Investments

Question 1

Investment risks

Answer 1

1. Default
2. Inflation
3. Liquidity
4. Marketability
5. Dividends (equities)

Question 2

Government uses interest rates to

Answer 2

1. Control inflation
2. Encourage economic growth
3. Manage exchange rate

Question 3

Theories of yield curve

Answer 3

LIME
1. Liquidity theory
* additional yield on less liquid bonds - normally LT
2. Inflation risk premium
*additional yield on long-term conventional bonds
*compensate for inflation
3. Market segmentation theory
*supply a d demand determine yields at each term
*demand comes from matching attempts
4. Expectations theory
*yield reflects future expectations of interest and inflation

Question 4

Economic factors affecting bonds

Answer 4

FIIERCE
1. Fiscal
2. Interest
3. Inflation
4. Economic growth
5. Perceived riskiest
6. Curreny
7. Exchange rate

Question 5

Economic factors affecting equity (secure options)

Answer 5

OPERATICS
1. Overseas equities
2. Political climate
3. Economic growth
4. Perceived riskiest
5. Alternative
6. Tax
7. Interest and inflation
8. Currency
9. Supply

Question 6

Investments selected should be appropriate to

Answer 6

CnUT
1. Currency
2. Uncertainty
3. Nature
4. Term

Question 7

Nature of benefits

Answer 7

1. Guaranteed money
2. Guaranteed index linked
3. Discretionary
4. Investment linked

Question 8

Matching options

Answer 8

1. Pure
2. Approximate
3. Liability hedging
   *approximate
   *full
4. Immunisation

Question 9

Custodian duties

Answer 9

1. Hold investment on behalf of investor
2. Independently account for financial transactions
3. Ensure financial instruments are housed under proper system
4. Bank/regulated inst
5. Services
   *income collection
   *tax recovery
   *. Cash management
   *securities settlement
   *foreign exchange
   *stock lending
   *voting

Question 10

Immunisation conditions

Answer 10

1. Pv are equal
2. Dmt are equal
   *weighted average duration of series of cashflow
   * measure of sensitivity of PV to small changes in force of interest
   *average life of investments
3. Spread about the Dmt of assets slightly more than of liabilities
   *larger convexity = higher spread =less affected by small changes in interest rates

Question 11

Limitations of immunisation theory

Answer 11

1. Profit (rules out equity ans property)
   *cut out opp to profit from excess returns
2. fixed
   *ideally for fixed interest
   *there might be lag for index Inked
3. Discounted mean term asset
   *not easy to find long term dmt
4. Curve
   *assume whole curve moves by same
5. Rearrangement/rebalancing
   *will require upkeep
6. Timing
   *?unknown timing
7. Interest
   * doesn’t work for big changes

Question 12

Valuation methods foe individual investments

Answer 12

1. Market value
2. Smoothed Market value
3. Fair value
4. Discounted cashflow
5. Stochastic models
6. Arbitrage value
7. Historic book value
8. Written up/down

Question 13

Market value valuation

Answer 13

not readily attained- unwuo

1.varies constantly-known with certainty at transaction date
2. Many quoted figures in open market at any time
3. Objective and easily obtained figure - starting pnt of val

*objective
*realistic
*easy
*well understood and accepted
*can be used for comparison

#volatile
#May not reflect values of future proceeds
#subjective decisions (mid, bid,offer)
#difficult to ensure consistency with liability basis
#value reflects position of marginal investor
#illiquidity-may notbe realised

Question 14

Smoothed market value

Answer 14

1. Where MV is avail smooth by taking some form of average over specified period to rem9ve fluctuations
2. Not great for consistent liability valuations - appropriate discount rate is indetermjnate

Question 15

Fair value

Answer 15

1. Market based method of valuation
2. Amount for which asset or liability could be excahnged/settled between knowledgeable, willing parties at arms length
3. Likely to be market price
   4 . Indicative price from brokwr/market maker
4. Use most recent adjusted for movement in appropriate index
5. Use stochastic asset modeling for market consistent value

Question 16

Discounted cashflow

Answer 16

1. Discounting the expected future cashflows from investment using LT assumptions
2. Advantage of being easily made consistent with basis of investors liabilities
3. Same approach to determine discount rate
   *portfolio of assets - use weighted average to get discount rate
   *str8 fwd for high quality fixed interest stocks

Question 17

Stochastic investment model

Answer 17

too complex

1. Extention of discounted cashflow
2. Future cashflows/ interest rates are stochastic
3. Ideal for when future cash flows are complicated- embedded options

*good for derivatives
*better pic of val
*consistent with liability val

#results depend on assumed distributions

Question 18

Arbitrage valuation

Answer 18

difficult to Replicate many assets I other classes

1. Means if obtaining proxy marker value
2. Replicate investment with combination of other investments
3. Condition - in efficient market all values must be equal

*used in val of derivative

Question 19

Historic valuation

Answer 19

little merit for other purposes

1. Price originally paid for assets
2. Used for fixed assets in published accounts

*objective
*Conservative
*well understood
*used for so.e accounting purposes

Question 20

Written up/down

Answer 20

subjective

1.Historic book value adjusted periodically for movements
2.

#not consistent to liability valuation
#cannot determine appropriate liability discount rate

Question 21

Optimal matched position

Answer 21

Matched position satisfying
1. Providers required degree of certainty in meeting liabilities at least cost
2. Incorporate regulatory requirements and investment objectives

Question 22

Investment matching

Answer 22

1. Pure
2. Approximate liability matching
3. Liability hedging
4. Approximate liability hedging
5. Immunisation

Question 23

Pure matching

Answer 23

1. Expensive
2. Difficult
3. Not enough suitable assets available

Question 24

Approximate matching

Answer 24

Immunisation

Question 25

Liability hedging

Answer 25

*Assets chosen to perform a similar way to liabilities in all events * try to get similar movements post impact *may be possible (theoretically for unit linked)

Question 26

Immunisation

Answer 26

PV(assets) - PV(liabilities) is immune to small changes in interest rates

Question 27

Discounted mean term

Answer 27

Weighted average time to receive proceeds from investment after adjusting for time value of money Helps *Measure interest rate risk *Understand when the cash flows really "matter" in present-value terms *Compare different bonds or loans more fairly *

Question 28

Duration

Answer 28

Weighted average time to payments weighted by ov of each paymeny *how much price of bond changes when interest rates change

Question 29

Convexity

Answer 29

Sensitivity of volatility of cashflows to change in interest rates **How much duration changes when interest rates change

Question 30

Conditions for immunity

Answer 30

1. Pv(liability) = pv(assets) 2. DMT(assets) = DMT(liabilities) 3. Spread/convexity about DMT(assets) > convexity about DMT(liabilities)

Question 31

Limitations of immunisation

Answer 31

1. Profit >possibility of mismatching profits and losses is removed 2. Fixed benefits >theory built on fixed monetary liabilities, can use index-linked 3. DMT > assets with suitable long dmt are hard to find 4. Curve > assume flat curve and same change along all terms is required 5. Rearrange >continuous rearrangement of portfolio to ensure conditions are met 6. Timing >not always known 7. Interest >theory is built in small changes