. This means that a portfolio
with a higher expected return will exist for the same level of risk or a portfolio with a lower
risk will exist for the same expected return.
𝑉𝐵 −𝐶𝐴𝐵
Part (iv): 𝑥𝐴 = is a minimum
𝑉𝐴 −2𝐶𝐴𝐵 +𝑉𝐵
QUESTION 28
Part (i):
𝐶𝑜𝑣 (𝑅𝑖 ,𝑅𝑀 )
Sub-part (a): 𝛽𝑖 = 𝑉𝑎𝑟 (𝑅𝑀 )
Sub-part (b): 𝑟𝑖 − 𝑟0 = 𝛽𝑖 (𝑟𝑀 − 𝑟𝑜 ); where r0 is the risk-free rate

Sub-part (c): Proof
Part (ii):
2 1 1 1
Sub-part (a): 𝜋1 = ; 𝜋2 = ; 𝜋3 = ; 𝜋4 =
5 5 5 5
11 7 6 6
Sub-part (b): 𝛽1 = 8
; 𝛽2 = 8 ; 𝛽3 = 8 ; 𝛽4 = 5
Sub-part (c): 𝑟1 = 14%; 𝑟2 = 10%; 𝑟3 = 9%; 𝑟4 = 8%; 𝑟𝑀 = 11%

SECTION 4
QUESTION 1
𝜕𝑓 𝜕𝑓 1 𝜕2𝑓 𝜕𝑓
Part (i): 𝑑𝑓 𝑡, 𝑋𝑡 = 𝜕𝑡
+ 𝜇𝑡 𝜕𝑥 + 2 𝜍𝑡2 𝜕𝑥 2 𝑑𝑡 + 𝜍𝑡 𝜕𝑥 𝑑𝑊𝑡
Part (ii): Proof
QUESTION 2
Part (ii): For f to be a martingale, a = ½ σ2
QUESTION 3
Part (i): Proof
Part (ii):
Sub-part (a): 𝑝0 = 𝑆0 𝑒 𝜇 −𝑟+𝜍𝑀 𝑇
Sub-part (b): Proof
QUESTION 4
Part (ii): Theory
QUESTION 5
Part (i): The continuous-time lognormal model of security prices assumes that the log of the prices
forms a random walk.
If St denotes the market price of an investment, then the model states that, for T>t, the log
returns are modelled by the following distribution:
log 𝑆𝑇 − log 𝑆𝑡 ~𝑁 [𝜇 𝑇 − 𝑡 , 𝜍 2 𝑇 − 𝑡 ]
where µ is the parameter associated with the drift and σ is the parameter associated with
the volatility.
Part (ii): p = 0.1194
Part (iii): The option appears to be over-priced and so should not be bought.
Part (iv):
Sub-part (a): µ’ - µ ~ N[0, 0.00144]
Sub-part (b): P [µ’ - µ > 0.03] = 0.2146
Part (v):
Sub-part (a): The option would then appearunder-priced and we would want to buy it.
Sub-part (b): From part (iv)(b), we know there is a 21.5% probability that the estimator for µ is at
least 3% higher (in absolute terms) than the true value of µ. This is a significant
probability!
The estimator is very variable and this has a corresponding impact on the price offered. In fact, this
shows the difficulty in estimating drifts in market models generally.
QUESTION 6
Part (i):
Sub-part (a): St ~ lognormal [0.08875t, 0.252t]
Sub-part (b): A = £41,168
QUESTION 7
Part (i): Theory
Part (ii): Theory
Part (iii): Taking an individual option, volatility is the only parameter that isn't directly observable
and so needs an assumption. Looking at the actual option price in the market, we can back
solve to find the implied volatility. If we repeat this exercise on different days, the implied
volatility is likely to change, perhaps quite considerably in volatile markets.
Calculating the implied volatility for options with different strike prices or different terms to
maturity, but on the same underlying, is likely to give different figures. This tells us that
traders are not happy with the geometric Brownian motion assumption underlying Black-
Scholes theory and so make adjustments to the volatility input, to allow for the non-
normality of log returns.
If we can't find a set of parameters that will reproduce simultaneously the various option
prices observed in the market on the same underlying, then either there are arbitrage op-
portunities present or it indicates that traders are using a different model for option pricing.
QUESTION 8
Part (i): Theory
Part (ii): Theory
Part (iii): 𝑑𝑓 𝑡, 𝑋𝑡 = 2𝑓 𝑡, 𝑋𝑡 {𝑡𝑌𝑡 𝑑𝐵𝑡 + 𝑋𝑡 + 𝑡𝐴𝑡 + 𝑡 2 𝑌𝑡2 𝑑𝑡}

QUESTION 9
Part (i): d log St = 0.275dt + 0.5dBt
Part (ii): E[S2] = 215.88p; var[S2] = (173.87p)2
Sub-part (a): dUt = 0.5e0.4tdBt
Sub-part (b): E[R2] = £0.44; var[R2] = (0.50p)2
QUESTION 10
Part (i): The continuous-time lognormal model of security prices states that, for u > t, log returns are
given by:
log (Su) – log(St) ~ N [µ (u – t), σ2 (u – t)]
Where µ is the drift of the log price, and σ is the volatility.
Part (ii):
Sub-part (a): 𝑓 𝑡, 𝑊𝑡2 = 𝑊𝑡2 − 𝑡
Sub-part (b): The process has zero drift
Part (iii): For min (s, t), we need α = 0 and β = 1;
For min (t, s), we need α = 1 and β = -1
QUESTION 11
Part (i): P (Z1> 0, Z2< 0) = 0.125
Part (ii): Geometric Brownian motion may be defined in terms of a general Brownian motion Wt:
𝑆𝑡 = 𝑒 𝑊𝑡 ; where Wt = W0 + µt + σZt
Part (iii): Standard Brownian motion can (and will) go negative, whereas stock prices can't. The ex-
ponential nature of geometric Brownian motion prevents negative values.
Standard Brownian motion has zero drift, whereas geometric Brownian motion drifts up-
wards (for positive values of µ).
This exponential nature of geometric Brownian motion also causes larger movements to be
more likely for bigger values of the process. However, with standard Brownian motion, a
daily movement of 100 is just as likely regardless of whether the current value is 1 or 1,000.

QUESTION 12
Part (i):
Sub-part (a): The conventional continuous-time lognormal model of security prices assumes that
log prices form a random walk. If St denotes the market price of an investment, then
the model states that, for u > t, log returns are given by:
log (Su) – log(St) ~ N [µ (u – t), σ2 (u – t)]
Where µ the drift, and σ the volatility, are parameters specific to the investment
considered.
Sub-part (b): E [Su] = St exp (µ (u – t) + ½ σ2 (u – t))
var [Su] = (St)2 exp (2µ (u – t) + σ2 (u – t)) [exp (σ2 (u – t)) – 1]
Part (ii): µ = 0.2684; σ2 = 0.2633
QUESTION 13
𝜕𝑓 𝑡,𝑋𝑡 𝜕𝑓 𝑡,𝑋𝑡 1 𝜕 2 𝑓 𝑡,𝑋𝑡 𝜕𝑓 𝑡,𝑋𝑡
Part (i): 𝑑𝑓 𝑡, 𝑋𝑡 = + 𝜇𝑡 + 𝜍𝑡2 𝑑𝑡 + 𝜍𝑡 𝑑𝑊𝑡
𝜕𝑡 𝜕𝑋𝑡 2 𝜕 𝑋𝑡2 𝜕𝑋𝑡
𝑡
Part (ii): 𝑋𝑡 = 𝑒 𝜆𝑡 𝑋0 + 𝜍 0
𝑒𝜆 𝑡−𝑠
𝑑𝑊𝑠
QUESTION 14
Part (i): St ~ lognormal (0.08t, 0.04t)
Part (ii): A = €11,972
QUESTION 15
The key arguments against modelling market returns using a Gaussian random walk include the following:
 Market crashes appear more often than one would expect from a normal distribution (i.e. the real-
world distribution has 'fat tails').
 Whilst the random walk produces continuous price paths, jumps or discontinuities seem to be an
important feature of real markets.
 Days with very little change happen more often than the normal distribution suggests (ie the real-
world distribution is 'more peaked').
 The assumption of independent increments is contradicted by empirical evidence of mean rever-

sion and momentum effects.
 The assumption of constant volatility is contradicted by empirical evidence.
 It can be argued that expected returns on shares are likely to vary with bond yields, which contra-
dicts the assumption of a constant mean.
 Market returns are often (negatively) skewed.
QUESTION 16
Part (i): St ~ LogN [0.12875t, 0.0625t]
Part (ii): The investor would need to invest about £69,806
QUESTION 17
𝜇 −𝑟
Part (i): 𝜆=
𝜍
QUESTION 18
Part (i): Theory
Part (ii): The expected value of investment is approximately £12,182
Part (iii): P (S (5) < 10,000) = 0.8484
QUESTION 19
Part (i): E[X] = 1.2776; Var[X] = 0.4636
Part (ii): P (S (5) > L) = 0.544
Part (iii): The one-year 95% VaR is $59,448
Part (iv): Selling 51.045% of the stocks would be acceptable, which could generate $61,254 in cash.
Part (v): P (S (10) + B10> L10) = 0.326
Part (vi):
Sub-part (a): The investor has a slightly better than even chance of repaying the loan at time 5.
The deposit account offered by the bank has a lower rate of interest than that of the
loan. So, the investor would be better off using the cash generated by the sale of the
stocks to repay part of the loan (if this is allowable) rather than saving it with the
bank.

Sub-part (b): To improve the probability of repaying the loan the investor could seek investments
with higher potential returns.
This is likely to involve taking additional risk which may be unacceptable to the in-
vestor (or the bank).
QUESTION 20
Part (i): Investing £100 in stock A would have an expected value of £123.37 at time 3.
Investing £100 in stock B would have an expected value of £145.50 at time 3.
Part (ii): Investing £100 in stock A would have a standard deviation of £44.05 at time 3.
Investing £100 in stock B would have a standard deviation of £81.01 at time 3.
Part (iii): Investing £100 in the portfolio would have an expected value of £134.44 at time 3.
Part (iv): Investing £100 in the portfolio would have a standard deviation of £51.59 at time 3.
Part (v): The expected return on the portfolio is the average of (and so halfway between) the ex-
pected returns of the two stocks.
However, the standard deviation of the portfolio is significantly less than the average stan-
dard deviation of the two stocks.
This occurs because the performances of the stocks are not perfectly correlated.
The portfolio shows the benefits of diversification.
QUESTION 21
Theory
QUESTION 22
1 2 2𝑡 2𝑡
Part (i): 𝐸 𝑆𝑡 = 𝑆0 𝑒 𝜇𝑡 + 2𝜍 𝑡 ; 𝑉𝑎𝑟 𝑆𝑡 = 𝑆02 𝑒 2𝜇𝑡 + 𝜍 𝑒𝜍 −1
Part (ii): µ = 0.18201; σ2 = 0.11194
Part (iii): P (2,000 < S5< 2,500) = 0.1174
QUESTION 23
Part (i): Theory
𝜕𝑓 𝜕𝑓 𝜕𝑓 1 𝜕2𝑓
Part (ii): 𝑑𝑓 𝑡, 𝑋𝑡 = 𝑑 𝑋 𝑌𝑡 𝑑𝐵𝑡 + 𝜕𝑡
+ 𝑑𝑋 𝐴𝑡 + 2 𝜕 𝑋 2 𝑌𝑡2 𝑑𝑡
𝑡 𝑡 𝑡
Part (iii):
𝑑𝑓 𝑡, 𝑋𝑡 = 4𝑡 2 exp 4𝑡 2 𝑋𝑡 𝑌𝑡 𝑑𝐵𝑡 + 8𝑡𝑋𝑡 exp 4𝑡 2 𝑋𝑡 + 4𝑡 2 exp 4𝑡 2 𝑋𝑡 𝐴𝑡 + 8𝑡 4 exp 4𝑡 2 𝑋𝑡 𝑌𝑡2 𝑑𝑡

SECTION 5
QUESTION 1
Proof
QUESTION 2
Part (i):
Sub-part (a): Proof
Sub-part (b): The tree of stock prices at time 0, 6 months and 1 year looks like this:
Part (ii): V0 (standard) = 15.71
Part (iii): V0 (special) = 8.74
QUESTION 3
Part (i): ∆ - (delta) is the sensitivity of the price of the derivative to small changes in the price of the
underlying asset.
Γ - (gamma) is the sensitivity of delta to small changes in the price of the underlying asset.
𝜈 - (vega) is the sensitivity of the price of the derivative to small changes in the assumed vo-
latility of the underlying asset.
Part (ii): Gamma
A delta-hedged portfolio has an overall delta of zero, so its value is unaffected by small
changes in the price of the underlying asset. However, if the price of the underlying asset
does change, the portfolio delta will change and it may be necessary to rebalance the portfo-
lio to maintain a delta of zero.

Since gamma is the rate of change of delta, it provides a measure of the extent to which re-
balancing will be required if the price of the underlying does change. Ideally, gamma should
have a value close to zero, ie the portfolio should be 'gamma-neutral'.
Vega
The future volatility of the underlying asset cannot be observed directly, but this parameter
has a significant effect on the value of many derivatives, such as options.
If an inappropriate value has been assumed for the volatility this can lead to inaccurate es-
timates of the values of the derivatives.
Since vega is the sensitivity to changes in the assumed volatility, it provides a measure of
the risk of mispricing. Monitoring the value of vega provides a means of controlling this risk.
Ideally, vega should have a value close to zero, i.e. the portfolio should be 'vega-neutral’.
QUESTION 4
Proof
QUESTION 5
Part (i):
Sub-part (a): d < er< u = 0.8 < 1.0618 < 1.2
Sub-part (b):
Part (ii): V0 = 16.72

Part (iii):
Sub-part (a): Same as for the standard call option, i.e. 16.72
Sub-part (b): The two prices we have calculated using the stated binomial model are the same.

In practice, we would expect the special option to be worth less than the standard
option because the presence of a 'barrier’ restricts when the special option can be
exercised, compared with the standard option.
In order to reflect the impact of the 'barrier', we would need much more granularity
in our binomial tree, i.e. many more time steps.
QUESTION 6
𝑢𝛽 −𝑑𝛼 𝛼−𝛽
Part (i): 𝑥 = 𝑒 −𝑟 𝑢 −𝑑
; 𝑦 = 𝑢−𝑑
𝑒 𝑟 𝑦+𝑥 −𝛽
Part (ii): 𝑞= (𝛼−𝛽 )
Part (iii):
Sub-part (a): The value of the call option is 11.11
The value of the put option is 11.11
Sub-part (b): Put-call parity holds.
QUESTION 7
Part (a): Five factors that affect the price
1. the price of the underlying
2. the strike price
3. the volatility of the underlying
4. the risk-free force of interest
5. time elapsed/ time to expiry.
Part (b): Effect of a change in each factor on the put option premium
1. An increase in the price of the underlying will reduce the put option premium
2. An increase in the strike price will increase the put option premium
3. An increase in the volatility will increase the put option premium
4. An increase in the risk-free force of interest will reduce the put option premium
5. An increase in the time elapsed (a reduction in the time left to expiry) will usually re-
duce the put option premium.

QUESTION 8
Part (i): Covered in Booklet 4
Part (ii): Covered in Booklet 1
Part (iii): Net cost = £67,032
QUESTION 9
1
𝐹0 = 𝑒 𝑥 +𝑟 𝑇
{𝑆0 − 𝑦𝑒 − 2(𝑥+𝑟) }
QUESTION 10
Part (i): State price deflators for the three nodes at the maturity date are:
Top node: 0.7420; Middle node: 0.8999; Bottom node = 3.0042
Part (ii): Option price = 2.78
Part (iii): Although we used real-world probabilities in the calculation of the option price, these cancel
out when we multiply the SPD by the real-world probabilities in the calculation of the ex-
pectation.
The final answer depends only on the risk-neutral probabilities. So, if we changed the as-
sumption about the real-world probabilities, the answer for the option price would not
change.
QUESTION 11
Part (i): r must lie strictly between 15% and 40%
Part (ii): V0 = 15,984p
QUESTION 12
Part (i): Lower bound for c is zero; Upper bound for c is S0 = $28
Part (ii): Price of the call option is $1.00
QUESTION 13
The derivative value is 8.05 pence
QUESTION 14
Part (i): V0 = £2.49

Part (ii):
Sub-part (a): V0 = £2.47
Sub-part (b): pt = £2.47
Part (iii): It would be optimal to exercise an American put option early in this case.
QUESTION 15
Part (i): Puu = 219.605 – 2.14976Pud – 1.15537Pdd
Part (ii): 0 <Puu< 219.605
Part (iii):
Sub-part (a): The option is worth approximately 105p
Sub-part (b): The option is worthless
QUESTION 16
Part (i): V0 = 29.143

Part (ii):
Sub-part (a): Auu = 0.71793; Aud = 1.07102; Adu = 1.08017; Add = 1.75146
Sub-part (b): V0 = 29.143
Sub-part (c): The two answers in parts (i) and (ii)(b) are the same. This is to be expected as state
price deflators are just an alternative way of presenting the same model.
Part (iii):
Sub-part (a): Auuhas the real-world up-probabilities in its denominator, so a decrease in the up-
probabilities will cause an increase in Auu
Add has the real-world down-probabilities in its denominator, so a decrease in the up-
probability will cause an increase in the down-probability and so a decrease in Add·
The SPDs values associated with the middle final node involve both the up and down
probabilities in the denominator and so the effect will be much smaller than for the
above two cases.
Sub-part (b): There won't be any impact on the option price, since this is independent of the real-
world probabilities.

QUESTION 17
Part (i): F = S0e(r – q)T
Part (ii): The portfolio is risk-free and therefore, by principle of no arbitrage, must earn the risk-free
rate.
QUESTION 18
The value of a call option increases with time to expiry, all else being equal, so:
 A is more valuable than B
 D is more valuable than E (unless there are very high dividends).
The value of a call option increases with decreasing strike price, all else being equal, so:
 A is more valuable than C.
American options are at least as valuable as their European equivalent, so:
 A is at least as valuable as D
 B is at least as valuable as E.
So, A is the most valuable, B is at least as valuable as E and it is impossible to rank the other pairings
(although D is probably more valuable than E).
QUESTION 19
Part (i): 𝑐0 + 𝐾𝑒 −𝑟𝑇 = 𝑝0 + 𝑆0
This is the put-call parity relationship for a stock paying no dividends.
Part (ii): The implied volatility must be 30% pa to the nearest 1%.
Part (iii):

Part (iv):
Sub-part (a): Upper bound = S1 – 120; Lower bound = S1 – 121
Sub-part (b): 17.71 ≤ p0 ≤18.69
Part (v): p0 = 18.35
QUESTION 20
The price of the American put option is $7.77
QUESTION 21
Part (i): F0 = S0erT
Part (ii): F0 = 436.79
Part (iii): The dividend yield has been taken into account when determining the arbitrage-free ‘fair'
forward price in part (ii). So, assuming this forward price is used, there can be no arbitrage
opportunity.
In practice, the dividend yield won't be known in advance and so this would lead to addi-
tional uncertainty when trying to set up any arbitrage opportunity.
QUESTION 22
Part (i): 𝑐0 + 𝐾𝑒 −𝑟𝑇 = 𝑝0 + 𝑆0
This is the put-call parity relationship for a stock paying no dividends.
Part (ii): S0 = $12.80
QUESTION 23
𝝏𝒇 𝝏𝟐 𝒇 𝝏𝒇
Part (i): 𝐷𝑒𝑙𝑡𝑎 ∆ = 𝝏𝑺
; 𝐺𝑎𝑚𝑚𝑎 Γ = 𝝏𝑺𝟐
; 𝑉𝑒𝑔𝑎 𝜈 = 𝝏𝝈
QUESTION 24
Part (i): Proof
Part (ii): K = 5.64 approx
Part (iii): V1 = 0.85
QUESTION 25
Part (i): Upper bound for c0 is S0 = $10

QUESTION 26
Part (ii): Proof
QUESTION 27
Part (i): Proof
Part (ii): The fair price of the forward contract is €20.40
Part (iii): 𝑉𝑡 = 𝑆𝑡 − 20.40 ∗ 𝑒 −𝑟 (2−𝑡)
Part (iv): The value of the forward contract to the investor is €0.40 at time 1.
Part (v): 𝐷𝑒𝑙𝑡𝑎 ∆1 = 𝟏; 𝑇𝑕𝑒𝑡𝑎 Θ1 = −𝟎. 𝟕𝟖𝟒; 𝑉𝑒𝑔𝑎 𝜈1 = 𝟎; because the forward contract does not
depend explicitly on the volatility of the underlying share.
QUESTION 28
Part (i):
Sub-part (a): In case of the binomial model, the no-arbitrage is met if and only if the inequality
holds: d <𝑒 𝑟Δ𝑡 < u;
Where d and u are the down-step and up-step growth factors respectively, r is the
continuously compounded risk-free rate of interest and Δ𝑡 is the size of the time
step.
Sub-part (b): The no-arbitrage condition holds since 0.95 < 1.0408 < 1.1
Part (ii): Price of European call option = 10.52
Part (iii): c = 18.09
QUESTION 29
Part (i): Lower bound for put option must be:
𝑝𝑡 ≥ max {𝐾𝑒 −𝑟(𝑇−𝑡) − 𝑆𝑡 , 0}
Part (ii): Option (b) should have a higher price than Option (a) because it is written on an underlying
with a higher level of volatility.
Option (d) should have a higher price than Option (c) because the higher strike price means
that it will never have a lower payoff than Option (c) at expiry.
Option (e) should have a higher price than Option (d) because American options can be ex-
ercised at any time, whereas European options can only be exercised at expiry. Therefore,
American put options are always more valuable than their European equivalents because of
this additional flexibility.
The theoretical lower bound is not met.
The put-call parity relationship does not hold in this case.
QUESTION 30
Part (i): In case of the binomial model, the no-arbitrage is met if and only if the inequality holds: d
<𝑒 𝑟Δ𝑡 < u;
Where d and u are the down-step and up-step growth factors respectively, r is the conti-
nuously compounded risk-free rate of interest and Δ𝑡 is the size of the time step.
This can be verified since we know that 0.95 < 1.0042 < 1.11
Part (ii): Price of European call option = 2.62
Part (iii): c0 = 2.00
Part (iv): Down-and-out call option has a value of 2.62
QUESTION 31
Part (i): Let ft be the derivative price at time t and let St be the price of the underlying risky asset.
𝜕𝑓𝑡
Sub-part (a): ∆= 𝜕𝑆𝑡
𝜕𝑓𝑡
Sub-part (b): 𝜈= 𝜕𝜍
;where σ is the volatility parameter of the underlying asset.
𝜕𝑓𝑡
Sub-part (c): 𝜃= 𝜕𝑡
;where t is the current time
𝜕 2 𝑓𝑡
Sub-part (d): Γ=
𝜕 𝑆𝑡2
Part (ii): Value of call option at time 1, c1 = 2.99 approx

Part (iii): All else being equal, an increase in the underlying asset price increases the chance of the as-
set price being above the strike price at expiry and also increases the extent to which it
might be above the strike price at expiry. Consequently, the value of the call option, which
provides its holder with the option of being able to buy the asset at the fixed strike price at
expiry. increases.
For a put option, a fall in the asset price likewise increases the value of having the option to
be able to sell the underlying asset at a fixed strike price at expiry.
Part (iv): The higher the volatility of the underlying asset, the greater the chance that its price can
move significantly in favour of the holder of the option by expiry, i.e. upwards above the
strike price for a call or downwards below the strike price for a put.
Although there is also a greater chance of the asset price ending up significantly out-of-the-
money, it doesn't matter how far out-of-the-money it goes, as the holder can simply let the
option expire worthless.
So, the value of an option will increase with the volatility of the underlying share.
QUESTION 32
Part (i): Price of the European put option at time 0 is p0 = 12.82
Part (ii): Probability = 0.4433
Part (iii): Risk-neutral probabilities are, by definition, the probabilities under which the expected rate
of return on the underlying risky share is equal to the risk-free force of interest.
Conversely, under the real-world probability measure, the expected rate of return on the
underlying risky share is equal to the risk-free force of interest, plus a suitable risk premium
to compensate the investor for the additional risk associated with investing in the share.
Consequently, in a binomial tree model, using the real-world probability measure would as-
sign a higher probability to an up-step than under the risk- neutral measure.
So, the real-world measure would result in higher probabilities for outcomes with a higher
share price and hence a higher probability of this put option expiring out-of-the-money.
QUESTION 33
Part (i):
Sub-part (a): This will reduce the price of the option
Sub-part (b): This will reduce the price of the option
Sub-part (c): This will increase the price of the option
Sub-part (d): This will reduce the price of the option

Part (ii):
Sub-part (a): All else being equal, a fall in the price of the underlying security will lessen the
chance of the option being in-the-money at maturity (i.e. that ST>K), and hence the
chance of making a profit, and also the possible extent of any profit.
Sub-part (b): All else being equal, an increase in the strike price of the option will again lessen the
chance of the option being in-the-money at maturity (i.e. that ST>K), and hence the
chance of making a profit, and also the possible extent of any profit.
Sub-part (c): All else being equal, an increase in the volatility will increase both the chance of the
option price moving above the strike price prior to expiry and also the possible ex-
tent to which it will do so. Although it will also increase the chance the option price
will fall below the strike price, it doesn't matter how far below it goes as the holder
can simply let it expire worthless.
Sub-part (d): A fall in the risk-free rate of interest will reduce the value of the option because the
money saved by purchasing the (cheaper) option, rather than the share itself, can
only be invested at a lower rate of interest.
Part (iii): 𝑐𝑡 + 𝐾𝑒 −𝑟(𝑇−𝑡) = 𝑝𝑡 + 𝑆𝑡
Part (iv): The risk-free rate is 2.9% pa
Part (v): In the case of a share that pays no dividends, as is the case here, it is never optimal to exer-
cise an American call option prior to expiry. Hence, the option to do so is worthless and the
American call option has the same value as the corresponding European call option.
Conversely, it can sometimes be optimal to exercise an American put option prior to expiry.
For example, if the option is very in-the-money and hence the time value is negative, so that
the intrinsic value obtained if exercised exceeds the total value of the option.
Consequently, in such a scenario, an American put option would be worth more than the
corresponding European put option.
QUESTION 34
Part (i): Proof
Part (ii):
Sub-part (a): You could borrow $100 cash and use this to buy exactly one share. In three months'
time, you could then sell the share and use the proceeds to repay the $100 cash plus
the interest accumulated over the three months at the risk-free force of interest.

Sub-part (b): If the share price rose to $125, the profit from this strategy would be 23.74
If the share price rose to $105, the profit from this strategy would be 3.74
Part (iii): Price of the put option is pt = $14.18
QUESTION 35
Part (i): Forward price, F = 12.21
Part (ii): The price of the call option is approximately £0.96
Part (iii): With no premium to at the outset, the final loss is £0.21
Part (iv): With an initial premium of £0.96, the accumulated loss is £1.17, where the accumulation is
taken to be at the risk-free rate.
Part (v): In order to acquire the call option Mr Jones needed to pay an initial premium. Since the op-
tion expires worthless then a loss is inevitable, having paid to receive zero.
However, this loss is never greater than £1.17.
Part (vi): S4< 11.04; where S4 is the stock price at time 4.
QUESTION 36
Part (i): In general, a market is arbitrage-free if and only if there exists a probability measure under
which discounted asset prices are martingales.
In this binomial case such a condition holds if: 1-d% <er<1+u%
Here the risk-free rate of interest r is expressed per period. Note that the parameters u and
d have been defined differently in this question.
Part (ii): Price of the European put option at time 0 is p0 = 11.23
Part (iii): The new market conditions would mean that the up-step increase of 5% equals the risk-free
rate, and the condition in part (i) would not be met since er = 1.05
This would allow for arbitrage opportunities to arise.
QUESTION 37
Part (i): Proof
Part (ii): The price of Option B is $1.25
Part (iii): $2.41 ≤ C ≤ $7.41
Part (iv): $5 ≤ D ≤ $10

QUESTION 38
Part (i): Price of the European call option at time 0 is c0 = 12.87
Part (ii): Value of the European put option is p0 = 7.05
Part (iii): The put-call relationship says that the portfolio is worth -5.82
This relationship does not depend on the volatility of the share price, or of the method used
to model it. Therefore, the portfolio value would not change even if the stock price fall was
30% rather than 20%.
QUESTION 39
Part (i): Proof
Part (ii): Fair price, K = £15.41
Part (iii): Value of forward contract at time 1, V1 = -£2.62
Part (iv): The forward price should not be affected directly by the payment of the unexpected divi-
dend since the forward price reflects the current share price, future expected dividends, the
risk-free force of interest and time to maturity.
However, the unexpected dividend might still have an indirect impact on the current share
price:
 either negatively because money (that could have been reinvested in the business) has
been transferred out of the business, or
 positively because it suggests confidence in the business.
QUESTION 40
Part (i): As the share price St increases, the intrinsic value, max(K – St, 0), falls and the put option
price falls.
For an option with a higher strike price K, the intrinsic value, max(K – St, 0), increases and
the put option price rises.
As the volatility σ increases, the share price is more likely to move in a favourable direction
and the put option price increases.
As the time to expiry T – t increases, there is more chance for the share price to move in a
favourable direction and the put option price increases.

As the dividend yield q increases, a shareholder derives value from being able to defer the
sale by holding a put option, whilst meanwhile benefiting from the increased dividends. This
increases the put option price.
As the force of interest r increases, a shareholder derives value from selling the share now
(and investing the proceeds at the higher interest rate) rather than holding a put option to
sell the share at a later date. This decreases the put option price.
Part (ii): New call option price can be approximated as $15.87
Part (iii): Gamma measures the sensitivity of delta to changes in the share price. Since delta changes
over time (as the underlying share price changes), then, in order to remain delta-hedged, a
portfolio will require rebalancing. Rebalancing takes time and results in dealing costs.
A low value of gamma means that the delta is not particularly sensitive to changes in the
share price and hence that the portfolio will require less rebalancing than if gamma was
high.
QUESTION 41
Part (i):
Sub-part (a): An increase in the share price will decrease the price of the option.
Sub-part (b): An increase in the strike price will increase the price of the option.
Sub-part (c): A decrease in the time to expiry will decrease the price of the option.
Sub-part (d): A decrease in the dividend yield will decrease the price of the option.
Sub-part (e): A reduction in the risk free rate will increase the price of the option.
Sub-part (f): An increase in the volatility will increase the price of the option.
Part (ii): A decrease in time to expiry will reduce the price of both options because the 'optionality’
becomes less valuable as the final outcome becomes more certain.
An increase in volatility will increase the price of both options because the ‘optionality' be-
comes more valuable as the final outcome becomes less certain.
QUESTION 42
Part (i): Risk- neutral price, c0 = $12.69

QUESTION 43
Part (i): Core reading
Part (ii): Core reading
Part (iii): pt ≤ £98.02
Part (iv): The value of the put option will be maximised if the underlying asset is worthless at expiry.
This will happen if it is worthless now and has zero volatility. The option will approach the
bound if the share price is expected to fall towards zero during the life of the contract.

SECTION 6
QUESTION 1
Part (i): The implied volatility is 20%
Part (ii):
Sub-part (a): Payoff (new derivative) = D = 100 x min [max (ST – 320p, 0), 1p]
Payoff (combination) = 100 max (ST – 320p, 0) – 100 max (ST – 321p, 0)
Sub-part (b): Fair price of the special derivative is 69p
Part (iii): Probability = 70.8%
QUESTION 2
Part (i): Theorem
Part (iii):
Sub-part (a): c = 0875
Sub-part (b): r = 0.045
QUESTION 3
Part (i): Let X denote the payoff at time T from a derivative security. Then the value at an earlier
time t is given by:
𝑉𝑡 = 𝑒 −𝑟 (𝑇−𝑡) 𝐸𝑄 𝑋 𝐹𝑡 ]
In this formula:
 r is the continuously-compounded risk-free rate of interest
 Q represents the risk-neutral probability measure
 Ft represents the past history of the process underlying the derivative
Part (ii): r = 14.51%
Part (iii): Fair price of the new derivative security, V0 = £36.40
Part (iv): The initial hedging portfolio is:
 13.237 units of stock
 A loan of £36.40

QUESTION 4
Theory
QUESTION 5
Part (i): 𝑉𝑡 = 𝑒 −𝑟 (𝑇−𝑡) 𝐸𝑄 𝐷 𝐹𝑡 ]
In this formula:
 Vt is the fair price of the derivative at time t
 T – t is the time to maturity of the derivative
 D is the payoff on the derivative at time T
 Ft represents the past history (or filtration) of the process underlying the derivative up
to and including time t
Part (ii):
Sub-part (a): The implied volatility is 20%
Sub-part (b): For 1,000 options on the share, the hedging portfolio will consist of 559.62 shares
and -£56,354 in cash
Sub-part (c): Vega = 46.773
Part (iii): Price of a put option, pt = 5.03
Part (iv): The hedging portfolio consists of 0.915 shares, -£104.50 in cash and 1.186 put options
QUESTION 6
Part (i):
Sub-part (a): If the option is not exercised at time 1, it will become a European cash-or- nothing
put option with a strike price of $2. The fixed cash payoff is $1,000 and, at time t, the
option will have a remaining life of 2 – t. So, we can use a pricing formula for this
type of option, e.g. one based on the Black-Scholes model, to calculate the price dur-
ing this time range.
𝑆
ln 𝑡 −0.025 (2−𝑡)
Sub-part (b): 𝑝𝑡 = 1,000𝑒 −0.02 2−𝑡
Φ −𝑑2 ; 𝑤𝑕𝑒𝑟𝑒 𝑑2 = 2
0.3 2−𝑡

Part (ii): If the share price at time 1 is less than or equal to $2, the option will not be exercised at that
time. So its value will just be equal to p1+
But if the share price at time 1 is above $2, we can choose whether or not to exercise at this
time. If we do exercise, we will get $500; if we don't, the value will equal p 1+. Since we will
choose to do whichever of these gives the higher value, the value in this case will be
max(p1+,500).
So, the value at time 1 is:
max 𝑝1+, 500 𝑖𝑓 𝑆1 > $2
𝑝1 =
𝑝1+ 𝑖𝑓 𝑆1 ≤ $2
Part (iii):
Sub-part (a): The option holder will choose to exercise the option if S 1>2 and also if the $500 ob-
tained from exercising is greater than p 1+ (the value if the holder doesn't exercise).
Since, when there is a movement in the share price, the price of a put option moves
in the opposite direction, this is equivalent to S1> constant for some constant.
So, putting these two conditions together, we see that the holder will choose to exer-
cise if S1>k for some fixed value k.
Sub-part (b): k = 2.035
QUESTION 7
Part (i): Common strike price is 306 pence
Part (ii): The implied volatility is approximately 10%
Part (iii): The hedging portfolio consists of 2,600 shares and a short cash position of £7,200
QUESTION 8
Theory
QUESTION 9
Part (i): The bonus is £50,000 for each penny by which the share price exceeds 100p in one year's
time. This can be written as:
£50,000 x max(S1 -100,0)
where S1 is the share price in pence at time 1.

Since £50,000 equals 5 million pence, this is the same as the payoff from 5 million one-year
European call options on the share, with an exercise price of 100p
Part (ii): The hedging portfolio is 1,650,250 shares and a short holding (i.e. borrowing) of £1,325,200
in cash
Part (iii):
Sub-part (a): a = 5,000,000; b = 3,333,333
Sub-part (b): The amount saved is £16,441
QUESTION 10
Part (i): The payoff is equal to 100 times the value of the function I a (St), so the value of the security
is given by:
𝐷0 𝑎 = 𝑒 −𝑟𝑇 𝐸𝑄 [100 𝐼𝑎 𝑆𝑇 |𝑆0 ]
In this formula:
 X is the payoff on the derivative at time T
 Ft represents the past history (or filtration) of the process underlying the derivative up
to and including time t
1 ∞
Part (ii): Price at time 0 of this call option is 𝐶0 𝐾 = 𝐷0 (𝑎) 𝑑𝑎
100 𝐾
Part (iii): 𝐷0 𝐾 = 100𝑒 −𝑟𝑇 Φ(𝑑2 )
Part (iv): Price = 36.444
QUESTION 11
Part (i): Implied volatility = 15.9%
1
Part (ii): Stock price in three months’ time is 𝑆0.25 = 120 exp⁡
[ 𝜇 − 2 ∗ 0.162 0.25 + 0.16 ∗ 𝑍0.25 ]
1 5
Stock price in six months’ time is 𝑆0.5 = 120 exp 2
µ − 8 0.162 + 0.16(2𝑍0.5 − 𝑍0.25 )
Part (iii): The put option price is 8.393c

QUESTION 12
Part (i): (at, bt, ct) are previsible if they are known based upon information up to but not including
time t. In other words, if they are Ft- - measurable
Part (ii): 𝑑𝑉 𝑡 = 𝑎𝑡 𝑑𝐴𝑡 + 𝑑𝑎𝑡 𝐴𝑡 + 𝑑𝑎𝑡 𝑑𝐴𝑡 + 𝑏𝑡 𝑑𝐵𝑡 + 𝑑𝑏𝑡 𝐵𝑡 + 𝑑𝑏𝑡 𝑑𝐵𝑡 + 𝑐𝑡 𝑑𝐶𝑡 + 𝑑𝑐𝑡 𝐶𝑡 + 𝑑𝑐𝑡 𝑑𝐶𝑡
Part (iii): The portfolio strategy is described as self-financing if the instantaneous change in the value
of the portfolio is equal to the pure investment gain, i.e.:
𝑑𝑉 𝑡 = 𝑎𝑡 𝑑𝐴𝑡 + 𝑏𝑡 𝑑𝐵𝑡 + 𝑐𝑡 𝑑𝐶𝑡
Consequently, 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)
Part (iv): A replicating strategy is a self-financing strategy (at, bt, ct), defined for 0 ≤ t < U, such that:
V (U) = 𝑎𝑈 𝐴𝑈 + 𝑏𝑈 𝐵𝑈 + 𝑐𝑈 𝐶𝑈 = X
Part (v): Suppose a self-financing strategy can be found that replicates the payoff at maturity of the
derivative. Then the investor could buy this portfolio and rebalance it without cost all the
way through to the maturity date of the derivative. Alternatively, they could simply buy the
derivative and hold it until maturity, which also constitutes a self-financing strategy.
Either way, they receive the same payoff at maturity without having to spend any money af-
ter the initial purchase. Consequently, if markets are arbitrage- free, the current value of the
self-financing strategy portfolio must equal the current price of the derivative.
Part (vi): The market is complete if for any contingent claim X there is a replicating strategy (a t, bt, ct).
QUESTION 13
Part (i): 𝑄 𝑀𝑎𝑥𝑡<1 𝑆𝑡 < 2 = 𝟎. 𝟗𝟗𝟒𝟓𝟐
Part (ii):
Sub-part (a): The price of the option at time 1 is equal to:

𝑒 −𝑟 𝐸𝑄 [100max⁡
(𝑆2 /𝑆1 − 1,0| 𝑆1 ] 𝑖𝑓 𝑚𝑎𝑥𝑡<1 𝑆𝑡 ≤ 2
𝑉1 =
0 𝑜𝑡𝑕𝑒𝑟𝑤𝑖𝑠𝑒
Sub-part (b): Proof
Sub-part (c): Value of the option at time 0, V0 = 10.952

QUESTION 14
Part (i): Δ𝑐 = 𝟎. 𝟏𝟖𝟔𝟕𝟑
Part (ii): Implied volatility is 22% pa
Part (iii): Price of a one-year put, p0 = 31.45
Part (iv): The investor must have a short position in 100,000 put options.
The investor has a short-holding of 100,000 units of stock
QUESTION 15
Part (i): The function g must satisfy:

𝜕𝑔 𝜕𝑔 1 𝜕2𝑔
𝜕𝑡
+ 𝑟 − 𝑞 𝑆𝑡 𝜕𝑆 + 2 𝜍 2 𝑆𝑡2 𝜕 𝑆 2 = 𝑟𝑔
𝑡 𝑡
Where: r is the continuously compounded risk-free rate
q is the continuously compounded dividend rate
σ is the assumed volatility of the stock price over the period 0 to T
The boundary condition applies at maturity and is DT = g (T, ST) = f(ST)
Part (ii): µ = (r – q)n – r + ½ σ2 n(n – 1)
QUESTION 16
Part (i): Probability density function is:

1 −𝑦+𝜇𝑡 −𝑦 −𝜇𝑡 −𝑦 −𝜇𝑡
𝑓 𝑦 = 𝜙 + 𝑒 2𝜇𝑦 𝜙 − 2µ 𝑒 2µ𝑦 Φ
𝑡 𝑡 𝑡 𝑡
Part (ii): The fair price is given by:
𝑉𝑡 = 𝑒 −𝑟(𝑇−𝑡) 𝐸𝑄 [𝐷𝑇 |𝐹𝑡 ]
Where: r is the continuously compounded risk-free rate
Q denotes the risk-neutral probability measure
Ft is the filtration associated with the process S
Part (iii): Fair price of the derivative, V0 = 2.70

QUESTION 17
Part (i): The delta of an option price (f) is the first partial derivative of the option price with respect
to the underlying stock price (S), all else being equal, i.e.
𝝏𝒇
∆=
𝝏𝑺
Part (ii): The implied volatility must be σ = 20%

Part (iii): If 𝑆𝜏 ≥ 𝐾1 , then the choice at time 𝜏 is to receive $100 immediately or to wait and receive ei-
ther an amount c or zero later.
If c ≤ $100, then there is no benefit in not exercising and so the option should always be ex-
ercised at time 𝜏 in this situation.
Part (iv): The option value just after time 𝜏 is given by:
𝑉𝜏+ = 𝑐𝑒 −𝑟(𝑇−𝜏) 𝑄[𝑆𝑇 /𝑆𝜏 ≥ 𝐾2 |𝐹𝜏 ]

Where Q[A] denotes the risk-neutral probability of Event A happening and 𝐹𝜏 is the filtration
at time 𝜏 with respect to the share price.
Part (v): In a Black-Scholes model, 𝑆𝑇 /𝑆𝜏 |𝐹𝜏 under Q is given by:
1
𝑟− 𝜍 2 𝑇−𝜏 + 𝜍 (𝑊𝑇 − 𝑊𝜏 )
𝑆𝑇 /𝑆𝜏 |𝐹𝜏 = 𝑒 2 (1)
Where 𝑊𝑡 is a standard Brownian motion under Q.

Since Brownian motion has independent increments, the expression in (1) and hence 𝑉𝜏+
does not depend on 𝑆𝜏 .
Part (vi): Fair price of exotic option, V0 = $130.24
QUESTION 18
Part (i):
Sub-part (a): ∆𝑝 = −Φ −𝑑1 = Φ 𝑑1 − 1
Sub-part (b): ∆𝑝 = −𝟎. 𝟐𝟒𝟖𝟑
Part (ii): Implied volatility is 7.1% pa

Part (iii):
Sub-part (a): Price of the put option is 7p
Sub-part (b): Ψ = £𝟏𝟔𝟓, 𝟖𝟕𝟐
QUESTION 19
Part (ii): S0 = $12.80
Part (iii): The implied volatility to the nearest 1% is 26%
QUESTION 20
Part (ii): ∆𝑐 = Φ 0.845 = 𝟎. 𝟖𝟎𝟏
Part (iii): The portfolio contains 0.801 shares and a short position in cash of $30.15
Part (iv): The new option price is $18.49
QUESTION 21
Part (ii): The implied volatility is 16.1%
Part (iii): The portfolio contains 59 shares and a short position in cash of $440
QUESTION 22
Part (i): If 0 ≤ y ≤ 1, then Y ~ U(0, 1)
Part (ii): a = 0.09596; b = 0.3111
Part (iii): Fair price of derivative = 32.03
Part (iv): Fair price of derivative = 28.02
QUESTION 23
Part (i): The portfolio strategy is self-financing if the instantaneous change in the value of the portfo-
lio is equal to the pure investment gain, i.e.:
𝑑𝑉 𝑡 = 𝜙𝑡 𝑑𝑆𝑡 + Ψ𝑡 𝑑𝐵𝑡
That is to say, the change in the value of the portfolio between time t and t+ dt comes exclu-
sively from the changes in the stock and bond prices.

QUESTION 24
Part (i): The delta of a European call option on a non-dividend-paying stock is given by:
Δ𝑐𝑎𝑙𝑙 = Φ(𝑑1 )
1
(𝑆0 /𝐾) + 𝑟+ 𝜍 2 𝑇
ln ⁡
Where, 𝑑1 = 𝜍 𝑇
2
Part (ii): Implied volatility is 32%

𝑆1 𝑅1
Part (iii): 𝑉0 = 𝑒 −𝑟𝑇 × 𝑐 × 𝑄 𝑆0 < 𝑘𝑆 × 𝑄 𝑅0 < 𝑘𝑅
Where Q(A) denotes the risk-neutral probability of outcome A occurring.
𝑅1
Part (iv): 𝑉0 = 𝑒 −𝑟𝑇 × 𝑐 × 𝑄 𝑅0 < min⁡
{𝑘𝑆 , 𝑘𝑅 }
Part (v): The value of the option is approximately $1.61
QUESTION 25
𝜇 −𝑟
Part (i): 𝜆= 𝜍
Part (ii): P* must be the risk-neutral probability measure.
QUESTION 26
Part (i): Price of the call option, ct = 1.50
Part (ii): Implied volatility is 60%
QUESTION 27
Part (i): Suppose that Zt is a standard Brownian motion under P. Furthermore suppose that 𝛾𝑡 is a
previsible process. Then there exists a measure Q equivalent to P and where:
𝑡
𝑍𝑡 = 𝑍𝑡 + 𝛾 𝑑𝑠
0 𝑠
is a standard Brownian motion under Q.
Part (ii): The discounted value of a security price process (discounted at the risk-free rate) is a mar-
tingale under the risk-neutral measure.
Part (iii): Proof
Part (iv): λ = 0.1
Part (v): 𝛾 = 𝟎. 𝟔

QUESTION 28
Part (i): The price of a derivative at time t is given by:
𝑉𝑡 = 𝑒 −𝑟(𝑇−𝑡) 𝐸𝑄 [𝑋𝑇 |𝐹𝑡 ];
where:
 r is the risk-free force of interest
 T is the maturity date of the derivative
 Q is the risk-neutral probability measure
 XT is the derivative payoff at maturity
 Ft is the filtration at time t.
Part (ii): Price of the European call option = 4.66
Part (iii): It is never optimal to exercise an American call option on a non-dividend- paying share prior
to expiry.
Consequently, the option to do so has no value and so the American option has the same
value as an otherwise identical European call option, which in this case is £4.66.
Part (iv): Price if the option is a European put = 2.45
Part (v): If dividends were payable between now and the expiry date of the option, then this would
cause the value of the share to fall – in theory, each time by the amount of the dividend pay-
able.
Consequently, the value of the European call would decrease, as having the option to buy a
share which would be worth less, for a fixed price at the expiry date, would be less valuable.
Conversely, the value of the European put would increase, as having the option to sell a
share which would be worth less, for a fixed price at the expiry date would be more valua-
ble. The value of the American call would increase relative to the European call, i.e. it would
now be worth more than the European call. This is because the American option could po-
tentially be exercised early in order to obtain the dividends.
QUESTION 29
Part (i): The market is complete if for any contingent claim X there is a replicating strategy (𝜙𝑡 , Ψ𝑡 )
Part (ii): Proof
𝜇 −𝑟
Part (iii): In order for Dt to be a martingale under Q, 𝛾 = 𝜍

QUESTION 30
Part (i): Price of the call option is £11.42
𝜕 𝑐𝑡
Part (ii): The delta of a call option, ∆𝑐 , is defined by:∆𝑐 = 𝜕 𝑆𝑡
Where ct is the value of the call option and St is the value of the underlying at time t.
Part (iii): ∆𝑐 = 𝟎. 𝟖𝟔𝟐𝟏
Part (iv): ∆𝑝 = −𝟎. 𝟏𝟑𝟕𝟗
QUESTION 31
Part (i): Price of the call option is approximately £3.06
Part (ii): The probability of the option expiring in-the-money is 98.72%
Part (iii): The value of the option at time zero is 0.98
Part (iv): Theory
QUESTION 32
Part (i): 𝑑 𝑒 −𝑟𝑡 𝑉 𝑡 = Φ𝑡 𝑑 𝑒 −𝑟𝑡 S𝑡
Part (ii): The process is a martingale if µ = r
QUESTION 33
Part (i): Theory
Part (ii): Value of the put option is 1.01
Part (iii): A put option can be viewed as delaying the sale of the underlying share.
If interest rates were to rise then it would be preferable to sell the share immediately so as
to take advantage of the increased return. This reduces the demand for put options and so
𝜕𝑓
the price tends to decrease. This behaviour is confirmed by the Greek𝜌 = 𝜕𝑟 being negative
for put options.
QUESTION 34
Part (i): Theory
Part (ii): The price of the put option is approximately €2.03
Part (iii): The price of the call option is approximately €1.59

Part (iv): The price of the call option would be lower if there were dividends. The higher the dividend,
the stronger the preference to own the share now (and hence receive the dividends) rather
than hold a call option and obtain the share later. This reduces the demand for the call op-
tion and hence reduces its price.
The price of the put option would be higher if there were dividends. The higher the divi-
dend, the stronger the preference to defer the sale of the share (and hence receive the divi-
dends) by holding a put option rather than sell the share now. This increases the demand
for the option and hence the option price.

SECTION 7
QUESTION 1
Part (i): The bond price is: B (t, T) = E[exp(-X)], where X ~ N(m, s2)
Using the formula for the moment generating function (MGF) of a normal distribution, this
is:
 1 2  1 
B  t,T   E exp  X    M X  1  exp  m  1  s 2  1   exp  m  s 2 
 2   2 
Part (ii):
Sub-part (a): The main drawback of this model is that it allows the short rate of interest to take
negative values, which is not always realistic (although negative interest rates have
been seen in some countries in recent years).
Sub-part (b): The Cox-Ingersoll-Ross (CIR) model avoids this problem by incorporating the cur-
rent interest rate in the volatility term. The SDE for this model is:
𝑑𝑟 𝑡 = 𝑎 𝑏 − 𝑟 𝑡 𝑑𝑡 + 𝜍 𝑟(𝑡)𝑑𝑊𝑡
QUESTION 2
Theory
QUESTION 3
Theory
QUESTION 4
Part (i):
Sub-part (a): Theory
Sub-part (b): The outcome of a default may be that the contracted payment stream:
 is rescheduled
 is 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
 is totally wiped out.

Sub-part (c): Theory
Part (ii): Theory
Part (iii): For Bond A, λA = 0.23606; For Bond B, λB = 0.40293
Part (iv):
Sub-part (a): Hedging portfolio consists of:
 -£250 nominal of Bond A (selling 2 bonds)
 -£250 nominal of Bond B (selling 3 bonds)
 -1 unit of Security D (selling 1 unit)
 5 units of the risk-free zero-coupon bond (£500 nominal)
Sub-part (b): Price of the Security S must be £35.55
QUESTION 5
Part (i):
Sub-part (a): The value of the senior debt at maturity, S3 say, is given by:
𝐿1 𝑖𝑓 𝐹3 ≥ 𝐿1
𝑆3 = = min(𝐿1 , 𝐹3 )
𝐹3 𝑖𝑓 𝐹3 < 𝐿1
Sub-part (b): The value of the junior debt at maturity, J3 say, is given by:
𝐿2 𝑖𝑓 𝐹3 ≥ 𝐿1 + 𝐿2
𝐽3 = 𝐹3 − 𝐿1 𝑖𝑓 𝐿1 + 𝐿2 > 𝐹3 ≥ 𝐿1 = max⁡
[min 𝐿2 , 𝐹3 − 𝐿1 , 0]
0 𝑖𝑓 𝐿1 > 𝐹3
Part (ii): The value of the junior debt at time 0 is £66.25 per £100 nominal.
QUESTION 6
Part (i): The risk-neutral pricing formula is given by:

𝑇
𝐵 𝑡, 𝑇 = 𝐸𝑄 [exp(− 𝑟𝑢 𝑑𝑢) |𝐹𝑡 ]

𝑡
Where Ft represents the past history (or filtration) of the process underlying the short rate
up to and including time t.

The real-world pricing formula (using state-price deflators) is given by:

𝐴 𝑇 | 𝐹𝑡
𝐵 𝑡, 𝑇 = 𝐸𝑃 𝐴𝑡
Where At is the state-price deflator at time t.
Part (ii): The Vasicek SDE is given by:
𝑑𝑟𝑡 = 𝛼 𝜇 − 𝑟𝑡 𝑑𝑡 + 𝜍 𝑑𝑊𝑡
Where α, µ and σ are constants and 𝑊𝑡 is standard Brownian motion under Q.
The Vasicek SDE is an example of a generalized Ornstein – Uhlenbeck.

𝑡
Part (iii): 𝑟𝑡 = 𝑒 −𝛼𝑡 𝑟0 + 𝜇 1 − 𝑒 −𝛼𝑡 + 𝜍 0
𝑒 −𝛼 𝑡−𝑠
𝑑𝑊𝑆
Part (iv): The distribution of the zero-coupon bond price is lognormal
QUESTION 7
Part (i): Theory
Part (ii): Theory
Part (iii): The model is arbitrage-free, since the calculations are based on risk-neutral probabilities. As
with the Vasicek model, the HW model, which also assumes constant volatility, can lead to
negative interest rates.
With this model, interest rates are mean-reverting. The HW model is just as tractable as the
Vasicek model.
Although graphs of simulations of interest rates based on this model look similar to actual
observed rates, the dynamics still only reflect a single source of uncertainty. It can repro-
duce the usual shapes of yield curves that are observed.
The presence of the µ(t) function in the HW model allows us to calibrate the model exactly
to match the interest rates currently observed in the market.
Although the HW model allows us to price contracts with payoffs linked to interest rates
more accurately than the Vasicek model, it is not flexible enough to cope with derivatives
with payoffs linked to more than one interest rate, where these rates are not perfectly cor-
related.

QUESTION 8
Part (i): Jarrow-Lando-Turnbull model diagram
The model has n states, with State n corresponding to the (absorbing) default state and States
1 to n – 1 corresponding to the different rating levels used (with State 1 denoting the state
with the lowest risk). λij (t) denotes the transition intensity from State i to State j at time t. For
pricing purposes, risk-neutral transition intensities, denoted by 𝜆𝑖𝑗 𝑡 , must be used.
Part (ii):
Sub-part (a): Proof
𝑑𝑘 𝑡
Sub-part (b): 𝑑𝑡
= −0.5𝑘(𝑡)
Part (iii): p3(2) = 0.71164

Part (iv):
Sub-part (a): Bond price = 68.7294
Sub-part (b): The credit spread is 16.75%
QUESTION 9
Part (i): The SDE for the short rate at time t, r(t), under the Vasicek model is:
dr(t) = α [µ - r(t)]dt + σ dZ(t)
Where Z(t) is a standard Brownian motion and α (> 0), µ and σ are constants.
Part (ii): The Vasicek model is a one-factor, mean-reverting short-rate model. In particular, it's an
Ornstein-Uhlenbeck process.
𝑡
Part (iii): 𝑟 𝑡 = 𝑟 0 𝑒 −𝛼𝑡 + 𝜇 1 − 𝑒 −𝛼𝑡 + 𝜍 0
𝑒 −𝛼 𝑡−𝑢
𝑑𝑍(𝑢)

Part (iv): Since Z(t) has a normal distribution, r(t) must also have a normal distribution.
Part (v): First moment of r(t): 𝐸 𝑟 𝑡 = 𝑟 0 𝑒 −𝛼𝑡 + 𝜇 1 − 𝑒 −𝛼𝑡
𝜍2
Second moment of r(t): 𝐸 𝑟 𝑡 2
= 2𝛼
1 − 𝑒 −2𝛼𝑡 + 𝑟 0 𝑒 −𝛼𝑡 + 𝜇 1 − 𝑒 −𝛼𝑡 2
Part (vi): Due to the normal distribution of increments of r(t), it's possible for the model to output
negative interest rates, which goes against one of the desirable features of (nominal) inter-
est rate models (although negative interest rates have been seen in some countries in recent
years).
QUESTION 10
Part (i): A simple model can be set up, in continuous time, with two states:
1. N= not previously defaulted
2. D= defaulted (an absorbing state).
Under this model it is assumed that the default-free interest rate is constant and the same
for all maturities. The transition intensity from N to D at time t is usually denoted by λ(t).
If the entity being considered defaults then a recovery rate of δ is assumed.
For projecting possible future outcomes, real-world transition intensities would be used,
but when used in a pricing formula, risk-neutral transition intensities would be needed.
A more general and more realistic model was developed by Jarrow, Lando and Turnbull
with n-1 credit ratings plus default.
In this n-state model, transfer is possible between all states except for the default Staten,
which is absorbing. The transition intensity from State i to State j at time t is usually denoted
by λij(t).
Part (ii): λA = 0.74204; λB = 0.68583
Part (iii): P(double-default) = 0.079894; λDD = 0.11102
Part (iv): The price of the derivative security will be $39,763
QUESTION 11
 The model should be arbitrage-free.

 Interest rates should be positive.
 Interest rates should be mean-reverting.

 Bonds and derivative contracts should be easy to price.

 It should produce realistic interest rate dynamics.
 It should fit historical interest rate data adequately.
 It should be easy to calibrate to current market data.
 It should be flexible enough to cope with a range of derivatives.
QUESTION 12
Part (i): Vasicek SDE = 𝑑𝑟 𝑡 = 𝛼 𝜇 − 𝑟 𝑡 𝑑𝑡 + 𝜍 𝑑𝑊𝑡
CIR SDE = 𝑑𝑟 𝑡 = 𝛼 𝜇 − 𝑟 𝑡 𝑑𝑡 + 𝜍 𝑟(𝑡) 𝑑𝑊𝑡

Part (ii): In the Vasicek model, the coefficient in the volatility term is σ, which is a constant and so not
impacted by any movement in the short rate.
In the CIR model, the coefficient in the volatility term is 𝜍 𝑟(𝑡), which will be impacted by a
movement in the short rate. If the short rate increases, the volatility coefficient also increas-
es and so the volatility is likely to be greater.
QUESTION 13
Part (i): Theory
Part (ii): 𝐷 0 = 𝐹 0 Φ −𝑑1 + 3,200𝑒 −3𝑟 Φ(𝑑2 )
Part (iii): Fair price of the default insurance is £82,404.
Hence the insurance seems cheap at £55,000 and so there is an arbitrage opportunity.
QUESTION 14
Theory
QUESTION 15
Part (i): Theory
Part (ii):
Sub-part (a): The current price of Bond 1 per $100 nominal is B1 = $94.649
The current price of Bond 2 per $100 nominal is B2 = $87.810
Sub-part (b): Risk-neutral probability of no default over the next two years is 0.76209
Part (iii): 𝜆1 = 𝟎. 𝟏𝟎𝟑𝟏𝟕; 𝜆1 = 𝟎. 𝟏𝟔𝟖𝟓𝟐

QUESTION 16
Part (i): dr(t) = α [µ - r(t)] dt + σ dZ(t)
Where Z(t) is a standard Brownian motion under Q and α (> 0), µ > 0 and σ are constants.
Part (ii): Desirable features
 The Vasicek model is arbitrage-free and generates mean-reverting interest rates.
 It's easy to use to price bonds and other simple interest rate derivatives.
Undesirable features
 The Vasicek model allows negative interest rates. (How undesirable this is depends on
the economy being modelled, as negative interest rates have been seen in some coun-
tries in recent years).
 Although it can produce a range of yield-curve shapes, it doesn't produce realistic dy-
namics (e.g. bond prices at different durations are perfectly correlated).
 With only three parameters (α, µ and σ), it can't fit historical data or be calibrated to
current market data accurately.
 Being a one-factor model, it is not flexible enough to cope with more complicated inter-
est rate derivatives where the correlations between interest rates are important.
Part (iii):
𝑇 −𝛼 𝑇−𝑢
Sub-part (a): 𝑟 𝑇 = 𝑟 𝑡 𝑒 −𝛼 (𝑇−𝑡) + 𝜇 1 − 𝑒 −𝛼(𝑇−𝑡) + 𝜍 𝑡
𝑒 𝑑𝑍(𝑢)
Sub-part (b): Mean of the distribution = 𝑟 𝑡 𝑒 −𝛼(𝑇−𝑡) + 𝜇 1 − 𝑒 −𝛼(𝑇−𝑡)

𝜍2
Variance of the distribution = 2𝛼 1 − 𝑒 −2𝛼 (𝑇−𝑡)
QUESTION 17
Part (i): Theory
Part (ii): 𝐷 0 = 𝐹 0 Φ −𝑑1 + 120𝑒 −4𝑟 Φ(𝑑2 )
Part (iii): D(0) = $92.526m
Part (iv): Implied volatility is 40% pa
Part (v): Implied risk-neutral probability of default is about 42%

QUESTION 18
Part (i): Suitability of the model:
 The model is arbitrage free, which is good.
 It allows negative interest rates, due to the volatility term having a normal distribution.
This is ordinarily viewed as a drawback, although it depends on the economy being
modelled (as negative interest rates have been seen in some countries in recent years).
 It is only mean reverting if µ<0 and then it mean reverts to zero.
 It's easy to use to price bonds and other simple interest rate derivatives since the model
is computationally tractable.
 It can't produce a realistic range of yield-curve shapes.
 With only two parameters (µ and σ), it can't fit historical data or be calibrated to current
market data accurately. For example, the assumption of constant volatility isn't borne
out in practice.
 Being a one-factor model, it is not flexible enough to cope with more complicated inter-
est rate derivatives where the correlations between interest rates are important.
𝜍 𝑇
Part (ii): 𝐶 =𝑎 𝑡
(1 − 𝑒 −𝑎 𝑇−𝑠
𝑑𝑍𝑠
𝑇
Part (iii): 𝑡
𝑟 𝑢 𝑑𝑢 has a normal distribution
QUESTION 19
Part (i): The price at time t of a zero-coupon bond that matures at time T with a payoff of 1 is given
𝑇
by: 𝐵 𝑡, 𝑇 = 𝑒 −𝑟 𝑇−𝑡
[1 − (1 − 𝛿){1 − exp⁡
(− 𝑡
𝜆 𝑠 𝑑𝑠)}]
where:
 r is the constant continuously-compounded risk-free rate
 δ is the recovery rate
 λ(s) the deterministic risk-neutral default intensity.

Part (ii): Risk-neutral probability of default for Bond A = 10.317%
Part (iii): Current price for Bond C is 𝒆−𝟎.𝟎𝟓 𝟏 − 𝝆𝑨 (𝟏 − 𝟎. 𝟓𝝆𝑪 )
Part (iv): Risk-neutral probability of default for Bond C is 0.32580

QUESTION 20
Part (i): The price at time t of a zero-coupon bond that matures at time T with a payoff of 1 is given
𝑇
[1 − (1 − 𝛿){1 − exp⁡
(− 𝑡
where:
Part (ii): Risk-neutral probability of default is 8.789%
𝐥𝐧 𝑳/𝑭𝟎 −𝟎.𝟎𝟐𝟏𝟓𝟓
Part (iii): Risk-neutral probability that the company defaults is 𝚽
𝟎.𝟏𝟑
Part (iv): The required ratio is 0.8569

Part (v): Percentage of assets represented by equity at time 0 is 20.5%
QUESTION 21
Part (i): Theory
Part (ii): Merton's model assumes that a firm has issued both non-dividend-paying equity and a zero-
coupon bond such that the firm's total value at time t is F(t).
The zero-coupon bond has a promised repayment amount of L at a future time T, when the
remainder of the firm's value will be distributed to the shareholders and the firm will be
wound up.
The firm will default if F(T) <L. This can be regarded as treating the shareholders of the firm
as having a European call option on the assets of the firm with maturity T and a strike price
equal to L.
Hence, we can use the Black-Scholes framework to determine the shareholder value, and
therefore equate the risk-neutral probability of default to the probability of the call option
expiring out-of-the-money, i.e. 1 − Φ 𝑑2 = 𝑃(𝐹 𝑇 < 𝐿)
Part (iii): The price at time t of a zero-coupon bond that matures at time T with a payoff of 1 is given
𝑇
[1 − (1 − 𝛿){1 − exp⁡
(− 𝑡
where:


Part (iv): λ(s) = s2 /2
Part (v): Value of the contract is £176,998
QUESTION 22
Part (i): Under the Vasicek model: 𝐵 𝑡, 𝑇 = 𝑒 𝑎 𝜏 −𝑏(𝜏)𝑟𝑡
Where:
 𝜏 = 𝑇 − 𝑡 is the time until the bond matures
1 − 𝑒 −𝛼𝜏
 𝑏 𝜏 = 𝛼
𝜍2 𝜍2
 𝑎 𝜏 = 𝑏 𝜏 −𝜏 µ − 2𝛼 2 − 4𝛼 𝑏 𝜏 2
Part (ii): For a nominal value of $100, fair price for Bond X is $97.72
Part (iii): Three-year spot rate is 3.51%
Part (iv): Forward rate = 4.11%
QUESTION 23
Part (i): Theory
Part (ii): Using the risk-neutral probability measure Q,
𝐸0 = 𝑒 −𝑟𝑡 𝐸𝑄 max 𝐹𝑇 − 𝐿 𝑇 , 0
where:
 T is the time to expiry
Part (iii): F0+ = 21.56
Part (iv): Credit spread is 1.13%
QUESTION 24
Part (i):
Sub-part (a): Forward rate = 5%
Sub-part (b): Bond price = 98.02
Sub-part (c): Spot rate = 3%
Sub-part (d): Cash amount = 109.42
Part (ii): Loss = £8
Part (iii): There's no mention of the possibility of these bonds defaulting, so we can assume that the
interest rates provided are actually risk-free rates.
Any portfolio that consists entirely of risk-free assets will only be able to produce a return
equal to the risk-free rate if interest rates do not change.
To recoup the losses the investor would need to find risky assets in which to invest in order
to produce a higher rate of return.
QUESTION 25
Part (i): Theory
Part (ii): Probability of default at time 2 = 0.0676
Part (iii): Recovery percentage on default is 25
Part (iv): Credit spread on bond is 2.6%
Part (v): The price of the bond can be viewed as the present value of the future expected cashflow. If
that cashflow arrives at the earlier time of default rather than at maturity, then the present
value will be higher due to the decreased impact of the discounting.
Therefore, the price of the bond would increase.
QUESTION 26
Part (i): Proof
Part (ii): Proof
Part (iii): Proof
Part (iv): The main drawback of the Vasicek model is that the short rate of interest is permitted to
take negative values. In most circumstances, this is an undesirable characteristic for an in-
terest rate model to have.

QUESTION 27
Part (i):
Sub-part (a): The one-factor Vasicek model exhibits the following properties:
 It incorporates mean reversion.
 It has constant volatility.
 It is time-homogeneous, i.e. the future dynamics of rt only depend upon the cur-
rent value of rt rather than what the present time t actually is.
 It is arbitrage-free.
 It allows negative interest rates.
 rt has a normal distribution, which ensures the model is tractable.
Sub-part (b): The Cox-Ingersoll-Ross model exhibits the following properties:
 It incorporates mean reversion.
 It is a one-factor model.
 It is time-homogeneous.
 It is arbitrage-free.
 The volatility depends on the level of the rates, i.e. it is high/low when rates are
high/low.
 It does not allow negative interest rates.
 rt has a non-central 𝜒2 distribution, so this model is less tractable than the Vasi-
cek model.
𝑡
Part (ii): 𝑟𝑡 = 𝑟0 𝑒 −𝑎𝑡 + 𝑏 1 − 𝑒 −𝑎𝑡 + 𝜍 0
𝑒 −𝑎 𝑡−𝑠
𝑑𝑊𝑠
𝜍2
Part (iii): 𝑟𝑡 |𝑟0 ~ 𝑁 𝑟0 𝑒 −𝑎𝑡 + 𝑏 1 − 𝑒 −𝑎𝑡 , 2𝑎 1 − 𝑒 −2𝑎𝑡
QUESTION 28
Part (i): B(0) = F(0) – c
Part (ii): Bond price = £94.63 per £100 nominal

Part (iii): Price change of each share is approximately £0.984. Per £100 nominal, the bond price in-
creases by £0.016
Part (iv): Clearly the bulk of the change in the company assets is accounted for by a change in the
share price rather than the value of the bond.
Because the total company assets are twice the value of the debt liability, we can say that
the bond is already very likely to be repaid in full. Therefore, any additional increases in the
company's assets are likely to go directly to increasing the value of the shareholders' posi-
tion, and have very little impact on the riskiness (and hence the price) of the bond.
The high value of delta shows that the share price moves almost in line with the value of the
company.
Part (v): If the total value of the company was lower, the risk of default on the bond would be higher.
Therefore, any increases in the value of the company would have a greater impact on the
price of the bond as its level of riskiness decreases, and by implication, a smaller impact on
the price of the shares.
QUESTION 29
Part (i): Desirable characteristic of a term structure model
 The model should be arbitrage-free.
 Interest rates should be positive.

 Interest rates should be mean-reverting.
 Bonds and derivative contracts should be easy to price.

 It should produce realistic interest rate dynamics.
 It should fit historical interest rate data adequately.
 It should be easy to calibrate to current market data.

 It should be flexible enough to cope with a range of derivatives.
Part (ii): Proof
𝑇
Part (iii): 𝐵 𝑡, 𝑇 = exp⁡
[− 𝑡
𝑓 𝑡, 𝑠 𝑑𝑠]
QUESTION 30
Part (i): Theory

Part (ii): The corporate entity will default if, at the maturity date of the debt (time T), the total value
of its assets, F(T), is less than the repayment value of the debt, L.
Part (iii): F(t) is assumed to follow geometric Brownian motion
Part (iv): The risk-neutral probability of default in the Merton model is:
𝐹 1
𝑙𝑜𝑔 0 + 𝑟−𝑞− 𝜍𝐹2 𝑇
𝐿 2
1−Φ 𝜍𝐹 𝑇
where:
 F(0) is the current value of the company's total assets
 L is the par value of the debt
 r is the risk-free force of interest
 q is the constant force of payment provided by the company's underlying assets
 σF is the volatility of the value of the company's assets.
QUESTION 31
Part (i): The model allows the short rate (and hence other interest rates) to go negative.
Part (ii): This depends largely on how negative the interest rates generated using the model might go
and also how often they might go negative, both of which will depend on the parameter val-
ues used.
It also depends on the likelihood that actual interest rates may go negative in whichever
economy is being modelled.
For example, it has been less of a problem in recent years, as nominal interest rates have
been at historically low levels, often very close to zero in many developed economies and
actually below zero in a handful of countries.
Part (iii): The CIR model avoids the problem of negative interest rates by inserting 𝑟(𝑡) into the vo-
latility term in the stochastic differential equation for the short rate rt.
This makes the volatility term vary in direct proportion to 𝑟(𝑡)
Thus, the volatility term will be lower when rt is lower and will tend to zero if rt tends to ze-
ro. This means that if rt approaches zero, the volatility term will become very small and will
be outweighed be the mean-reverting term pulling rt back upwards, so ensuring that rt (and
all other interest rates) cannot go negative.

Part (iv): Interest rates are mean-reverting and will tend to revert towards b.
Part (v): A higher value for a implies that the short rate converges to its long-run mean value of b
more quickly.
QUESTION 32
Part (i): Current value of firm’s debt = €76.88 million
Part (ii): Yield to maturity = 5.26% pa
Part (iii): Credit spread = 3.26% pa
QUESTION 33
Part (i): Proof
Part (ii):
Sub-part (a): Replicating portfolio must contain -0.5 bonds and 50 e-3ramount of cash.
Sub-part (b): Value of derivative = 35e-3r (1 – e-3λ)
Part (iii): Risk-neutral pricing approach
Let Vt denote the value of the portfolio at time t. Under the risk-neutral probability measure
P, risky assets are expected to grow at the risk-free rate. Therefore, under P,𝑒 −𝑟𝑡 𝑉𝑡 must be a
martingale, and specifically:
𝑉0 = 𝐸[𝑒 −3𝑟 𝑉3 ]
The probability of the bond defaulting by time t = 3 is 1 – e-3λ, therefore the expectation can
be written as: 𝐸 𝑒 −3𝑟 𝑉3 = 𝟑𝟓𝐞−𝟑𝐫 𝟏 – 𝐞−𝟑𝛌
This is the same expression as in part (ii).
QUESTION 34
Part (i):
Sub-part (a)(b): r (0, 0.25) = 10.13%; r (0, 0.5) = 10.47%
Sub-part (c): Bond price = 96
Sub-part (d)(e): f(0, 0.5, 1) = 10.61%; f(0, 1, 1.5) = 10.96%

Part (ii):
Vasicek model: 𝑑𝑟𝑡 = 𝛼 𝜇 − 𝑟𝑡 𝑑𝑡 + 𝜍 𝑑𝑊𝑡
Cox-Ingersoll-Ross model: 𝑑𝑟𝑡 = 𝛼 𝜇 − 𝑟𝑡 𝑑𝑡 + 𝜍 𝑟𝑡 𝑑𝑊𝑡
QUESTION 35
Part (i): Value of company’s assets after issuing the debt is $350,000
Part (ii): Redemption value of debt is $302,851
Part (iii): Credit spread on the debt is 0.86%
Part (iv):
Sub-part (a): Since the share price has halved from $1 to $0.50, the equity value has also dropped
by 50%
Sub-part (b): Current worth of debt is 60.57% of its original value
Part (v): Debt ranks above the equities when a company defaults...
…….so the bondholders have a more secure investment.
Unless the company assets are worth zero after five years, the bondholders will receive
something.
By contrast, shareholders won't receive anything unless the bond is repaid in full.
QUESTION 36
Part (i): Theory
Part (ii): Implied volatility = 20%
Part (iii): Vega of the debt is -€0.5m%--1
Part (iv): The volatility of a company's value is not directly observable and is not easy to estimate.
It is therefore desirable to use a model where the output is relatively insensitive to the vola-
tility figure because this will give a more accurate answer even if our estimate of the volatili-
ty is wrong.

SECTION 8
QUESTION 1
Part (i): 1 + (120α – 5) R = e100α R
Part (ii): Proof
𝑑𝑅
Part (iii): Setting 𝑑𝛼 = 0 and solving for α gives the value of retained proportion α that maximises R (if
there is such a value).
Lundberg’s inequality for Ψ(𝑢), the probability of ultimate ruin given an initial surplus of u
states that Ψ 𝑢 ≤ 𝑒 −𝑅𝑢
Maximizing R minimizes the upper bound for this probability, so makes ruin less likely.
𝑑𝑅
Hence, the value of α for which = 0 is an optimal value in this sense.
𝑑𝛼
Part (iv): α = 0.48526
QUESTION 2
𝜃
𝑅=
1+𝜃 𝜇
QUESTION 3
1 2𝜃 𝑚 1
Part (i): 𝑀
log 1 + 𝜃 < 𝑅 < 𝑚2
Part (ii):
Sub-part (a): 0.08745 < R < 0.23077
Sub-part (b): Upper bound on probability of ruin = 𝑒 −0.08745 𝑈
QUESTION 4
Part (i): R is defined as the unique positive root of λ MX(R) = λ +cR
 MX(R) is the MGF of the claim amount distribution, evaluated at R
 λ is the Poisson parameter
 c = (1 + θ) λm1, the insurer's premium income per unit of time
 m1 = E(X).

Part (ii):
2𝜃 𝑚 1
Sub-part (a): 𝑅= 𝑚2
Sub-part (b): 𝑅2 𝑚3 + 3𝑅𝑚2 − 6𝜃𝑚1 = 0
Part (iii): 1st approximation of R = 0.03; 2nd approximation of R = 0.02416;

True value of R = 0.02308
The second approximation of R is closer to the true value, because it includes an extra term
in the series expansion of the MGF
QUESTION 5
Part (i): The insurer’s surplus at time t is given by:
U(t) = U + ct – S(t);
where
 c = rate of premium income per unit of time = 1   E S  1    E  X 
 X = individual claim amount random variable
 S(t) = aggregate claims up to time t
Part (ii): Ψ 𝑈, 𝑡 is the probability that the insurer's surplus becomes negative at any time in the in-
terval (0,t], given that the insurer has a surplus of U at time 0. In symbols, this can be writ-
ten as:
Ψ 𝑈, 𝑡 = P(U(s)<0 for some s such that 0<s ≤ t|U(0) = U)
Ψ 𝑈 is the probability that the insurer's surplus becomes negative at any time, given that
the insurer has a surplus of U at time 0. In symbols, this can be written as:
Ψ 𝑈 = P(U(s)<0 for some s such that 0<s<∞|U(0) = U)
Part (iii): As λ increases, the premium rate and the claim rate both increase. This means that the
process is effectively speeded up, so any ruin that occurs will occur earlier. Hence the finite-
time ruin probability Ψ 𝑈, 𝑡 increases as λ increases.
However, the probability of ultimate ruin, Ψ 𝑈 , is not affected by the Poisson parameter.
This is because we now are not interested in the time when ruin occurs- we're only inter-
ested in the probability that ruin ever occurs.

QUESTION 6
Part (i): MX(t) = (1 – 100t)-2 for t < 0.01
Part (ii): Adjustment coefficient = 0.00215578
The upper bound given by Lundberg’s inequality is Ψ 𝑈 ≤ 𝑒 −𝑟𝑈 = 𝑒 −0.00215578 𝑈
Part (iii): U = 2,136.197
Part (iv): The adjustment coefficient would be higher than 0.00215578
As r increases, the upper bound for the probability of ultimate ruin decreases. So, if the
claim amounts are fixed, ruin becomes less likely. This makes sense since, although the ex-
pected claim amount has not changed, there is less variability when the claim amounts are
fixed and therefore lower risk.
QUESTION 7
Part (i):
Ψ 100 = 𝑃 𝑈 𝜏 < 0, 𝑓𝑜𝑟 𝑠𝑜𝑚𝑒 𝜏, 0 < 𝜏 < ∞
Ψ 100, 1 = 𝑃 𝑈 𝜏 < 0, 𝑓𝑜𝑟 𝑠𝑜𝑚𝑒 𝜏, 0 < 𝜏 ≤ 1
Ψ1 100,1 = 𝑃 𝑈 𝜏 < 0, 𝑓𝑜𝑟 𝜏 = 1 = 𝑃 𝑈 1 < 0
U(t) is the surplus process at time t: U(t) = U + ct – S(t)
Where: U is the initial surplus, which is 100
c is the premium income per unit of time
S(t) is the aggregate claim amount at time t
Part (ii): The adjustment coefficient is the unique positive root, r = R, of the equation:
λ + cr = λ MX(r)
Where: λ is the claim rate per unit of time
c is the rate of premium income per unit of time
MX(r) is the MGF of the claim amount distribution
Part (iii): Proof
Part (iv): Ψ 100 ≤ 𝑒 −100𝑅 = 33.287%; Ψ1 100, 1 = 1.07%

Part (v): The probability of ruin in the first year, 1.07%, is much smaller than the probability of ulti-
mate ruin, 33.287%. This suggests either that the upper bound provided by Lundberg's in-
equality is not very tight or that there is a significant chance of ruin after the 1st year. (There is
a big difference between whether ruin ever happens and whether it happens before time 1.)
QUESTION 8
Part (i): P = 63.75
Part (ii): P [X < 200] = 0.95221
Part (iii): Probability = 0.9881
Part (iv): The reinsurer’s premium, PR = 0.3271
Part (v): E (profit) = 26.07
QUESTION 9
Part (i): The smallest value of M is 2.8333
Part (ii): 1 + 0.66Mr – 0.32r = 0.7er + 0.3eMr
Part (iii): r = 0.13
3 8−𝑀
Part (iv): 𝛼= 31
Part (v): The adjustment coefficient with proportional reinsurance would be lower
Part (vi): Lundberg's inequality gives us an upper bound for the probability of ultimate ruin:
Ψ 𝑈 ≤ 𝑒 −𝑟𝑈
With the XOL reinsurance arrangement, the adjustment coefficient is higher than with the
proportional reinsurance arrangement.
Therefore, with the XOL reinsurance arrangement, the upper bound for the probability of
ultimate ruin is lower than with the proportional reinsurance arrangement.
So, given that the premium is the same, the insurer should probably opt for the XOL rein-
surance arrangement.
QUESTION 10
Part (i): Altering the Poisson parameter λ does not affect the probability of ultimate ruin. It just
speeds up the process – premiums come in faster and claims come in faster.

Increasing µ will increase the probability of ruin because the claim amounts are larger, rela-
tive to the surplus held.
Increasing θ will reduce the probability of ruin as the premiums increase at a quicker rate
for the same sized claims so there will be a larger buffer.
If u increases, the probability of ruin decreases as there is a bigger cushion with which to
absorb the claim(s).
Part (ii): RB = 0.00115; RA> 0.00115 = RB; RC> 0.00115 = RB
Part (iii): Proof
QUESTION 11
Part (i):
Ψ $0.1𝑚, 1 = 𝑃 𝑈 𝜏 < 0, 𝑓𝑜𝑟 𝑠𝑜𝑚𝑒 𝜏, 0 < 𝜏 ≤ 1
Ψ $0.1𝑚 = 𝑃 𝑈 𝜏 < 0, 𝑓𝑜𝑟 𝑠𝑜𝑚𝑒 𝜏, 0 < 𝜏 < ∞
Where U(t) is the cashflow process at time t: U(t) = $0.1m + ct – S(t)
c = the premium receive per unit time
S(t) = Claims received up to time t
Part (ii): c = $0.0845m
Part (iii): Ψ $0.1𝑚, 2 = 𝟎. 𝟎𝟗𝟕𝟓
QUESTION 12
B and C are equivalent in terms of when ruin is likely to occur. For example, a fare of £2.10 on the first
day will cause ruin under both options.
The larger capital buffer under option A means that they are more likely to last longer before they are
ruined, if at all. For example, a fare of £2.10 on the first day will not cause ruin.
So, A results in the lowest probability of running out of cash.
QUESTION 13
We require the premium loading factor to be greater than 19.48%

QUESTION 14
Part (i): The adjustment coefficient R is the unique positive root of:
λ + cR = λ MX(R)
Part (ii): Proof
Part (iii): The adjustment coefficient of RB is the largest and hence gives the lowest probability of ruin.
Part (iv): We can see that arrangement B will be better than arrangement A because the reinsurer
charges a lower premium loading than the insurer. So, the 30% of claims that are passed to
the reinsurer are charged at a lower than 30% reduction in the premium.
Arrangement C is better than arrangement A as the adjustment coefficient is higher; howev-
er, it is not as good as arrangement B. This is because:
 the retention limit is so high that only 5% of claims hit the reinsurance layer, and
 it has a higher premium loading than arrangement B.
QUESTION 15
Part (i): Claims will arrive with the reinsurer as a thinned Poisson process with rate λe -M/µ
𝜇𝑡
Part (ii): 𝑀𝑋 𝑖 𝑡 = 1 + 𝑒 −𝑀/𝜇 1−𝜇𝑡
Part (iii):
Sub-part (a): 𝐸 𝑋𝑖 = 𝜇𝑒 −𝑀/𝜇

𝜃
Sub-part (b): 𝑅=𝜇 1+𝜃
Part (iv): The adjustment coefficient R does not depend on the retention M.
This is due to the memoryless property of the exponential distribution (i.e. X i – M |Xi> M is
also Exp(1/µ)
QUESTION 16
Part (i): Adjustment coefficient, R = 0.0066
Part (ii):
𝑴𝟐
Sub-part (a): E(Z) = − 𝑴 + 𝟐𝟓
𝟏𝟎𝟎
Sub-part (b): M >5.279

Part (iii): The cost of reinsurance will fall, so the insurer can afford to purchase more reinsurance, i.e.
it will pass more claims to the reinsurer. Hence, M min decreases.
QUESTION 17
Part (i): Ψ 𝑈 is the probability of ultimate ruin given initial surplus U (also called the probability of
ruin in infinite time).
Ψ 𝑈 = 𝑃(𝑈 𝜏 < 0, 𝑓𝑜𝑟 𝑠𝑜𝑚𝑒 𝜏, 0 < 𝜏 ≤ ∞)
Ψ 𝑈, 𝑡 is the probability of ruin within time t given initial surplus U (also called the proba-
bility of ruin in finite time).
Ψ 𝑈, 𝑡 = 𝑃(𝑈 𝜏 < 0, 𝑓𝑜𝑟 𝑠𝑜𝑚𝑒 𝜏, 0 < 𝜏 ≤ 𝑡)
Ψ 𝑈, 1 = 𝑃(𝑈 𝜏 < 0, 𝑓𝑜𝑟 𝑠𝑜𝑚𝑒 𝜏, 0 < 𝜏 ≤ 1)
where U(t) is the surplus process at time t:
U(t) = U + ct – S(t)
where: U is the initial surplus,
c is the premium income per unit of time,

S(t) is the aggregate claim amount at time t.
Part (ii): Factors affecting Ψ 𝑈, 𝑡 are the:
 initial surplus U
 premium loading θ
 Poisson parameter λ, i.e. the expected number of claims occurring per unit of time
 Mean claim amount µ = E(X)
 Variance of the claim amounts, σ2 = var(X)
Part (iii): Ψ 𝑈, 𝑡 increases as λ increases, since the surplus process speeds up, so ruin (if it occurs at
all) will occur earlier.
Ψ 𝑈, 𝑡 increases as E(X) increases, because the claim amounts are larger relative to the ini-
tial surplus held.
Ψ 𝑈, 𝑡 decreases as θ increases, as the premiums increase relative to the claim size.
Ψ 𝑈, 𝑡 decreases as U increases, as there is a bigger cushion with which to absorb claims.

Part (iv): Analyzing ruin probabilities in discrete time:
 is less accurate
+ is simpler to calculate
QUESTION 18
Part (i): The adjustment coefficient, R, is the unique positive root of the equation:
λ + cR = λ MX(R)
Part (ii): R = 0.00648
Part (iii):
Sub-part (a): Using Lundberg’s inequality and the value of R, Ψ 300 ≤ 𝟎. 𝟏𝟒𝟑
Sub-part (b): Ψ1 300,1 = 𝟎. 𝟎𝟏𝟏𝟎
Part (iv): If the value of β reduces from 0.5 to 0.4, E(X) and var(X) both increases. The probability of
ruin at time 1 will be higher than before since:
 the mean claim amount is a higher proportion of the initial surplus, and
 the increase in the variance makes large claims more likely.

Part (v): Any TWO of the following will reduce the probability:
 by increasing the initial surplus
 by increasing the premium loading factor
 by changing the policy terms (such as introducing an excess or having a maximum sum
insured)
 by taking out reinsurance
 by diversifying the mix of business in order to reduce the volatility of the claims.
QUESTION 19
Part (i): E(S) = 142,500; sd(S) = 28,861.74
Part (ii): Um = 52,657.86
Part (iii): α < 0.766
Part (iv): The insurer could

 increase the initial surplus
 increase their premium loading factor
 insure more type I policies to reduce the variance.
QUESTION 20
Sub-part (a): The statement is FALSE
Sub-part (b): The statement is FALSE
Sub-part (c): The statement is FALSE
Sub-part (d): The statement is TRUE
QUESTION 21
Part (i): Adjustment coefficient, r = 0.000708
Part (ii): The ultimate probability of ruin is bounded above by 0.029
Part (iii): New adjustment coefficient, R < 0.002
The new upper bound = 0.189
Part (iv): Normal distributions permit negative outcomes, which is unrealistic when modelling claim
amounts.
Normal distributions do not have "fat tails", which are commonly observed in insurance
claims.
Normal distributions are not positively skewed, unlike typical claim amounts.
Suitable alternative distributions include gamma, Pareto and Weibull.
QUESTION 22
Part (i): The adjustment coefficient is the unique positive solution to:
λ MX(R) = λ + cR; where c = λ(1+θ) E[X]

𝟐𝜽𝒎𝟏
Part (ii): 𝑅= 𝒎𝟐
𝜽𝜸
Part (iii): 𝑅 = 𝟏+𝜽

Part (iv): The approximate value of R is greater than the true value because of the truncation of the
series in part (ii). This leads to a weaker upper bound on the ultimate probability of ruin via
Lundberg’s inequality.
Part (v): Ψ<6.86%
Part (vi): To reduce the ultimate probability of ruin the insurance company could:
 increase the initial surplus
 increase the premium loading factor θ
 arrange some form of reinsurance.
QUESTION 23
Part (i): The insurer’s assets after the April 2019 premiums are received comprise the initial surplus
of £750 plus three premiums of £50, i.e. £900
Part (ii): Probability of ruin when the April 2019 exam results are released is 15.625%
Part (iii):
Sub-part (a): The insurer’s assets after the October 2019 premiums are received, assuming no
student qualified in April 2019, are the £900 from part (i) plus three premiums of
£50, i.e. £1,050
Sub-part (b): Probability of ruin when the October 2019 exam results are released is 1.5625%
Part (iv):
Sub-part (a): The insurer’s assets after the October 2019 premiums are received, assuming one
student qualified in April 2019, are the £900 from part (i) less payments of £500 foe
the student who qualified, plus two premiums of £50 from the remaining students,
i.e. £500
Sub-part (b): Probability of ruin when the October 2019 exam results are released is 6.25%
Part (v): Overall probability of ruin before the end of year 2019 is 18.92%
Part (vi): The ultimate probability of ruin will increase because:
 For each policy written, the premium income of £50 per student is significantly less than
the expected payment of 0.25 x £500 = £125. Therefore, ruin is expected to occur in the
first exam session.
 As the number of policies increases, the extent to which the initial surplus of £750 can
provide a cushion decrease.

QUESTION 24
Part (i): P(N(1) < 3) = 0.9298
Part (ii): Adverse selection-people who know that they are particularly bad risks are more inclined to
take out insurance than those who know they are good risks.
Moral hazard - policyholders, because they have insurance, act in a way that makes the in-
sured event more likely.
Part (iii): Insurance companies can reduce the risk from adverse selection by trying to find out lots of
information about potential policyholders.
Policyholders can then be put in small, reasonably homogeneous pools and charged appro-
priate premiums.
Insurers might also ensure that the pay-out is proportionate to the loss incurred.
To try to mitigate moral hazard insurers might apply an excess to the policy or award a dis-
count to policyholders who do not claim.
Part (iv): Premium = £156.25

SECTION 9
QUESTION 1
The estimated reserve is 134.7
QUESTION 2
Part (i): W = 1,803.0; X = 1,803.0; Y = 1,632.0
Part (ii): Z = 1,410.0
Part (iii): Reserve = 1,228.6
QUESTION 3
Part (i): Total reserve = 85.60
Part (ii): Proof

𝑗 −1 𝑗 −1 2
𝑓𝑗 ~ 𝑙𝑜𝑔𝑛𝑜𝑟𝑚𝑎𝑙( 𝑖=1 𝜇𝑖 , 𝑖=1 𝜍𝑖 )
Part (iii): Upper limit = 129.7702
QUESTION 4
Part (i): Total reserve = 47.60
Part (ii): Total reserve = 76.07
This is 28.46 higher than the reserve calculated in part (i)
Part (iii): By using the largest development factor in each case, we are using a worst- case scenario for
the cost of claims. This may mean that we hold a higher reserve than is actually necessary.
Since there is a considerable difference between the largest and the average development
factor for DY0 to DY1, and again for DY1 to DY2, the increase in the reserve is substantial.
Holding higher reserves ties up money that could perhaps be used more profitably else-
where.
It seems more sensible to use a weighted average of the individual development factors (as
in the chain ladder method) unless there is some reason to suggest that the development
factors are likely to increase from this average in the future.

QUESTION 5
Outstanding claims reserve is 959.57
QUESTION 6
Part (i): Total reserve for the outstanding claims is 144.07
Part (ii): The actual payments less the fitted payments are:
Development Year
2008 0 -4.58 5.47 0.04
2009 0 8.55 -4.73
2010 0 -3.97
2011 0
Part (iii): Overall the model seems a reasonable fit (as the difference in the numbers are not too large
in absolute terms).
However, some of the differences are large in percentage terms, e.g. 5.47/30 = 18% which
indicates some defects.
QUESTION 7
Total reserve for the outstanding claims is 2,036.32
QUESTION 8
Outstanding claim reserve is 186,585
QUESTION 9
The estimated reserve is 1,182.02
QUESTION 10
Part (i): Outstanding claims reserve is 5,028.2

Part (ii): Assumptions:
 for each origin year, the number of claims in each development year is a constant pro-
portion of the ultimate number of claims from that origin year
 for each origin year, the average amount of claims in each development year is a con-
stant proportion of the ultimate average claim amount of claims from that origin year
 the first year is fully run-off.
QUESTION 11
Estimated total claims for 2014 is 3,225.01
QUESTION 12
Assumptions of the Bomhuetter-Ferguson method:
 payments from each accident year will develop in the same way
 weighted average past inflation will be repeated in the future
 the first policy year (2011) is fully run-off
 the estimated loss ratio (91%) is appropriate for other policy years.
Outstanding claims for the Policy year 2014 are 2,827.47
QUESTION 13
Part (i): When an insured event occurs, it may take some time before the full extent of the claim is
known and paid.
Run-off triangles allow insurance companies to analyse these delays and hence estimate the
reserves that need to be held to meet future claims.
Part (ii): The reserve is 11,250
QUESTION 14
Estimated outstanding claim reserve is 827.00
QUESTION 15
Part (i): Theory
Part (ii): Outstanding claim for policies written in 2014 to 2016 is 11,864.32

QUESTION 16
Part (i): Outstanding claim reserve is 1,937.603
Part (ii): Assumptions of the average cost per claim method
 Claims are fully run-off by the end of Development Year 2.
 The proportions of claim numbers relating to each development year remain constant in
different accident years.
 The average cost per claim figures relating to each development year remain constant in
different accident years.
 The cost of claims settled given in the question represents the actual amounts paid out
so far on these claims.
 Inflation can be ignored.
QUESTION 17
The reserve required is approximately £4.13m
QUESTION 18
Part (i): Cumulative number of reported claims for accident year
2015 is 547; 2016 is 607; 2017 is 643
Part (ii): The grossing-up factors and ultimate average cost per claim figures are given in the follow-
ing table:
Development Year ACPC
2014 78.057% 103.876% 99.757% 100% 11.507
2015 71.962% 100.715% 99.757% 13.842
2016 81.811% 102.295% 14.509
2017 77.277% 16.797
Part (iii): The total reserve required is 13,780
QUESTION 19
Part (i): Theory
Part (ii): Reserve = 121.8

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CM2- FINANCIAL ENGINEERING AND LOSS RESERVING ACTUATORS EDUCATIONAL INSTITUTE

CA PRAVEEN PATWARI 1 JAI SHREE SHYAM

CM2- Financial Engineering and Loss Reserving

CA PRAVEEN PATWARI 2 JAI SHREE SHYAM

CM2- Financial Engineering and Loss Reserving

CHAPTER 2 UTILITY THEORY

CHAPTER 3 STOCHASTIC DOMINANCE AND BEHAVIOURAL FINANCE

CHAPTER 4 MEASURES OF INVESTMENT RISK

CA PRAVEEN PATWARI 3 JAI SHREE SHYAM

1. Subject CT8, April 2010, Question 8

2. Subject CT8, April 2010, Question 9

CA PRAVEEN PATWARI 4 JAI SHREE SHYAM

(iii) Explain the behaviours exhibited by the following people:

Policy schedule Detailed booklet setting Limited information

CA PRAVEEN PATWARI 5 JAI SHREE SHYAM

(i) Calculate the mean and variance of R. [3]

(a) a benchmark rate of return of 0%

(b) a benchmark rate of return of -10% [4]

5. Subject CT8, October 2010, Question 2

(i) Explain what is meant by 'excessive volatility' of share prices. [2]

6. Subject CT8, April 2011, Question 4

CA PRAVEEN PATWARI 6 JAI SHREE SHYAM

8. Subject CT8, September 2011, Question 3 (part)

dSt  St  dt  dZt  ; where:

 Z t is a standard Brownian motion

 t is the time from now measured in years

(i) (a) Derive the distribution of S t .

(b) shortfall probability relative to £90,000

(c) 99% Value at Risk. [6]

9. Subject CT8, April 2012, Question 5 (amended)

(ii) Show that

(iii) Derive an expression for TailVaR   X  given that:

TailVaR   E  X | X  VaR   . [4]

CA PRAVEEN PATWARI 8 JAI SHREE SHYAM

11. Subject CT8, October 2012, Question 10 (part)

12. Subject CT8, April 2013, Question 1

 downside semi-variance of return

 Tail Value at Risk. [Total 10]

13. Subject CT8, September 2013, Question 1

(i) (a) State the expected utility theorem.

sion at a value of wealth of one unit is 0.25.

14. Subject CT8, September 2013, Question 3

CA PRAVEEN PATWARI 9 JAI SHREE SHYAM

16. Subject CT8, April 2015, Question 1

(iii) Calculate the 95% Value at Risk. [2]

CA PRAVEEN PATWARI 10 JAI SHREE SHYAM

18. Subject CT8, October 2015, Question 2

(iii) Determine a, b and c. [4]

dSt  St  dt  dZt 

 Z t is a standard Brownian motion

 t is the time from now measured in years; and

The instantaneous, constant, continuously compounded risk-free rate of interest is 4% pa.

(i) Derive the distribution of S t . [2]

(a) standard deviation

(b) 95% Value at Risk relative to €20,000. [4]

20. Subject CT8, April 2016, Question 1

 Asset B is risk-free, so every £1 invested in Asset B will always be worth £1.

(iii) Express her expected utility of wealth in terms of a. [2]

CA PRAVEEN PATWARI 12 JAI SHREE SHYAM

21. Subject CT8, April 2016, Question 2

CA PRAVEEN PATWARI 13 JAI SHREE SHYAM

24. Subject CT8, April 2017, Question 1

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

dSt  St  dt  dZt 