(Papers) ACET Paper May 2010 "ST5 – Finance and Investment A"

(Papers) ACET Paper May 2010 "ST5 – Finance and Investment A"

Q 1) You are the investment consultant to the trustees of a defined benefit pension scheme. Most of the assets are invested in fixed interest securities, but there is a sizeable equity portfolio which is well diversified. All of the scheme’s liabilities relate to pensions in payment. As a result of a global economic crisis, the trustees are looking to reduce asset and liability risks within the scheme.

a) Describe how the different types of shares within the equity portfolio will move over the economic cycle.

A global investment bank has approached the trustees with a product called a longevity swap. This swap is designed to hedge longevity risk in the scheme (i.e the risk pensioners live longer than expected).

Under the swap, the scheme will make a fixed stream of payments to the bank, known as the “fixed” leg. This “fixed leg” is essentially the expected payments the scheme expects to pay to its pensioners. In return, the bank pays an “actual” leg to the scheme, which is the actual payments the scheme ends up paying to its pensioners.

The swap will have a term of 10 years and payments are exchanged every month.

b) Discuss the issues the trustees should consider before entering the longevity swap.
c) Explain the other major risks in the value of the liabilities that the trustees may be looking to reduce.

Q 2) Explain the rationale, impact and limitations of the following investment restrictions on pension funds by the regulatory authorities:

(a) imposing restrictions regarding admissibility of assets;
(b) imposing restrictions regarding holding of derivative instruments;
(c) imposing restrictions regarding self-investment.

Q 3)
a) (i) Explain how a pension fund uses Asset Liability Modeling (ALM) in the context of investment strategy.
(ii) Describe the key stages in an ALM exercise.

b) Define the following terms:

(i) Marking to market
(ii) Arbitrage
(iii) Par Yield Curve
(iv) Reversion Interest

Q 4) An investor has been given information on two option strategies:

Strategy 1: 1 long call option with strike price Rs 50 which has a premium Rs 11
1 short call option with strike price Rs 70 which has a premium Rs 3

Strategy 2: 1 long put option with strike price Rs 50 which has a premium Rs 13
1 short put option with strike price Rs 30 which has a premium Rs 5

All the options are European, have the same term to maturity, and the underlying stock is the same in each case.

a) For each strategy, draw a diagram showing the payoff at maturity.
b) Explain what the current price of the underlying security might be.

Q 5) To complete its ambitious target of raising money through Public Sector Undertakings’s divestment, Govt of India is planning to sell 5% stake in Coal India Ltd. It has hired ABC as its merchant banker and the merchant banker has been asked to quote a price range for the IPO.

(i) Describe in detail the process ABC should follow to determine the price range.
(ii) Outline reasons why the recommended price range may be above or below the fair market value.

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