Examination: Subject SA6 Investment Specialist Applications

Faculty of Actuaries Institute of Actuaries
EXAMINATION
5 April 2005 (am)
Subject SA6 Investment

Specialist Applications
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
2. You have 15 minutes at the start of the examination in which to read the questions.
You are strongly encouraged to use this time for reading only, but notes may be made.
You then have three hours to complete the paper.
3. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
4. Mark allocations are shown in brackets.
5. Attempt both questions, beginning your answer to each question on a separate sheet.
6. Candidates should show calculations where this is appropriate.
AT THE END OF THE EXAMINATION
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.
Faculty of Actuaries
SA6 A2005 Institute of Actuaries
1 You are the investment consultant to a final salary pension fund with assets of £1bn.
The fund closed to new entrants 5 years ago, and has 2,000 contributing members,
3,000 deferred pensioners and 4,000 pensioners. The scheme actuary has advised you
that the fund s liabilities, measured using a corporate bond discount rate, are £950m.
£150m of the fund s liabilities arise from benefit payments due to be paid in the first
10 years, £450m in the next 15 years, and £150m in the subsequent 10 years.
For the past few years you have been advising the fund to improve its matching of
asset proceeds to expected liability outgo. After speaking to an investment bank, the
trustees and sponsoring employer are considering adopting one of the following three
strategies:
(1) Match expected expenditure less contributions in the first 25 years through
fixed income and inflation-linked bonds, using fixed income and inflation
swaps to improve cash flow matching further. A portfolio of 30% global
equity, 10% property, 10% private equity, 25% inflation index-linked
government bonds and 25% investment grade corporate bonds would be held
for the balance of the assets.
(2) Match 75% of expected cashflows after the first 10 years, for the next 25
years, using forward starting swaps. A portfolio of 30% global equity, 10%
property, 10% private equity, 25% inflation index-linked government bonds
and 25% investment grade corporate bonds would be held for the balance of
the assets. Expenditure for the first 10 years is able to be met from
contributions and investment income.
(3) A portfolio of 20% global equity, 5% private equity, 37.5% inflation index-
linked government bonds and 37.5% investment grade corporate bonds is held.
The chairman of the trustees has asked you to prepare a report comparing and
contrasting the three strategies above. You should assume that any bonds held have
an average maturity of 20 years. Describe the points that you would cover in your
report, including a description of the income profile of each of the proposed asset
classes, a discussion of their risks, and their suitability to match the following liability
features:
Mortality
Duration
Salary
Inflation
[54]
SA6 A2005 2
2 You have been appointed adviser to the Trustees of a £10bn. fund. The Trustees have
decided to review their investment strategy. Currently the fund invests in equities,
bonds, property and cash in the proportions 65:20:10:5 using a small in-house
investment management team.
The equity portfolio is split into three areas, Pan-European Equities, US Equities and
Japanese Equities. The portfolio has a fixed benchmark, which is subject to
rebalancing at the end of each calendar quarter.
(i) Discuss the advantages and disadvantages of the use of:
(a) a fixed benchmark for a regional asset split

(b) a benchmark based on regional market capitalisation weights
(c) one based on regional GDP weights
[12]
One of the Trustees believes that the fund should invest more widely and has
proposed that the fund invest in unquoted equities and commodities.
(ii) Outline the advantages and disadvantages of investing in each of these new
asset classes. [10]
(iii) Describe how exposure might be gained to each of these new asset classes and
the factors the Trustees should consider in comparing these alternative
methods. [12]
In the past publicly quoted companies have been acquired by private equity
firms and subsequently re-floated on the stock market some years later at a
higher valuation than when they were taken private.
(iv) Suggest reasons why this can occur. [8]
(v) Describe two methods that could be used in valuing an unquoted company.
[4]
[Total 46]
END OF PAPER
SA6 A2005 3
EXAMINATION
April 2005

EXAMINERS REPORT
Introduction
The attached subject report has been written by the Principal Examiner with
the aim of helping candidates. The questions and comments are based around
Core Reading as the interpretation of the syllabus to which the examiners are
working. They have however given credit for any alternative approach or
interpretation which they consider to be reasonable.
M Flaherty
Chairman of the Board of Examiners
28 June 2005
Institute of Actuaries
Subject SA6 (Investment Specialist Applications) April 2005 Examiners Report
In general the examiners were encouraged by the standard of answers from candidates but
some additional points are made below to help candidates appreciate what is being sought.
Candidates need to be aware that at this stage in the examinations they will be examined on a
limited amount of bookwork and that the majority of marks will come from application and
higher order skills answers. The solutions given are not all inclusive and other points could
be made that would receive marks. However they represent the level of detail expected.
On question 1 a number of candidates failed to read the question correctly and did not spot
that the portfolio outlined was for the balance of investments in options (1) and (2) and not
for the whole portfolio. This meant that they failed to pick-up numerous marks particularly
in the strategy risk section but also in the asset description section. Many candidates
failed to see the significance of the liability information given and in particular the large rise
in outgo that was implied from year 11 to 25. Candidates should try to visualise the whole
situation and not focus in too early on the specifics of the question. All information given is
there for a reason and should be used.
Question 2 had an element of bookwork in it and this was generally well done. However, as
in question 1, candidates were let down by their ability to apply their knowledge. this was
particularly relevant in parts (iii) to (v).
SOLUTIONS
1 Liability features
Mortality is unpredictable and generally non-investible although mortality bonds

are being developed.
The risk increases over time, so there is a particular difficulty with benefit payments
many years in the future.
Arguably for the most distant cashflows, there may be little benefit in reducing other
liability risks as mortality risk will be the dominant liability risk
although equity risks would still be larger, if there is a high equity allocation.
Duration can be matched in a large scheme where cashflows are relatively

predictable.
Changes to the scheme may accelerate payments.
Can invest to minimise this risk, subject to market capacity constraints (particularly
for longer-dated cashflows).
Salary growth is not investible, nor predictable.

Historically it has been believed that salaries are highly correlated to equity dividend
(or earnings) growth
although this assumes a constant (or mean reverting) distribution of wealth in the
economy between workers and owners of capital.
The evidence for a strong correlation is inconclusive, indicating a shifting distribution
of wealth in the economy.
Inflation is investible, although inflation itself is not predictable.

Benefits are not fully linked to inflation, as most are subject to a 5% p.a. cap and there
may also be some fixed benefits.
Page 2
Asset risks
forward starting swaps

fixed income and RPI swaps
global equity
property
private equity
index-linked gilts
investment grade corporate bonds
Discussion of income profile from each asset

Comments on credit and volatility risks
Suitability for each asset class to match mortality, duration, salary and inflation risks
Strategy risks
Discuss how each of the 3 strategies matches the expected benefit payments due from
the pension scheme, and (with reasons) the relative levels of risk remaining after the
strategy has been implemented.
General points
Other strategies are possible, with description

Covenant of company is a winding-up likely?
Pricing of strategies 1 and (especially) 2 is now the right time due to shape of
gilt/swap yield curve?
Costs of implementing strategies 1 and 2
Cost of dynamically altering strategies 1 and 2 especially if liabilities develop in a
different profile to that assumed at outset, compared to strategy 3
Governance/monitoring for strategies 1 and 2 is different to strategy 3
Other relevant issues will also be given marks
2 (i) Fixed Benchmarks:
They have a solid basis of a long term asset allocation policy.
They have a propensity to re-balance towards value forces selling of rising

markets and buying of falling markets.
This is advantageous if the markets are rising and falling on sentiment rather
than as a result of underlying economic trends.
However, this may prove to be a disadvantage where there is a longer term

trend.
Can be used to improve diversification.
Page 3
Capitalisation weighted benchmarks based on market size:
Will be affected both by breadth of market and also by stock prices.
They will automatically capture new developments in markets e.g. public to

private enterprise such as mass privatisations.
Their weakness is that they re-inforce trends in the markets so that if prices
rise through sentiment rather than fundamentals, they will encourage buying
that sentiment and selling stocks that are out of favour.
Can lose diversification
Re-balancing due to constituent changes and capital changes will be an issue

GDP weighted benchmarks:
This will grant greater economic exposure in a portfolio to countries which

have poor stock market representation relative to the size of their economies
and vice versa.
There may be little correlation between a country or regional GDP and its
investible securities.
With globalisation of companies, the country of quotation may not be relevant

to the weight applied.
The securities bought may not reflect the underlying regional GDP.
Increases risk of being incorrectly weighted to smaller markets
Real time comparable data may be hard come by/ not available regularly or at
the same time for each market.
All of the above have advantages and disadvantages, these is no absolutely

correct answer.
(ii) Unquoted Securities
Advantages:
Diversification, although if the unquoted companies operate in the similar

industries to quoted companies in which the fund invests there may be less
diversification than first thought.
Potentially higher returns as the security may be less well researched, leading
to pricing anomalies.
Page 4
Unquoted companies are often small and therefore can still grow rapidly even
in relatively mature industries.
Disdavantages:
The risks will be higher as often the company and the management will have
no track record.
The investment will be very illiquid and may need to be held for long time.
It will be difficult to value.
The company may be more dependent on one person.
It will require specialist knowledge to invest in this area, this will mean higher
management fees. It is unlikely that the in-house team will possess the
necessary skills, therefore a third party fund manager will need to be
employed, thus increasing costs.
The companies are likely to be less financially stable and will have less ability
to raise additional capital should the need arise.
Commodities
Advantages:
Investment in commodities would provide diversification for the pension fund.
It is possible to make significant profits from investing in commodities in

short periods, however there is also the opportunity to lose large amounts in
equally short periods.
Disadvantages:
Like investing in unquoted securities, the Trustees will almost certainly need
to employ third party fund managers.
Use of commodity shares (mining, exploration companies) gives less

diversification from equity market than physical would.
Institutions do not invest directly in commodities as this would involve

shipping and storage of large amounts of material and institutions do not have
the necessary skills or facilities.
Commodities do not naturally fit into an asset liability model as they are
neither real assets or fixed rate assets, therefore unless the Trustees can
identify an institution with a very good record in this area there is little to
justify investing in this area.
Page 5
(iii) Unquoted companies
As with quoted equities the Trustees, with the help of their advisors, should
investigate the fund managers that invest in unquoted securities. Investing in
unquoted equities requires a different skill set to investing in quoted equities.
In order to diversify the risk a portfolio of unquoted securities need to be

purchased.
The easiest way for this to occur is via some form of collective vehicle.
The collective vehicle may be quoted e.g. an investment trust.
Or it may itself be unquoted.
If unquoted then liquidity is likely to be very low.
And valuations will be infrequent.
The fees charged to manage venture capital investments are generally higher
than those charged to manage quoted investments.
Commodities
Should an institution wish to gain exposure to commodity price movements it

can do so in 3 ways.
The most obvious is via commodity derivatives which are widely traded on
major exchanges such as LIFFE and the Chicago Mercantile Exchange.
Options and futures are also available.
The futures which are available to trade fall into five main categories
Alternatively institutional investors do invest in companies whose share price

is influenced by commodity prices.
Typical examples of this is the oil and mining companies.
Investing in these companies also overcome the problems of investing directly

in the commodity itself and are generally less volatile than the commodity
futures.
There are, however, a number of disadvantages if these companies are used as

a proxy for commodity investment, these are:
It is unlikely that there will be exposure to just one commodity.
Page 6
The company s management may alter the exposure via acquisitions or

disposals or by hedging its position.
The company s share price may be influenced by other factors.
The company will incur various operating expenses which will dilute the
overall return.
(iv) The value of the company prior to being bid for may be artificially depressed
e.g.
When the VC buys the company the market may be depressed.
Or the industry in which the company operates may be going through a tough
time.
Investors may perceive that there are better opportunities elsewhere and
therefore ignore the company in question, this is particularly true of small
companies.
When the company is re-floated sentiment may have changed and/or markets
have risen.
The company may be suffering from failing management and if owned 100%
by the VC, management change becomes easier to implement.
Renewed management may turn around the company s fortunes or improve its
perception.
The company may need to restructure it operations, this may be difficult in the
quoted arena especially if investors take a short term view as the restructuring
may significantly reduce short term profitability.
VC s are generally given longer term mandates than their quoted equivalents.
The capital structure may need to be changed, possibly returns need to be

geared up or possibly the company need to reduce it borrowings. Again this
can be easier if the VC owns 100% of the equity.
When the company is floated it may be more liquid either as a result of

changing the shareholder structure (e.g. removal of a controlling interest) or as
a result of increased size.
The VC may brought about corporate activity, which has improved returns.
The above list is not exhaustive any reasonable comment should be accepted.
(v) Given that unquoted companies are not traded frequently a market based price
is not available.
Page 7
One solution would be to value the company at book cost, however this would
not take account of any changes (good or bad) that had occurred since
acquisition.
The company could be compared to a similar quoted company and a valuation

arrived at by putting the unquoted company on the same PE, or yield etc. Any
such valuation would then need to be revised downwards to take account of
the lack of liquidity.
A DCF valuation could be used with the weighted cost of capital being
increased to take account of the increased risk/reduced liquidity.
Page 8
EXAMINATION
6 September 2005 (am)

booklet.
supervisor.
question paper.
SA6 S2005 Institute of Actuaries
1 You are an investment consultant and have been asked to give advice on investment
strategy to the trustees of a UK final salary pension scheme with total assets of
£400m.
(i) Set out the considerations that need to be taken into account when formulating
an investment strategy for a pension scheme. [12]
All the invested assets of the pension scheme are actively managed by one external
fund management company that also provides custodial services through an
associated company. The trustees have asked you to conduct a full review of this
organisation. They have requested a proposal outlining, with reasons, the
investigations you plan to carry out.
(ii) Write down the headings you would include in your proposal. [5]
(iii) Set out the points you would include under each heading. [22]
One of the trustees has read a newspaper article suggesting that, over time, all
investment managers underperform market indices so everyone would be better off
with an index-tracking manager instead. The article also said it doesn t really matter
how the manager performs, if you get your asset allocation right.
(iv) Comment on the assertions of the article. [9]
Your firm has recently launched a manager-of-managers service for your clients in the
belief that it represents the best way to maximise returns.
(v) Describe the arguments you would use to sell this concept to the trustees as an
alternative to an index-tracking manager, identify the risks involved and
comment on any negative aspects of such a service. [12]
[Total 60]
2 You are the chief investment officer of an investment management company

managing over £10 billion of assets in a range of institutional and private client
mandates and with global equity, bond and derivative capabilities.
One investment trust client with a UK equity remit has gross assets of £240m, 200
million shares in issue and an unsecured loan of £30m. The loan carries an interest
rate of 7.5% and was issued with a margin of 100 basis points five years ago, with
interest payable half yearly on 5 September and 5 March, and a maturity date of 5
September 2015. Investment management fees are 1.0% of net assets, other expenses
are £375,000 and the annual dividend is 4.5 pence. The share price trades at a
discount of 14.3% to the net asset value.
(i) Draw up the balance sheet and income account for the trust assuming that 75%
of management fees and loan interest are charged to capital. [5]
Other investment trusts have been repaying their debt. The investment trust board
wishes to consider what action it should take.
SA6 S2005 2
(ii) Outline the impact that repayment of the loan might have on this trust, stating
any assumptions that you make. [8]
As an alternative, a stockbroker has suggested that he could place up to £75m zero

coupon bonds, which would mature in ten years to replace the existing debt. The
redemption amount would be £137.52m.
At the same time an insurance company that sells a product to its clients that tracks
the value of the FTSE All Share Index has offered to lend the trust money. The
insurance company will receive the dividend yield on the index as interest and a
redemption value equal to the original loan plus the capital change in the index. The
loan covenants include a condition that the size of the loan will not exceed 50% of the
net assets of the trust at any time.
(iii) Evaluate these proposals and make a recommendation to the board on the
appropriate action they should take. [13]
An investment bank has sent you some product ideas:
Product 1
A structured product offers a return of capital plus 80% of the upside of the FTSE 100
Index at the end of five years.
Product 2
A product with a term of six years offers either a monthly income of 0.6%, an annual
income of 7.5% or a capital return of 140% provided the FTSE 100 Index does not
close below 70% of its value at the date of the product s launch. If it does fall below
70%, the capital return will be reduced by 2% for each 1% that the index is below its
start value at redemption, but will be 100% if the index is above its start value. If the
index closes above 140% of its start value but has not fallen below 70% at any time
prior to that being achieved, the capital returns become guaranteed.
(iv) Outline the investment structure required to back each product and explain
how they work. [10]
(v) Explain why these products are useful and how they might be used for
different clients. [4]
[Total 40]
END OF PAPER
SA6 S2005 3
EXAMINATION
September 2005

EXAMINERS REPORT
Subject SA6 (Investment Specialist Applications) September 2005 Examiners Report
Candidates appeared to have good background knowledge and were able to cover the
bookwork sections reasonably well. They were very poor, however, in applications parts of
the questions and generally gave too little detail in the higher order skills elements of
questions. Many candidates appeared to be unaware of what was required by the verb used
to ask the question and there was a tendency to treat write down headings , set out ,
outline and describe as requiring similar answers when the examiners were looking for
increasing levels of detail.
Q1 Part (i) was well answered although there was a tendency for candidates to answer in a
general manner rather than in the context of the fund in question and several still managed to
avoid any consideration of liabilities in determining strategy. In (ii) many candidates wrote
complete report structures rather than giving just headings. This caused them a few issues in
the next part but where points were covered in (ii) rather than (iii) marks were still awarded,
candidates being given allowance for this being under examination conditions rather than in
a day to day context. Answers to (iv) covered the main points but often lacked focused
comment on the assertions. In (v) we had a good example of candidates failing to do what
was asked by describe and just listing or outlining points rather than describing the
arguments and as a consequence they failed to pick up as many marks as they should have
done.
Q2 Answers to this question were very disappointing. It was alarming that candidates could
not produce balance sheets or income statements in part (i) and many appeared to have no
idea as to how these should look and what they should contain. Most concerning was that
many treated management fees as income to the trust. In (ii) and (iii), whilst many could
remember the theory, few could apply it. The cost of repayment was ignored by many and the
impact on the trust s ability to pay dividends was missed. Most worked out the zero s rate of
accumulation and could reference it to the rate being paid on the current loan and current
rates but could not evaluate its impact and few realised how important the covenants
might be for this. The equity-linked note brought a whole range of responses but little
evaluation or cohesive argument. Candidates did earn marks for arguing an appropriate
view on the notes even if they had little information on which to base their arguments. Part
(iv) answers were frightening with many candidates showing a complete lack of
understanding of either structured products or derivatives. Given the popularity of such
products in institutional investment over the last 18 months, the lack of knowledge shown
demonstrates a severe lack of reading around the basic syllabus or being able to apply
basic knowledge. It is as well for many candidates that we do not negatively mark because
their answers showed a worrying lack of understanding. However, despite the shocking
responses to (iv), (v) did have some good structured answers although these tended to be
from those who had given better understanding in (iv).
The examiners would emphasise to candidates that they are sitting a paper in specialist
investment and that they should have a broad understanding of all investment topics.
Knowledge of CT2, CT7, CT8 and CA11 is expected along with ST5. They should also at
least be aware of the ST6 course of reading as it contains relevant background information
although passing both ST5 and ST6 is not a requirement for sitting SA6.
Page 2
1 (i) The principal aim is to meet its liabilities as they fall due.
The investment strategy should:
minimise actuarial risk
consider the liabilities i.e.
Nature (fixed, real or varying)

Currency
Term
Level of uncertainty both in amount and timing
Accounting constraints
Contribution and expense flows
Tax considerations
The investment strategy chosen will aim to most closely match their liabilities
by nature, currency and term. Even if such a strategy cannot be adopted,
alternate strategies should be evaluated against this benchmark position.
Uncertain liabilities (e.g. leavers, deaths in service) means that marketable

assets must be held.
The pension fund will also need a strategy that will satisfy the requirements of
the trust deed and rules as well as the Pensions Act 1995.
Subject to these points, the pension fund will seek to maximise the investment
return.
Under trust law the trustees have a duty to seek the best possible return in
relation to (acceptable) risk.
The attempt to maximise return may involve departing from the benchmark
position and hence conflict with the minimisation of risk. The value of the
assets relative to the liabilities will determine the risk involved.
Risk tolerance will depend largely on the attitudes of the sponsoring employer
and of the trustees.
For the purposes of the MFR, assets are taken at market value while, in most
cases, liabilities have to be discounted at rates reflecting equity returns for
active and deferred members and gilt returns for pensioners. The discount rate
is gradually adjusted from the equity level to the gilt level during a switch-
over period in the years leading up to retirement. The matching portfolio
consists of a mixture of gilts and equities depending on the maturity of the
scheme and for schemes which are close to 100% solvency level there is a
significant risk in departing from this portfolio. [It was recognised that MFR is
being abolished and so candidates may not have made these points.]
Page 3
Similar considerations apply to assessing the true solvency position with an

ostensibly gilts based target.
Pension funds are exempt from most taxes tax and returns the strategy should
make allowance for this.
The trustees need to consider the sponsors position the value in the
company s accounts is tied to corporate bond yield discount rates.
Other points that may be made are:
funding level may influence risk appetite

diversification needed to control risk
self investment risks
fund size can influence options
SIP
(ii)
Past performance
Client Relationship Management
People
Investment Process
Business Management
Custodial Services
(iii) 1. Past Performance
Investigate past performance relative to the appropriate benchmark and

style. This is an uncertain guide to the future but need to identify the
factors that led to that level of performance and to determine if they are
likely to persist or not.
Look at comparative rolling 3 year returns as a good indicator of fund

management ability across cycles.
Compare this with other large investment managers.
In additional look at the volatility of performance relative to the

benchmark this is a good indicator of the risk profile of the
manager.
Compare with other similar managers.
Page 4
In-house volatility look at the dispersion of returns achieved by the

manager for a portfolio with similar mandates to this scheme to
determine level of consistency.
Attribution analysis analyse where the performance relative to its
benchmark comes from i.e. asset allocation, sector allocation, stock
selection etc., and how this compares with the stated investment
philosophy and style.
Portfolio style analysis analyse the makeup of your scheme s stock

portfolios to make sure there is a bias towards the manager s chosen
investment styles, for example a growth style typically contains stocks
that have low dividend yields or high price to book ratios and high
expected earnings.
2. Client relationship
The quality and speed of delivery of the quarterly investment reports is

a good indication of the efficiency of the manager s mid and back
office. Given the size of your scheme s assets, your relationship should
be at the manager s executive board level.
3. People
The importance of the senior people who work for the investment
company is self-evident.
Research will examine:
The quality of senior people their experience, track record and

commitment to the business.
Depth of resources the number of investment staff involved for

each major sector, systems at their disposal, the dependence on any
star fund managers.
Continuity of staff this is a critical determinant of success. It is

important to examine whether the investment fund managers who
have achieved the returns for the scheme are still employed by the
company, and if not, what changes have been made. We will also
examine how the company plans to retain key staff.
4. Investment process
The firm should have a clear process of how it expects to outperform

the competition/benchmark.
Analyse this process in detail, looking at how research is carried out,

buy and sell disciplines and how asset allocation is determined. It is
important to try to evaluate the consistency of the process so that the
exploitation of market inefficiencies is repeatable. Relate this process
Page 5
to the performance attribution analysis carried out. The decision

structure will also be analysed in terms of its ability to enable making
fast effective decisions.
5. Business management
Examine growth in funds under management how they have planned

for and coped with growth.
Look at:
Investment in new capacity hiring new staff ahead of the new

business or improving the technology and systems to allow fund
managers to cover more clients.
Maintaining the quality of staff/not impairing the investment

process by having more people involved.
Solving the liquidity problem of growth this could affect the

firm s ability to buy/sell stocks and may require adjusting the
investment process.
6. Custodian
This may need to be changed if fund management contract is changed
Other relevant points were awarded appropriate marks.
(iv) Total investment return = risk free rate plus differential market impact (beta)
plus manager impact (alpha).
Most studies conclude that asset allocation contributes the bulk of historic
returns, around 80% or more.
If assets are managed passively then asset allocation will contribute 100% of
return.
Passive management can be achieved by sampling, optimization or replication.
Most institutional managers employ replication and achieve tracking errors

within 0.5% p.a. of the relevant market indices.
Past performance suggests that over the longer term, the average active
manager performs in line with the index.
So if you want average performance you might as well have a passive

manager.
The return is likely to be achieved and at lower cost.
Page 6
However by definition, 50% of managers do outperform the market over any

time period.
A diligent selection process should identify managers with persistent skill.
In a low nominal return environment, excess alpha will add disproportionately

to returns.
However genuinely skilful managers may cost more to employ and add to the
variability of returns which may be too risky for the trustee and sponsor to
bear.
If a passive policy is adopted though, the trustees become entirely responsible

for the returns generated.
There may be a significant increase in governance time and cost on the part of
the trustees which may offset the management savings.
(v) A manager of managers can be expensive because two layers of investment

manager need to be paid
However the manager of managers may improve returns because:
Allows assets to be managed by the best managers by each asset class and
region.
May allow better management of outperformance targets by combining

managers with different risk controls and tracking errors.
Benefit from research of investment managers by the manager-of-

managers.
Risk may be reduced if managers are chosen such that style bias is removed,
however this may lead to benchmark returns.
Client is too small to make a bespoke multimanager programme viable so a

third party offering may be optimal.
Multimanager is an increasingly popular way for consultants to generate

increased annuity income from their clients.
Claims to improve efficiency of implementing recommendations across client

base.
Greatest risk to consultant is conflict of interest and business risk

underperformance of multi manager programme may lead to total loss of
advisory mandate.
Concern over independence of advice and transparency of fees.
Page 7
As this is not a core business for the firm, it may not get the proper investment
to make it viable.
This could lead to underperformance.
2 (i) This is a straightforward calculation but needs to show the yield that is
required on the underlying portfolio to achieve the dividend.
Balance Sheet
Assets £ 000s Liabilities £ 000s
UK Equity Investments 240,000 Shareholders Funds 210,000

Debt 30,000
Total Assets 240,000 Total Liabilities 240,000
Cost of Dividend = 200m * £0.045 = £9.0m

Management Fees to Income = £210.0 * 0.01 * 0.25 = £0.525m
Interest Cost to Income = £30.0 * 0.075 * 0.25 = £0.563m
Fixed Costs = £0.375m
Total Income Required = Sum of above = £10.463m
This would then be re-sorted into a conventional income statement.
(ii) Using an approximation to current 10-year gilt rates, the premium that needs
to be paid on early redemption needs to be determined. The balance sheet and
income account then need to be reworked to see what conclusions can be
drawn.
The yield that is needed on the equity portfolio to produce the income required
is 4.36%.
Redemption yield on loan = 4.5% + 100bps = 5.5%

Value of loan = 30.0 [7.5a10 (2) + 100v10]/100 = 30.0 * 115.84 = 34.752
Ignoring dealing costs, marketability issues, tax implications and other

expenses and assuming that early repayment is permitted,
the fund will shrink to £205.248m.
Assuming that the portfolio has been prorata reduced i.e. the yield is still the
same, the income received will be £8.949m.
This is insufficient to meet the dividend and so a dividend cut is likely to be a

consequence of the repayment.
(iii) Each bond needs to be evaluated to show the impact that it would have. The
zero might have some attractions given that income could be enhanced but
breakeven points will need to be determined. The equity loan stock is
Page 8
interesting and draws out the effect of stock selection and dividend yield on
returns.
First the current breakeven position needs to be determined. The capitalised

costs are £1.575m + £1.688m = £3.263m or 1.36% of total assets.
The yield requirement from earlier was 4.36% and so the total return required
is 5.72%.
Zero Coupon Bond
The annual return on this is 6.25%.
By replacing the debt, total assets become £280.248m and net assets are
£205.248m. The breakeven capital cost becomes £6.227m = 2.22% of gross
assets. The income required to meet the other costs and the dividend becomes
£9.888m = 3.53% of gross assets, giving a total return requirement of 5.75%.
The quality of the portfolio is likely to have improved since the equity
dividend yield required has fallen from 4.36% to 3.53% c.f. 3.05% for FTSE
All Share.
Equity Index Loan Stock
Assume that we replace the loan with £75m of this stock. Therefore the fund
size and management cost figures are the same as the zero. However the
annual return for this bond is variable as the capital cost is a function of the
index return and so therefore will the breakeven.
To cover the management cost charged to capital requires 1.539/205.248 *

100 = 0.75%.
The income costs are 9.0 (dividend), 0.375 (fixed), 0.513 (management) and
2.288 (bond yield) = 12.176 = 4.34%.
Assuming that it is market movement that covers the cost and not good stock
selection the latter would not result in a capital cost for the debt the
return required is 5.09%.
A variety of conclusions are possible and so this should show understanding

by candidates. Comments on quality of income yield, early repayment risk,
stock selection v market return v fixed cost comparisons should be made in
coming to a view. There is no single appropriate answer and this should be
brought out by candidates.
Page 9
(iv) This is a case of showing the bond/derivative combinations required to make

these happen. The first is capital orientated and uses zero coupon bonds +
bought derivatives.
Between 75% and 80% of the investment goes into zero coupon bonds with an
annual return of ~5.25%. This provides the capital guarantee .
The balance is used to buy FTSE100 call options at the current market level.
Changing volatility levels will result in different levels of participation being

offered.
The second product uses income bearing bonds and complex derivatives.
The above average income is achieved through the use of corporate bonds and
the cross-subsidy from the capital only version to the income versions.
The derivatives are of the up and out and down and in variety being triggered
when the index hits one or other of the 70%/140% levels of the start value.
They are dependent on each other and only one is ever exercised.
These are normally issued in the form of notes by the investment bank and so
the product has a credit risk related to the bank.
(v) This again allows the candidates scope but in essence we are looking for
answers relating to gearing investment view, alternative asset classes, low
costs and enhanced returns.
END OF EXAMINERS REPORT
Page 10
EXAMINATION
3 April 2006 (am)

booklet.
supervisor.
question paper.
SA6 A2006 Institute of Actuaries
1 You are the Chief Investment Officer of a non-life captive insurance company
operating multiple lines of insurance, with approximately similar amounts of short,
medium and long tailed sterling-based liabilities (99% of claims settled within 3, 7
and 20 years respectively). The assets of the company are £500m and the liabilities
are £520m on a best estimate basis and £650m on a 95th percentile basis (discounted
at a risk free rate).
The Board of Management responsible for investing the funds backing the liabilities
has a policy that bonds are used to match closely long term liabilities and other assets
are held to maximise return for a given tracking error relative to short and medium
term liabilities. Risk budgeting and efficient frontier methods have been used to
construct the portfolio. As a consequence of this policy, the assets are currently
allocated as follows:
UK equity 15%
Global ex-UK equity 15%
European private equity 5%
Property 5%
Commodities 5%
UK investment grade corporate bonds 30%
Index-linked gilts 20%
Cash 5%
Global equity currency exposures are approximately 75% hedged but no hedging is
undertaken in respect of any other asset classes. The Board of Management have
asked you to undertake a review of their current investment policy and whether it
remains appropriate.
(i) (a) Describe how to construct a portfolio of assets that will cashflow
match the liabilities. [5]
(b) Give reasons why the insurer may not have followed this approach. [4]
(ii) Explain the risk budgeting process and how it might be used to compare
different asset strategies for the insurer s assets. [10]
(iii) Discuss why the insurer might have chosen to hedge only 75% of currency
exposures arising from global equities and what benefits and problems may
arise in hedging currency exposures for other asset classes. [10]
The Finance Director has queried why you have selected asset classes that neither
maximise expected return nor minimise volatility under your asset model.
(iv) Outline the points you would make in your reply. [5]
Two years later the parent company advises the Board of Management that there is
little benefit in continuing the operations of the captive insurance company. Rather
than attempting to wind up the captive insurance company and buy out the remaining
liabilities, it is agreed to run off the business since it is felt that reinsurers are taking a
somewhat cautious view of future investment returns and future claims experience.
Claim and expense payments have totalled £150m over the intervening two year
period. You may assume that risk free interest rates have been stable at 5% per
SA6 A2006 2
annum and that no new information has been gathered that could be used to improve
the liability estimates from two years ago.
(v) (a) Calculate an estimate of the liability value at the current time, stating
all assumptions you have used.
(b) Recommend with reasons an appropriate asset allocation using only

the asset classes mentioned earlier in the question. [12]
(vi) (a) Describe with reasons how the asset allocation should evolve over the
next ten years. [4]
(b) Based on your suggestion, recommend a target asset allocation to

apply at the end of the ten year period.
[2]
[Total 52]
2 A UK charity uses the income from its investment fund to meet its expenditure on
administration and projects as it receives no new funding. The costs of managing the
fund are 0.2% of assets plus £100,000 per annum. The current expenditure of the
charity after allowing for these expenses is £3.5 million. Historically expenditure has
risen 50% in line with inflation and 50% in line with earnings reflecting the mix
between materials and labour.
The investment fund is distributed currently as follows:
£m Historic Yield
UK Equities 90 3.6%
Overseas Equities 5 1.0%
UK Gilts 10 4.5%
Cash 2 4.0%
Total 107
(i) (a) Analyse and comment on the financial situation that the charity finds
itself in. [6]
(b) Outline any additional information that you would need to confirm
your analysis. [2]
(ii) Explain the options the charity has available to its investment fund to improve
its financial situation, assuming no other asset classes are available to it. [7]
A trustee of the charity has suggested that a part of the fund should be invested in
property.
(iii) (a) Outline the reasons why this proposal is worth considering. [3]
(b) Suggest a level of investment that might be appropriate. [1]
(c) Indicate the impact this might have on the charity s finances. [2]
SA6 A2006 3 PLEASE TURN OVER

After some discussion, it has been agreed that as a first step, £10 million will be
invested in property and the following portfolio has been proposed.
Property Amount No of Rental Occupancy Next Rent Review

£m Tenants Income
£ 000
Office block 2.5 5 140 80% 06/2007

(3 floors)
Shopping Mall
(2 floors) 4.0 22 170 95% Various 2006 2010
Warehouse 1.25 1 100 100% 12/2008
Child Care
Nurseries 2.25 1 150 100% 06/2010
(4 properties)
(iv) Comment on the proposed portfolio highlighting the additional information

that you would require to complete a report to the trustees. [9]
A property manager has suggested that 60% of the purchase should be funded using a
bank loan.
(v) Outline the points you would make to the trustees on the effect of this
mortgage proposal. Give a recommendation with reference to the proposal. [8]
One of the trustees has seen reports that pension funds have been using hedge funds
and structured products to reduce their risk and enhance returns.
(vi) Explain the nature of such investments and illustrate how they might be used
in the context of the charity s objectives. [10]
[Total 48]
END OF PAPER
SA6 A2006 4
EXAMINATION
April 2006

EXAMINERS REPORT
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.
M Flaherty
June 2006
Comments
The solutions given below cover the most important points for candidates but
additional points can be made and appropriate marks were awarded for these.
Alternative solutions are possible for certain parts of both questions (1(v) and (vi) in
relation to asset allocation, 2 (ii) and (iii) in relation to alternative strategies
provided they fitted the problem) and, provided that these were argued and
documented in a similar fashion to the one given, marks were awarded.
In general candidates who failed did so because they did not cover points in sufficient
detail or apply their knowledge. In 1(i) swaps appear to be known to only a few. Risk
budgeting in (ii) was generally well explained but lacked detail about assumptions,
timescales and tracking error. 1(iii) and (iv) were reasonably well answered
although many candidates appear to have forgotten about correlation and its
implications. In (v) candidates could work out the value of the liabilities but had
more problems with the assets with few commenting that the deficit might have been
removed. Candidates who failed mainly did not provide sufficient detail on the
liability duration and so had no starting point from which to base their proposed
asset allocation and the appropriate reasoning for it. This was also a feature of (vi).
In question 2 a high proportion of candidates appear to have interpreted after

allowing for as including management expenses in the £3.5 million. This creates a
different position for the charity less income constrained and so allows different
answers to (ii). Marks were awarded in (ii) for reasoned argument where this
assumption had been made in (i). There was evidence that poorer candidates were
not using all the information given to them and many provided solutions that looked
for a quick fix, including the unacceptable use of capital to supplement income,
without thinking about the longer-term issues. There were some totally
inappropriate short-term orientated strategies put forward. Parts (iii) and (iv) were
reasonably answered with poorer candidates tending to be too bookwork orientated
and failing to apply their knowledge to the portfolio in question. Part (v) showed a
lack of knowledge about mortgage/property loan rates which resulted in many
dismissing the proposal without fully analysing the issues. Part (vi) saw lots of
knowledge being written down but little relating to how the products could be used by
the charity.
Page 2
1 (i) (a) Matching portfolio:
If there was no uncertainty about the sizes of the claim payments, nor their
timing, then it would be possible to construct a cashflow profile for the
insurer s liability outgo.
Given this, risk free fixed income and index-linked bonds and/or strips could
be purchased so as to match the liabilities by duration exactly.
As virtually all of the payments will be made within 20 years, there are no
issues in terms of finding bond issues of appropriate duration.
Although durations will be correctly matched, it is unlikely to be possible to

exactly match cashflows as there will not always be bonds of the correct term.
Swaps can be used to further improve the profile of the asset proceeds and
match the anticipated cashflows exactly.
Using swaps will have a transaction cost but this may be offset by the reduced
future transaction costs as no/little rebalancing would be needed in the future.
Also using swaps may increase the yield on assets slightly as there is a swap
spread which reflects a small amount of counterparty risk and illiquidity risk
(once a swap has been transacted) relative to government bonds.
(b) Reasons:
In practice there is considerable liability uncertainty for a general insurance

portfolio, and this limits the usefulness of this approach.
The insurer would not necessarily be able to exit the swap transaction on
favourable terms if the liabilities were brought forward.
With bonds there is greater liquidity but the issue still applies.
A further disadvantage is that such an approach is based on risk free or swap

yields, and in this scenario the assets have a less than 50% probability of being
sufficient to cover the liabilities if they do not have a return above this level.
Therefore additional capital would be needed from the parent to support the
business (it may already be needed to cover statutory solvency margins but
ultimately this would be returned).
(ii) Definition:
Risk budgeting is a method of optimising investment efficiency (based on

assumptions) with the aim of maximising return for a given level of
investment risk.
Page 3
In a risk budgeting framework, return and risk are generally measured relative
to liabilities.
Risk budgeting involves asset and liability projections over a time horizon
although different implementations will vary in the level of detail in their asset
models and liability projection models.
Asset models will usually be stochastic in nature so that the distribution of

outcomes (typically the 95th or 99th percentile return is extracted) is available
as well as key statistics (e.g. mean, variance etc.).
Assumptions:
Risk budgeting requires assumptions about expected return, volatility and the
correlations between the different asset classes available to the investor.
These assumptions should be appropriate for the projection period.
The framework can be extended to allow for expected return, volatility and
correlation of an asset manager who is actively managing their position
relative to a benchmark.
Care is needed in setting the assumptions as these will have a key impact on
which asset classes and/or asset managers appear most attractive.
Setting the risk budget:
Before the risk budgeting process can be used to optimise the asset allocation
a key initial decision is how much risk relative to liabilities ( tracking error )
is desired.
The above question may itself be dependent on an investor s constraints e.g.

required return to target assets equal to liabilities after x years, or VaR (loss at
95th percentile) below a certain size.
Therefore the risk budgeting process may initially be run using broad
portfolios to attempt to assess the risk budget across the full range of asset
allocations (from 0% in risky assets to 100% in risky assets) before optimising
using the full opportunity set of asset classes in a narrower range.
Optimising the asset portfolio:
Once the risk budget (target tracking error) has been set, various portfolios are
run through the risk budgeting model and their returns and tracking errors
relative to liabilities are compared.
To speed up the iterative process of assessing asset classes, it is normal to look

at marginal changes in risk and return for a small (e.g. 1%) increase in the
allocation to each asset class.
Page 4
After iterating through a range of portfolios and assessing which of the

portfolios have most attractive return and risk characteristics the portfolios can
be checked to see that they are acceptable from a qualitative perspective to the
investor.
Those portfolios that are acceptable will (subject to the modelling

assumptions) be close to optimal.
Miscellaneous:
If the composition of portfolios on the efficient frontier is required, then these

can be obtained using mean-variance optimisation.
This approach does not yield the full range of statistics that a stochastic risk
budgeting model would.
(iii) Overseas equities:
Overseas equities are helpful in terms of diversifying equity risk, particularly

in view of the concentration risks of the UK equity market (the top 10 stocks
make up half of the FTSE All Share Index by value).
However, investment in overseas equities exposes an investor with UK

liabilities to currency risk.
Therefore this would not be an issue for UK investors with no constraints,

although such investors are rare.
Currency risk:
Currency risk is potentially a useful diversifier of portfolio investment return

as it has a low correlation to asset performance generally.
However it has an expected return of zero over long periods, and therefore if
there is more than a modest amount of currency risk present in the portfolio
then this is an unrewarded risk (relative to liabilities) and the risk taken should
therefore reallocated to a form of risk which is rewarded.
At times there may be a small positive or negative return through hedging due
to structural differences in short term cash rates between different currencies.
Hedging:
By hedging currency exposures, this unrewarded risk can be reduced or

removed.
For an overseas equity portfolio, over 75% of the currency exposure would
typically relate to the 3 major currencies (US dollar, Euro, Yen), and can
therefore be easily hedged at low cost.
Page 5
Therefore 75% is likely to be a pragmatic choice of hedge ratio.
The hedging could either be done based on actual exposures or on an

approximate basis. If done exactly then the hedge will need to be reviewed
periodically, potentially increasing transaction costs and overheads.
Other assets:
Of the other assets in the portfolio only the private equity and commodities
will have currency risks attaching.
Assuming part of the private equity fund is invested in the UK a suitable

hedge ratio might be in the region of 50 75%, hedging Euro exposures.
For commodities a suitable hedge ratio is less clear.
However prices for commodities are usually quoted in US dollars and a large
proportion of most producers costs will be dollar-linked and similarly the
USA accounts for a large proportion of world demand. Therefore a hedge
ratio of 50% to 100%, based on linkage to the dollar, could be justified.
(iv) Under an asset model there are three sets of parameters relating to each asset
mean, variance and correlation.
Correlation measures the degree to which returns for different asset classes are
linked .
This means that a diversified portfolio of weakly correlated assets will be

more attractive from a portfolio perspective that a less well diversified
portfolio or a portfolio comprised of more highly correlated assets, assuming
similar mean and variance characteristics for the constituent assets.
Similarly, a linear combination of the risk-free asset and the asset with the
highest mean/variance ratio is unlikely to be the most attractive portfolio for
intermediate target mean or variance figures, as there is no diversification
benefit which would reduce the portfolio variance for a given portfolio mean.
This is particularly the case when looking at the tails of a distribution, e.g. the
VaR at the 95th or 99th percentile.
Another measure of the degree of attractiveness of a portfolio is to look at the

50th percentile (median) compared to the mean. Positively skewed portfolios
are less attractive and more highly diversified portfolios will have a smaller
difference between the two statistics (with the mean being higher for a typical
asset distribution) than less well diversified portfolios.
This holds true except:
at the extremes of the distribution (ie if the target portfolio mean is set at too
high a level only one or two assets will have a sufficiently high mean return to
Page 6
be included in the portfolio, and similarly if the target portfolio variance is set
at too low a level).
if there are one or two asset classes that a very attractive in terms of
mean/variance ratio and/or correlations are high for all asset classes.
(v) Of the initial £520m liability, around £175m relates to each of short, medium
and long tailed claims.
Based on a cost of £150m over a two year period it would appear that the
original liability estimate was broadly reasonable
since one would expect the three year best estimate payout to be somewhat
over £175m (depending on how many of the medium tailed liabilities have
been paid; few of the longer tailed liabilities will have been paid).
A current liability figure might be:
525 1.052 150 1.05 £421m
The asset value is likely to have increased by more than 5% p.a. over the two
year period, based on its asset allocation. Therefore the assets and realistic
liabilities may be approximately equal now (or the deficit will be much
reduced).
It would be possible to allow for this by adopting a lower risk asset allocation
and matching liabilities more closely, however this would then leave the
insurer vulnerable to higher liabilities than expected if experience is poor.
If there is ultimately a surplus this will revert to shareholders and therefore

there is likely to be some incentive to take some investment risks from a
shareholder perspective.
After 2 years the liabilities will be approximately as follows:
Short: 175 1.052 140 1.05 £46m due within 1 year
Medium: 175 1.052 10 1.05 £182m due over next 5 years, midpoint
2.5 years say
Long: 175 1.052 £193m due over next 18 years, midpoint

10 years
For a similar level of risk a suitable broad asset allocation might therefore be:
11% cash/money market instruments

43% bonds of term up to 10 years (including inflation-linked)
46% risky assets (equities, private equity, property, commodities)
Page 7
Within the risky asset category it would not be appropriate to alter the
allocation to private equity and property so these would remain approximately
8% each (allowing for growth and liability payments being met from cash and
bonds).
UK equities, global equities and commodities would be allocated in proportion

to their original allocations for the rest of the risky asset portfolio.
Corporate bonds and index-linked gilts would be allocated in a 3:2 proportion

for the bond portfolio.
The asset allocation would therefore be:
UK equity 13%
European (inc UK) private equity 8%
Property 8%
Commodities 4%
UK investment grade corporate bonds 26%
Index-linked gilts 17%
Cash and money market instruments 11%
(vi) (a) In 10 years time (12 years) virtually all of the short and medium tailed
liabilities will have been paid out.
About half of the long tailed liabilities will have been paid out and the
balance will be due over the next 8 years.
At this time it is likely that the private equity investment will have
matured, unless it has been reinvested.
For liquidity reasons it will be appropriate to sell the property and

commodity investments (at a suitable price) if they are still present in
the holdings.
The diversification argument for holding property and commodities is

less relevant as only 25% or less of assets are to be held in risky assets.
Therefore a possible broad allocation might be (ignoring surplus):
12.5% (or possibly more) in cash

62.5% in bonds
25% (or less) in risky assets
Page 8
(vi) (b) The asset allocation should therefore be:
UK equity 11%
European (inc UK) private equity Nil
Property Nil
Commodities Nil
UK investment grade corporate bonds (under 10 years) 38%
Index-linked gilts (under 10 years) 25%
Cash and money market instruments 15%
2 (i) The current income being generated is
[90 * 0.036 + 5 * 0.01 + 10 * 0.045 + 2 * 0.04] = £3.82 million.
Expenses are £100,000 + 107 * 0.002m = £314,000.
Therefore the fund just meets the trust s current expenditure.
Any loss of income is critical.
Looking at the portfolio, the yield on the UK equity portfolio has a high yield
ratio (120%~).
Need to look at how sustainable this is and what growth might be seen.
Overseas equity yield is low and requires further investigation.
The gilt portfolio needs to be checked to see if the yield is being obtained at
the expense of capital.
We need to review whether cash has been held historically or if this is just a
snapshot at a point in time.
(ii) The problem that the fund has is that it is only just making its revenue
requirement and the outlook is challenging.
Given inflation of say 2.5% and earnings growth of say 4 5%, the revenue
needs to grow by 3.5 3.75% each year to maintain the expected expenditure.
Gilts and cash do not do that.
Therefore pressure on equity portfolios to achieve it as switching asset

allocation to gilts would just put off the time when outgo will exceed income.
Next year we need to generate £3.95million (approx) which would require the
UK equities to yield 3.75% at today s value.
We could do nothing and hope for a 4%+ rise in dividends.
Page 9
Alternatively we could move the overseas equities to either UK equities or

gilts.
Either way we would improve the position.
(iii) As the charity uses only the income from the fund, the illiquid nature of
property is not an issue.
Further as an asset class it is a good diversification

property yields are both higher than equities and bonds
assuming all yields are shown net of higher annual management charges
and tend to rise at least in line with inflation.
The level of investment needs to take into account loss of income risk if voids
were to occur.
An appropriate amount might be up to 25% of the fund but it would best be

done in stages.
A strategy for selling existing investments to fund the purchases would need to
be drawn up.
Assuming a property portfolio would yield about 6%, this would enhance the
income stream and allow changes to the equity yield ratio to allow for possibly
more long-term growth.
(iv) Well diversified, solid yields and fits the mandate.
Period to next reviews reasonably spread.
Office block has scope to enhance returns due to void.
Shopping Mall negotiations could be convoluted given number of tenants and

timing of review could be an issue given consumer downturn.
Yield of 5.6% helps revenue account and gives portfolio time to be adjusted.
Additional information required is detail of each lease, nature of space

available in office block, structure and nature of mall leasing, options that any
tenants may have, financial strength of company leasing warehouse and
nursery company, location of properties, rental incomes of similar properties
in same locations, likely property development in each area.
(v) Cost of debt will be crucial to proposal.
Needs to be around 50bps lower to make it workable.
Will it be non-recourse lending?
Will it be property by property or for the portfolio as a whole?
Page 10
If both options available, will interest rate be different?
What will covenants be?
If you can borrow at say 5.1%, yield becomes 6.35%, enhancing portfolio
revenue.
Term of loans required to fit with reviews/ possible sale plans, loan conditions
require to be studied.
Any reasoned argument should get marks but the best recommendation might
be to mortgage the properties other than the mall with a slight reduction in
yield. Loan against all properties rather than individual preferred.
(vi) Hedge funds come in many forms but in the main give a capital return rather
than an income.
Thus not that useful in this context, although good risk diversifier and could
grow capital to grow income.
Basically try to leverage return from difference in movement between two

investments.
May be absolute in nature rather than relative performance orientated.

and have high fee levels.
Structured products use combinations of conventional investments and

derivatives to produce guaranteed or protected returns .
Come in many forms and can use both up and down performance to derive
returns.
Normally provide both minimum and maximum returns linked to market

movement but subject to floor and ceiling levels.
Structured products may be used to generate capital or income.
These might be useful to the fund especially if they could provide inflation
linked return.
Cost effective as low management charges and can be tailored to purpose.
END OF EXAMINERS REPORT
Page 11
EXAMINATION
11 September 2006 (am)

booklet.
supervisor.
question paper.
SA6 S2006 Institute of Actuaries
1 You are the investment consultant to a board of pension fund trustees who have
fiduciary responsibilities for a retirement benefit fund.
You have been hired to advise the board in relation to all aspects of the selection of
investment managers.
You have been asked to advise on two bond fund managers who have provided the
following information:
Manager A Manager B
Ownership large retail bank private partnership

No. staff 400 80
Process fundamental research model driven
Decision making chairperson committee
Manager discretion limited none
Execution of trades by each manager central dealing desk
Remuneration salary plus annual bonus salary plus share of profits
Assets managed £100bn £10bn
No. Clients 40 140
Outperformance +100bps +50bps
Tracking error +100bps +50bps
Fees 15bps 10bps
Back Office Outsourced In house
(i) List the principal factors you would recommend the trustees should consider
in deciding which manager to select. [4]
(ii) Assess each manager against these factors and state what further investigations
you would make before you would be able to make a recommendation to the
trustees. [23]
(iii) Briefly describe the behavioural issues which may affect the trustees when
selecting or terminating an investment manager. In each case give an example
specific to the situation. [18]
(iv) Describe four possible outcomes of regret aversion. [6]
(v) (a) Describe the concept of a utility function in the context of the trustees
making their manager selection decision.
(b) Discuss why financially sub optimal manager selection decisions may
occur or be allowed to persist. [7]
[Total 58]
SA6 S2006 2
2 You are the Director of Investments for a pension fund with assets valued at £10bn.
The fund is sponsored by a multi-national organisation and manages its assets using
both internal and external investment managers. Historically the fund has always
followed an active management approach for all asset classes.
Following an actuarial valuation of the fund and an asset and liability modelling
study, you have been set a strategic asset allocation of 60% in global equities with the
balance of the fund to be invested in global bonds and property.
You are required to make a quarterly report to the Investment Committee responsible
for governance of the fund. At the last meeting the Chairman of the Investment
Committee asked for your assistance in determining appropriate benchmarks against
which to monitor the performance of the fund s investments.
(i) List the questions that should be addressed as part of the monitoring and
performance appraisal process. [7]
(ii) State the key qualities of an appropriate benchmark. [6]
(iii) In choosing an investment performance benchmark for the global equity

portfolio, describe the main advantages and disadvantages of using a market
capitalisation based total return index from a single provider such as MSCI as
compared with using a blend of quoted indices such as Dow Jones 30,
FTSE100 and TOPIX? [18]
The Investment Committee believes the fund should be invested in smaller companies
and emerging market equities as well as larger companies.
(iv) Describe the main benefits of having separate fixed benchmark allocations and
rebalancing limits for smaller companies and emerging markets. [6]
(v) Discuss briefly the other issues the Investment Committee would need to
consider in selecting an appropriate benchmark for these sectors. [5]
[Total 42]
END OF PAPER
SA6 S2006 3
EXAMINATION
September 2006
Subject SA6 — Investment

EXAMINERS’ REPORT
Introduction
M A Stocker
November 2006
© Faculty of Actuaries
© Institute of Actuaries
Subject SA6 (Investment Specialist Applications) — September 2006 — Examiners’ Report
General comments
This diet saw a continuation of an unfortunate trend for candidates to reproduce large tracts
of irrelevant bookwork with little demonstration of the ability to apply this information or
develop practical conclusions that would underpin an implementable solution in a real world
client situation. The investment syllabus lends itself to innovative applications of basic
concepts, more so than the pensions and insurance subjects and the examiners would expect
candidates looking to specialise in this area to demonstrate better understanding and
application skills.
Comments on individual questions
Q1 (i) Straightforward and most candidates picked up some marks on this although
many seemed unable to answer the specified question and cover topics that
were relevant to (ii).
(ii) Candidates tended not to answer in the context of the question, supplying
general answers rather than focused ones. As a consequence they scored only
around half the available marks.
(iii) This was generally done well with many candidates able to outline the
behavioural issues. However many failed to give appropriate examples.
(iv) Responses to this part were mixed with poorer candidates being caught out by
lack of understanding.
(v) Many candidates had no idea of the concept of a utility function. Poorer
candidates were unable to explain the “human nature” aspects that caused
the sub-optimal manager selection.
Q2 (i) This part tended to result in more brain dumps and many answers covered
aspects that were not required (although as always candidates were not
explicitly penalised for this).
(ii) This was effectively bookwork and so scoring was generally reasonable.
(iii) Candidates tended to answer in the general rather than the specific context.
They therefore covered the indices mentioned in detail rather than putting it in
the context of the global equity portfolio that was to be monitored.
Consequently answers contained lots about the structures of the indices
themselves but little about the issues of the different structure that the portfolio
might have and how this could be addressed. On average candidates scored
around 20–22 out of 36.
(iv) Candidates were poor at answering this part. We tended to get answers about
why smaller companies and emerging markets were a good idea rather than
what was asked. Where answers did try to do what was asked, they missed
many of the specific points.
(v) This was probably the poorest part for answers with few candidates having
any ideas although many did collect “carry-back” marks for giving answers
here that they should have covered in (iv).
As always those who failed didn’t give enough bookwork points, tended to brain dump rather
than answer the specified question, were weak on application and scored very poorly on
higher order skills. The examiners gave marks for relevant points and arguments not
necessarily on the marking schedule. Q1 (iii) and Q2 (iii) were the areas that tended to sort
out the passes and failures.
Page 2
1 (i) Decision making
Quality of business management

Quality of the investment team that will manage their assets
Perceived level of skill
Risk management process
Expected level of service
Past performance data
(ii) Quality of business management
Ownership — A +ve financial security of larger parent, can provide capital to

fund new systems, staff recruitment and provide continuity/stability of
ownership.
A –ve, may be small part of bigger business given little focus, internal funds
may be given higher priority.
B+ve – partnership allows clear focus,

–ve partnership structure may lead to decision by committee (all partners),
meaning consensus decisions. May lack capital for investment. May be open
to takeover / loss of ongoing business stability.
Remuneration policy for B encourages staff to develop the whole business and
fosters an ownership interest. A has a shorter term reward structure which
may encourage short term behaviour.
Stability of ownership.
Perceived commitment of Manager A’s parent to the asset management

business.
Neither manager remunerates investment staff on the basis of performance.
No long term incentivisation (such as deferred bonuses) as an aid to retain key

staff.
Importance of incentivising fund managers and researchers/analysts separately

on the basis of their respective performance.
Quality of the investment team that will manage their assets
Numbers of staff not directly relevant as no clear split between managers/

support staff, however A outsources back office so has more investment staff.
We are not given any information on the age/qualifications/experience/length

of tenure of staff. Likely that B has lower turnover of staff given partnership
structure and longer term nature of remuneration.
Page 3
Important to strike balance between long serving staff and bringing in new
talent with experience elsewhere in marketplace.
Assessing staff turnover, particularly of key staff.
Culture/strength of team culture.
Decision making
Decision making by single chairperson under A ensures that a decision is

made which will be implemented into portfolios. It requires a skilful
chairperson to ensure that all views are effectively accounted for.
Decision by committee in B allows all to contribute but will likely result in a

consensus decision which may not be the best decision or be a non decision.
Allowing manager discretion fosters individual managers to take active

ownership of these funds. It also allows clients to benefit from individual
manager expertise and market timing.
Not allowing any manager discretion ensures that all clients with similar
mandates and objectives have a low dispersion of achieved returns. High
dispersion is well and good for those with higher returns but can appear unfair
to those with lower returns — which can generate business and reputational
risk.
Perceived level of skill
Process — key is to have a process that allows effectively the views of key
people to influence the portfolio construction. Quality of research will be a
major influence. A has +ve of doing fundamental research. B uses model
driven process which may limit scope for all key individuals to effectively
contribute. B has advantage of ensuring that the model will at least generate a
decision.
A has 10× the assets of B, meaning A will have significantly more market
presence and influence than B. This may lead to an information advantage or
at least the ability to have better access to investment bank research. A may
suffer capacity limits in terms of executing trades in the market if their
required dealing size is above normal market size. Note we are discussing a
bond mandate so normal market size larger for government bonds. Will be
smaller for corporate bonds. Manager A, being a manager with significant
assets under management, would need to demonstrate that it can be a “nimble”
investor and take advantage of investment opportunities without being
encumbered by its large size.
Page 4
Risk management process
We are not given any direct information on risk management processes. Some
inferences can be made though — B has more direct control of back office
operations.
B uses a centralised dealing desk, separating the decision making function

from the dealing function may improve compliant dealing. However it may
introduce time delay and rely on personnel distanced from the market makers
both of which may lead to inefficient dealing.
Expected level of service
A has many more staff and many fewer clients than B. A should be in a
position to offer efficient and tailored client service. Has B undergone a
period of rapid expansion — it may suffer if it has not staffed up / planned
appropriately.
A has outsourced back office so should be able to concentrate on core fund

management business. Also better able to cope with expansion.
B has more control of back office function but it will reduce management
time/focus on investment management.
Past performance data
A has higher achieved performance. A has higher active risk. Measure of

skill is the information ratio A = 1, B = 1. Risk averse trustees may prefer B
who has same IR but lower active risk.
Better measure is the net information ratio A = 0.85, B = 0.8. Both are high,
A is better.
Lots of caveats about using past performance data:
Link between past and future performance is tenuous.
What factors, internal to the fund manager, likely to have influenced

performance have changed and which remain the same.
What period is involved?
What were the economic circumstances during the period considered. At least
a complete business cycle should be considered.
Were widely accepted standards for performance measurement and reporting

adhered to.
Were the risk levels similar?
Page 5
Are the staff who generated the past performance track record still employed,
and in the same roles, at the house?
Do the managers have the same mandates/mandate restrictions? Is the

benchmark the same?
(iii) Regret aversion — Feeling of sorrow after making a decision which turns out
to be wrong.
New manager underperforms.

Old manager outperforms.
Loss aversion — investors have a strong desire to avoid losses. In other words
investors have skewed preferences and are more unhappy about a decision
which results in a loss than they are happy about a decision which leads to the
same size of profit.
In this specific the trustees will prefer an asymmetric distribution of payoffs,

hoping that gains will be more likely than losses and that the chance of very
large losses can be avoided. This contrasts with the symmetric view of risk
expressed by the standard deviation of return, which is the commonest used
measure of risk.
Overconfidence — people are generally overconfident about their knowledge

and abilities. This may lead to the Trustees having too high an expectation of
future fund returns as they are overconfident at selecting successful investment
managers.
Framing — refers to the importance of context in the way people make

decisions. The way a problem is presented to a group may influence the
course of action taken.
For example if the reference point for the trustees is presented as the total
return on the portfolio they may make a different decision that if they focus on
the relative return.
Mental accounting — refers to the need of individuals to record, summarise,

analyse and report the results of transactions and financial events. A problem
can arise when individuals do not fully account for all aspects of the decision
and therefore do not take a fully considered decision. An example would be
where trustees split their total portfolio down into manageable parts, possible
the cash element, the bond element, the equity element etc, and mentally
summed these parts, without properly accounting for the covariances and
hence not properly considering the portfolio as a whole.
Over simplification — This relates the human instinct to find simple rules and
patterns to simplify decisions. This may lead to the trustees relying on
shortcuts based on their past experiences. For example if the trustees have
experience of a poorly performing manager turning into a top performing
manager they may believe that this will be the general case.
Page 6
Over simplification is compounded by cognitive dissonance which is the

mental anguish that results from being presented with evidence that out beliefs
and assumptions are wrong. More intelligent individuals can construct
reasonable arguments to allow them to believe that new information is
consistent with existing beliefs.
Familiarity bias — people attach less risk to things with which they are
familiar. Trustees may decide to retain an existing manager or appoint a local
manager rather than a new, unknown manager.
Performance Myth pitfalls — past performance data has a tenuous link to

future performance. Trustees may attach too much weight or significance to
past performance data when making their manager selection.
(iv) Decision-making paralysis, i.e. no decisions means no wrong decisions,

possibly holding on to underperforming managers too long.
Herding instinct/peer group behaviour — hire a well known manager, reduce

scope for peer criticism if it goes wrong.
Familiarity — fear of unknown/uncertainty can lead to sticking with familiar

options, possibly outdated. Slow acceptance of new innovative managers.
Consensus decision making — fear of sticking out as an individual, therefore

agree on decision on a collective basis (not necessarily the best decision).
Fiduciary fear — trustees have fiduciary duties. More conservative/prudent

decisions may be expected from trustees who are subject to scrutiny from
regulators and stakeholders.
(v) The term utility may be defined as the amount of satisfaction to be derived
from a commodity or service at a particular time.
The utility function can described as the trustees’ preferences for different
factors relating to the manager selection decision.
To derive the utility function we need to consider what factors may provide
them with satisfaction (utility).
These factors will include the maximisation of returns, minimisation of risk,

funding / solvency level of fund, appreciation of plan sponsors’ views, low
and stable contribution rates, peer group comparison.
These preferences will vary by individual trustee and also over time.
Because of the fiduciary nature of the trustees’ duties and as a result of the
behavioural effects described above there may be elements in the utility
function which are non-financial. To this extent these factors will provide
utility at the expense of purely financial factors which may result in financially
sub optimal decisions.
Page 7
2 (i) Questions that should be addressed in the benchmarking and monitoring

process:
• Are the assets increasing at a faster rate than the change in liabilities? (i.e.
is the Investment Strategy, as reflected in the Benchmark Asset Allocation,
correct?)
• Is the rate of growth consistent with the level of risk taken?
• Is the asset portfolio outperforming the relevant broad market indices? (i.e.
is it right to utilise Active Investment Management in each asset class?)
• Are the asset managers outperforming their peers? (i.e. has the Fund
appointed the right managers?)
• Are the asset managers outperforming their own style specific benchmark?
(i.e. are the manager skilful or is outperformance of the market or peers
simply due to their style of management being in favour?)
• Is each asset manager’s target outperformance of their benchmark (net of

fees) achievable, given their style of management and the level of risk
taken in the portfolio? If not, should the target and/or the manager be
changed?
(ii) Benchmarks against which to measure investment management should ideally

be:
• representative of the investable universe

• transparent and unambiguous
• easily measurable
• investable (i.e. easy to replicate)
• appropriate to the manager’s professed investment style; and, most
importantly
• specified in advance
Benchmark should cover a large proportion of a manager’s portfolio
• most of the time; and
• make it easy to set consistent subsidiary (e.g. localised) performance

targets over a variety of periods
Composite or broad market benchmarks may be considered suitable, accepting

they may not reflect a manager’s professed style.
Managers should be assessed against bespoke style-constrained universes (e.g.

smaller companies or high yield/value stocks) to identify superior selection
skills
Page 8
(iii) No single “right” answer to developing a multi-region or multi-sector

benchmark. Index may be built with a market-capitalisation, Gross Domestic
Product-weighted, industry-average or fixed-weight approach.
The principal reason for increasing the investable universe is diversification.
At the individual stock level, multinational investment expands the universe of

available opportunities and allows active fund managers to invest in
companies giving the best return/risk profiles, wherever those companies have
chosen to list (which may be a very different economy from that in which they
derive most of their earnings).
Also, overseas currency exposure is an additional means of diversifying

investment returns, although some investors may prefer to hedge this. Clearly,
the benchmark used should reflect the approach taken to currency exposure.
Under a market capitalisation approach, the weight in each region reflects the
market capitalisation of its stock market relative to world stock markets as a
whole.
The positive features are its similarity with the investment manager’s role of
investing dollars in proportion to stock size and its consistency with modern
financial theory. Efficient markets theory suggests “all information is in the
price” and so market capitalisation should reflect all available information —
although this assumes markets are efficient, the degree of efficiency for many
varies.
Use of a MSCI global index will, by default, give a high weighting to the US
market & the US$. In the interests of diversification, some investors may
prefer to restrict US exposure and so use some kind of fixed or capped
weighting to this market.
This approach does provide a transparent and dynamic benchmark.
Particularly now that the major index providers have adjusted the component
weightings to allow for free float, that part of the equity that is tradable and
investable.
The major negative of market cap-weighting is that at any given time the
weight reflects the historic relative stockmarket success.
There’s no scope for reflecting the situation where economic prospects aren’t
accurately reflected in share prices and this becomes dangerous when investor
sentiment grows to an extreme.
Once stock prices are inflated by positive sentiment, the market cap approach
maximises the allocation to that country when the investor sentiment bubble is
at its largest. Classic examples include the peaks of Japan in 1989 and the US
in 2000.
Page 9
Under some form of fixed-weight system the benchmark is set as a fixed

allocation to each of the regions.
This provides a well-defined benchmark since fixed weights remain constant

and they can be set on a forward-looking basis, rather than on the basis of past
economic or stock market success.
The approach has the principal advantage of potentially maximising diversity.
Requires a subjective decision on the weights to apply and whether, and under
what conditions, they should change.
It has the further advantage of being known to the investment manager at all
times, thus enhancing the benefit (or cost) of their short-term tactical
positions, relative to the benchmark strategy.
There are many local market index providers and often the index with the
strongest local market brand recognition is not the one with the broadest
market coverage e.g. Dow Jones in the US, Nikkei in Japan
The index provider may restrict themselves to just one country index.
Often such indices have long histories and are frequently recalculated and
quoted.
However their lack of coverage (perhaps only 5% or less of the total market),
infrequent change of the constituents, lack of adjustment for dividend income
or individual stock weightings (or lack thereof) make them poor performance
benchmarks.
Other providers and their indices specialise in certain sectors of the market
(small cap is the most common area) and so whilst offering a good
representation of a particular investable sub-universe, do not allow uniformity
of comparators across markets.
The two principal multi-market equity index providers are MSCI and FTSE.
Not much differentiates these providers in their index creation, coverage,

global data collection, methodology (in such areas as free float) and
processing capabilities and service delivery.
The MSCI series of indices has a slightly broader coverage and capitalisation
and is more easily and consistently sub-dividable into regions and
capitalisation.
Indices may overstate the opportunities in a market where companies with

cross-ownership are both included in the same index. This double counting of
securities would distort valuation ratios and performance data, as well as
market capitalisation. Each MSCI country index is constructed so as to
minimize cross-ownership, assuring that all industry groups are
Page 10
proportionately represented, and that each country’s contribution to the global

or regional index is accurately based on its true market capitalisation.
The FTSE 100 and Dow Jones 30 indices are narrow, large cap indices with
intrinsic biases to certain sectors. Some investors may be uncomfortable with
this and prefer broader-based indices.
(iv) Such securities over time demonstrate superior growth and return
characteristics.
Also have inherent risk not solely attributable to the relative price and
information “inefficiency” of these markets.
The purpose of separate allocations is to control the level of this risk
By fixing the allocations, introduce through rebalancing limits an inherent

profit-taking mechanism (monies will be disinvested from areas that have
relatively outperformed and invested in areas that have previously
underperformed — to the extent that all equity markets display a degree of
mean reversion and similar long term performance then this may help to direct
some monies to areas before they outperform).
Determination of the benchmark proportions must also have regard to the

method of implementation.
Given the relatively high costs of dealing in these markets, it can be argued
that rebalancing should not take place too often, so some latitude in the
rebalancing ranges should be given. Perhaps cashflows to the Fund can be
used to rebalance rather than selling existing holdings.
This is a very large fund — it is likely that it should consider index tracking,
or enhanced indexation, for larger efficient markets. It could also consider
some kind of core satellite approach for these markets — i.e. use of a passive
core with high conviction active managers for a minority proportion.
Given the probable significant size of the fund’s assets in relation to the
average market capitalisation of the underlying companies, then indexing the
smaller cap area through replication may not be possible without having a
noticeable detrimental impact on market prices and liquidity.
Any sampling methodology inevitably incurs additional tracking errors which

eventually offset the low risk intention of employing passive management in
the first place.
In any case, the very inefficient nature of smaller company and emerging
markets lend themselves to active management.
Page 11
(v) Other issues:
• definition of emerging markets and small cap (established or bespoke; vary

by market?)
• performance targets and objectives generally
• overall asset allocation, benchmarks and rebalancing guidelines
• method of implementation
• management of other assets
• socially responsible investment considerations
• currency exposures and management
• availability of suitable benchmark
END OF EXAMINERS’ REPORT
Page 12
EXAMINATION
18 April 2007 (am)

booklet.
supervisor.
Graph paper is required for this paper.
question paper.
SA6 A2007 © Institute of Actuaries
1 You are the investment consultant to a defined benefit pension scheme with £9bn of
assets actively managed by specialist managers. The scheme is 90% funded on a risk-
free basis (where the liabilities are discounted at swap yields). 60% of the scheme’s
assets are invested in a mixture of inflation index-linked and fixed interest bonds with
30% in global equities and 10% in real estate. To reduce the risk level, the scheme
trustees have been advised by an investment bank to execute swap transactions to
extend the duration of the bond portfolio to equal that of its liabilities and to match the
inflation characteristics of the liabilities.
(i) (a) Define the term “vanilla interest rate” swap.
(b) Draw a diagram of how the investment bank would set up the swap
contract with the pension scheme.
[4]
(ii) Explain why the trustees may be interested in an interest rate swap. [4]
(iii) Outline the key sources of risk that will remain within the scheme after the
swap programme has been completed. You should distinguish between risks
attaching to the bond and the non-bond assets, relative to the scheme’s
liabilities. [8]
(iv) (a) Explain how diversification of the non-bond portfolio using alternative
asset classes can reduce risks.
(b) Comment on the expected return of such a portfolio.

[4]
(v) Explain why implementing a swap overlay over the existing non-bond assets
may be less effective at reducing the annual variation in funding level than
diversifying the non-bond assets. [7]
At the trustees’ meeting, as an alternative it is suggested that the trustees move all the
assets to one active investment manager and implement a dynamic liability
benchmark. The scheme has historically held equities in the anticipation of
generating excess returns to make up any funding deficit. However the trustees are
becoming more concerned with limiting risk in the event of an equity market
downturn due to expected changes in the local economy.
(vi) (a) Explain what is meant by a dynamic liability benchmark.
(b) Comment on its appropriateness for different pension schemes.

[4]
(vii) Describe how the economic cycle can impact on the valuations of different
types of companies. [5]
(viii) (a) Give three examples of how the trustees could limit the downside risk
of a market fall in equities.
(b) Outline the potential problems with these methods. [9]
SA6 A2007—2
Six months after the transition to the swap overlay strategy has been completed, an
independent external trustee joins the board. She comments that in her view it is most
appropriate for shorter term liabilities to be matched, rather than longer term liabilities
that are subject to more uncertainty.
(ix) Explain why the approach the new trustee has outlined is unlikely to achieve
the desired risk reduction. [7]
(x) (a) Outline the considerations that would need to be made when
formulating an alternative strategy that could result in a similar risk
reduction to that expected under the swap overlay strategy.
(b) Comment on alternative methods of risk reduction that could be

adopted.
[6]
[Total 58]
2 You are an investment consultant for the defined benefit pension fund of a company
with assets of £500m. The assets are managed across multiple asset classes by a single
investment company. Having decided on a new asset allocation benchmark for the
fund, the trustees have asked you to review the investment management arrangements
of the pension fund.
(i) Describe the investigations you will carry out in your review. [12]
The company has decided to sell one of its subsidiaries and the pension fund is
required to pay a bulk transfer of approximately £100m to another pension fund. The
amount to be paid is linked to the total return of the FTSE All Share Index.
(ii) Explain the investment risk for the pension fund as a result of this sale. [5]
(iii) (a) Explain how derivatives may be used to mitigate this risk.
(b) List the problems that may arise under such a process.
[5]
(iv) Outline the advantages and disadvantages of:
(a) cash transfers and
(b) in-specie asset transfers
from the point of view of the trustees of the existing scheme and the trustees
of the receiving scheme. [10]
SA6 A2007—3 PLEASE TURN OVER

As a result of the sale the fund’s liability profile has changed and it is likely that cash
outflows on benefits and expenses will exceed income over the next few years. You
have been asked to prepare a report to advise the trustees how the fund’s investment
strategy should change to accommodate the new circumstances.
(v) (a) Set out the modelling investigations you would perform.
(b) Discuss the investment strategy you would put to the trustees to
accommodate the net cash outflow that is likely.
[10]
[Total 42]
END OF PAPER
SA6 A2007—4
EXAMINATION
April 2007

EXAMINERS’ REPORT
Introduction
M A Stocker
June 2007
Subject SA6 (Investment Specialist Applications) — April 2007 — Examiners’ Report
Comments
Generally candidates scored better on question 2 rather than question 1, with the best
candidates achieving two-thirds of the available marks. Although it was pleasing to see the
scores achieved by better candidates, it continues to be a source of frustration and
disappointment that the majority of candidates appear to ignore valuable information
contained within the questions and lose easily achievable marks as a consequence.
In every diet there will be candidates who are very close to the pass mark and yet receive an
FA — indeed I suspect candidates would be very surprised to see just how tightly distributed
the marks are; deciding where the pass mark falls will have a material impact on the
numbers of candidates who are successful and the examiners take great care to ensure a
consistency of standard across candidates, subjects and diets. The pass rate for this diet was
slightly lower than the last session although the pass mark was lower. Although most
candidates were able to reproduce the required bookwork, the low pass mark reflects an
inability to apply the bookwork knowledge appropriately.
All extenuating and mitigating circumstances were considered in awarding grades —

coincidentally those candidates who had submitted the most severe mitigating arguments had
in fact achieved sufficiently high marks to justify a Pass grade.
Candidates should note the bias in the paper towards recognising higher level skills and
practical application — this is intentional and will continue. Likewise the examination
system does properly allow for prior subject knowledge to be assumed. It is not appropriate
to repeat all relevant material within the Core Reading and in the exam creation process, the
profession takes great care to ensure that the paper can be answered by a candidate who has
taken a “normal” route through the exams — indeed questions have been removed from
previous draft papers as a result. Investment is a necessarily practical subject and at this
level, the examiners expect candidates to demonstrate a breadth and depth of competency as
would be expected from a practising actuary in what is a frequently evolving discipline.
Hence simple regurgitation of bookwork will not be sufficient to ensure a Pass grade.
Candidates should ensure they familiarise themselves with the current investment issues
facing institutional investors in the 18 months preceding a diet and the solutions (and sources
of) being debated by the various stakeholders. A recurring theme in recent years has been a
move towards capital market rather than purely insurance and asset management solutions
— hence a question regarding banking and derivative approaches to asset and liability risk
management should be considered a reasonable framework for examination.
Page 2
1 (i) (a) Vanilla meaning the most basic form of swap.
(b) Some sort of diagram showing bank being paid fixed in return for
floating and with counterparty on the other side.
(ii) A fund of assets has been set up due to the existence of liabilities (rather than
some other reason)
Liabilities influenced by rates, inflation and longevity
Regulatory, accounting and risk based levies are encouraging “derisking”
One way to address risk is to build a liability-matching portfolio using suitable

bonds. However, the bond market does not offer sufficient maturities to be
able to match a pension fund’s annual liability profile. The result is a very
staggered profile, leading to considerable reinvestment risk.
Constructing a portfolio of swaps greatly diminishes the mismatch risk

regardless of what happens to rates. In this way, the fund could meet its future
pension obligations with a high degree of certainty.
More importantly, the size of any deficit is quantified and stabilised so

creating the scope for using a structured approach or active asset management
approaches to repair the deficit within a finite term whilst eliminating
uncertainty in corporate reported earnings.
The Trustees may be interested in taking out an interest rate swap to reduce
risk,
or
swap market might offer better value than physical due to demand/price
anomaly
or
An overlay strategy may be desired to temporarily alter the asset allocation of

the portfolio
(iii) Non-bond portfolio
Active management risks — risk of actively managed assets underperforming

relative to the benchmark index for the asset class
Strategic (asset class vs liability) risks — the risk of investment returns on the
asset class (equities, real estate) not being in line with the increase in
liabilities.
Page 3
Bond portfolio
Active management risks — risk of actively managed assets underperforming

relative to the benchmark index for the asset class
Strategic (asset class vs liability) risks will be much lower than for the non-
bond portfolio due to the swap overlay which removes first order interest rate
and inflation risks.
Residual strategic risks will include:
Basis risk — the risk of the swap values not moving precisely in line with the
assets used to derive the discount rate used to measure the liabilities.
Cross hedging risk — as an overlay approach has been used, if the bond assets
held are different to that assumed in the overlay (as is likely for any actively
managed bonds) this will lead to cross hedging risks as the bond values will
move differently to that assumed in the overlay design.
Curve risk — unless a precise cashflow matching approach has been adopted
in the swap design this will lead to a further cross hedging risk on the swap
overlay.
Liability risks — this is similar to basis risk in that the cashflows used to
define the hedge profile may be revised at future actuarial valuations as new
information about demographic trends and scheme-specific experience
emerges.
Liability risks arise both from changes to valuation assumptions and variations
between experience and assumptions.
(iv) By adding new asset classes with low to moderate correlations with the
existing asset classes, a portfolio can be constructed that has lower risk than
the existing portfolio.
This is even the case if the new asset classes are of similar volatility to the
existing asset classes…
…due to volatility of a portfolio of weakly correlated assets being lower than
the individual volatilities of the asset classes.
Many alternative asset classes have a lower expected return than equities,
however.
Whilst this will lead to a higher Sharpe ratio (or information ratio), it will lead
to a lower expected return for the non-bond portfolio.
(v) Over long periods of time, the largest source of variation in funding level is
likely to arise from the volatility of return for the non-bond portfolio.
This reflects that some 60% of liabilities are already closely hedged (subject to
basis and cross hedging risks, but these are likely to be small in magnitude).
Page 4
Putting a swap overlay over the non-bond assets will replace the existing
liability return target (a mixture of the returns on perfectly matching fixed
interest and index-linked bonds) with a target return expressed in terms of
short-term interest rates (LIBOR).
The key risk from a funding perspective is therefore the risk of equities and
property underperforming a LIBOR-related target (e.g. LIBOR + 2–3% p.a.).
Due to the volatility of equities (typically 15-20% pa) there is a significant risk
of a large variation in funding levels from year to year in the event of an
equity market crash.
In contrast, a diversified non-bond strategy will lead to a lower variation in

asset values from one year to the next although the underlying interest rate and
inflation risks are not hedged.
Whilst the interest rate and inflation risks do lead to some volatility in funding
level it is likely that the latter approach would lead to a lower level of funding
level variation than the former approach.
This argument assumes that in the short term equities are more volatile than a
portfolio of matching bonds.
(vi) (a) A dynamic liability benchmark relates to when an investment mandate

is varied according to the changing nature of the liabilities. Essentially
instead of a fixed benchmark (say 30% UK, 20% O/S, 50% bond based
benchmark), the manager would be set a performance target which
would vary depending on the liabilities. This could be set based on the
actual liabilities and constantly reset to changes in the underlying
liabilities, a least risk portfolio basis (e.g. 30% fixed interest, 70%
ILG) or a broad brush approach taken, i.e. to beat RPI by 2%.
(b) They are appropriate for pension schemes who wish to more closely
align the performance of the assets with the liabilities. Due to the
complexity and the time required to ensure that the benchmarks are
appropriate they would normally be more suitable to Trustees with a
high degree of financial knowledge and time to monitor/change the
benchmark. Also, more appropriate for a well funded pension scheme,
or one with strong sponsor. Underfunded scheme may need to take
equity risk and therefore, not appropriate.
(vii) If the economy is moderately buoyant and profits are fairly stable, both
defensive and cyclical companies might be similarly rated in terms of the P/E
ratios.
As the economy starts to move into recession P/E ratios for cyclical companies
are likely to fall while those of defensive companies will remain stable or may
even rise slightly.
Page 5
At the bottom of the cycle P/E ratios of cyclical companies will probably have
risen from their low point as earnings have fallen, but defensive stocks will
still be more highly rated.
As the economy starts to recover, the P/E ratios of cyclical companies will rise
in anticipation of future earnings growth. P/E ratios of defensive companies
may now be lower than those of cyclical stocks.
As growth continues, the earnings of cyclical companies will catch up with the
share price and P/E ratios will fall back towards their long-term average level.
(viii) Sell UK equities — costs involved, loss of beta return and alpha return
Hedge using future contracts — basis risk, cross hedging risk
Options based strategies to limit downside risks
(ix) Whilst it is correct that longer-term liabilities are likely to be less certain, and
that liability risk factors are (in most cases) unhedgeable, there is still
significant merit in managing investment risk factors.
These risk factors will include asset risks and interest rate or inflation risks,
which this strategy has been designed to manage to a particular level.
The liabilities are calculated by reference to a bond-based discount rate.

Assuming the liability calculation method does not change, the liability value
will move in response to changes in the levels and shapes of the interest rate
and breakeven inflation curves.
However hedging the first 50–60% of liability cashflows is unlikely to achieve

a significant risk reduction compared to that achieved under the new strategy.
This reflects that the later cashflows, although smaller in present value terms,
contribute significantly to the interest rate sensitivity.
This can be seen if one were to analyse the sensitivity of the liabilities to
interest rate movements, for example showing the PV01 (change in liabilities
for a 1bp movement in interest rates).
The chosen hedging approach is not unique, and other hedging profiles could
be created that would achieve a comparable risk reduction.
Also, it would be possible to hedge a smaller or larger proportion of interest

rate and inflation risks than the 60% adopted under this strategy.
(x) To target a particular level of risk reduction, any potential strategy will need to
consider the following risk exposures:
• Active management risk

• Asset risks relative to either the unhedged liabilities, or to a short term
cash (e.g. LIBOR) benchmark if the liabilities are hedged
• Interest rate and inflation risks
• Longevity risk
Page 6
Total risk will be a combination of the above risks.
Other risk reduction techniques will include:
• diversification of the portfolio through inclusion of asset classes with low

correlations to existing assets.
• equity option or swaption strategies that limit the maximum loss that could
occur due to falls in asset values or falls in interest rates respectively.
• dynamically altering the asset allocation in response to changes in risk
expectations across various asset classes.
• insurance/risk transfer techniques, such as mortality hedging.
2 (i) The investigations that should be carried out are as follows:
Past performance
Past performance relative to the appropriate benchmark.
Use rolling 3-year returns as a good indicator of fund management ability, and
compare this with other large investment managers.
Compare the volatility of performance relative to the benchmark and other

large investment companies — this is a good indicator of the risk profile of the
Investment Company.
In-house volatility — we would look at the dispersion of returns achieved by

the Investment Company for portfolios with similar mandates to the pension
scheme.
Ideally one would wish for a small dispersion thus implying consistency.
Attribution analysis — analyse the performance relative to its benchmark into

asset allocation, sector allocation, stock selection etc., and compare this
against the investment managers stated objectives.
Portfolio style analysis — Analyse the makeup of your scheme’s stock

portfolios to make sure the style is consistent with that stated.
Quality of Investment process
The decision process must be effective and allow the views of key people in
the Investment Company to influence portfolio construction in a manner
appropriate to the style. The quality of research carried out by the
organisation will have a major influence on the results as will the ability of the
organisation to translate paper decisions into real portfolios at the best price.
Suitability of Risk Controls
Analysis of risk controls implemented by the Investment Company.
Page 7
Client relationship
The quality and speed of delivery of the quarterly investment reports is a good
indication of the efficiency of the Investment Company’s mid and back office.
People
The ability of the Investment Company to attract and retain key individuals is
a major determinant of quality.
The quality of senior people
• Experience
• Track record
• Commitment to the business
Depth of resources — the number of investment staff involved for each major
sector, systems at their disposal, the dependence on any “star” fund managers.
(ii) The amount of the bulk transfer is linked solely to the level of the market for
UK equities.
The fund is invested across a range of asset classes in accordance with a set
benchmark distribution.
Unless the proportion of the benchmark allocated to UK equities explicitly

allows for this bulk transfer, part of the bulk transfer liability is effectively
mismatched by asset class.
There is no particular advantage to the existing or receiving scheme from this

proposal.
This could go either way and the size of the potential disparity will depend on:
• The length of the period between the assessment date and the payment date
• The assets held by the existing scheme
If for example, the portfolio is 50% invested in UK equities and 50% in

overseas equities, bonds, properties etc., then circa £100m of the bulk transfer
is matched by asset class.
However, there is still a circa £50m liability linked to UK equities which will
be settled by transferring securities to the requisite value from the overseas
equities, bonds, properties etc. classes i.e. this £50m is mismatched by asset
class.
(iii) You may be able to reduce your exposure to these other asset classes and
increase your exposure to UK equities by using financial futures.
Page 8
In total, you need to change your exposure for approx. £50m i.e. sell £50m
worth of futures on these other asset classes and buy £50m worth of UK equity
futures.
A variety of futures would be sold related to the markets in the other asset
classes and in proportion to the distribution of the assets amongst these
markets.
At the time of payment the futures position would be unwound.
The principal problem is that there may not be appropriate derivative contacts
for some of these other asset classes e.g. property, venture capital etc.
Other main problems are:
• The basis risk associated with futures contacts,
• The need to take account of foreign exchange hedging in relation to

overseas asset classes.
(iv) The Trustees of Existing Scheme
The trustees have a liability to pay a specified amount and as such they will
want to meet that in the most efficient manner i.e. at the least expense to their
scheme but without any other adverse affects.
If they pay in cash then any securities they sell will be priced on a bid basis
i.e. based on the bid prices of the underlying investments.
If the transfer is settled in stock then the value of the stock transferred can be
based on a more favourable basis, subject to the agreement of the relevant
parties.
Typically, the basis would be to value the transferred stock on mid market
prices. In this way, the managed fund avoids the transaction expenses of
selling the stocks (although there may be some administrative expenses) and
this saving can be passed onto the existing scheme in the unit prices it
encashes units at. The saving achieved includes half the market turn and
commission to the broker (if any).
The transaction expenses for a block trade have reduced substantially over the
last decade but the existing scheme may achieve a saving of the order of ½%
of the value transferred.
The Trustees of Receiving Scheme
The issues from the perspective of the trustees of the new scheme are similar
i.e. if they receive cash they will incur transaction expenses on reinvesting
which may be avoided if they accept stocks.
Page 9
Further, they may suffer purchase price related tax that a stock transfer may
avoid.
However, the stock received may not be what they wish to hold.
In this case, they will be worse off as they will incur not only the purchase
transaction costs but also the sale transaction costs that would have fallen on
the existing scheme if the payment had been in cash.
If cash is received then the scheme is effectively mismatched by term and type
and they will not want to be out of the market for long. A stock transfer keeps
them in the market.
(v) In order to ensure that there is sufficient cash to pay benefits in future an
asset/liability study will need to be performed.
This will allow account to be taken of the variation in the assets

simultaneously with the variation in the liabilities.
Information will be needed on the assets and the liabilities so that a suitable
cashflow model can be constructed.
The outcome of a particular investment strategy is examined with the model

and compared with the investment objectives.
The investment strategy is adjusted in the light of the results obtained and the
process repeated until the optimum strategy is reached.
Modelling can either be deterministic or stochastic.
If a deterministic model is used based on a set of specific assumptions about

the future, scenario testing will also be performed.
If a stochastic model is used judgement will be required to establish the most

appropriate form and appropriate value of the parameters.
The success of the strategy must be monitored by means of regular valuations.

The valuation results will be compared with the projections from the
modelling process and adjustments made to the strategy to control the level of
actuarial risk if necessary.
Running yields on various asset classes will be investigated since an income

deficiency is in prospect.
Since the fund is maturing there may be a requirement for closer matching
irrespective of the income question.
The solution is likely to be to increase holdings of fixed interest investments

and property. This could include higher yielding corporate bonds and some
overseas bond markets, matching considerations permitting.
Page 10
Property also has a high running yield, particularly slightly less than prime
property, and this may be a better long term choice given recent poor returns
and a prospect for some level of rental growth in future compared with purely
fixed interest investments.
Some cash will also have to be held on an ongoing basis to meet the expected
outgo.
Without knowing the extent of the shortfall and the precise asset distribution it
is not possible to suggest what proportions need to be switched into higher
yielding investments.
There are other possible long-term considerations including a bias within

overseas portfolios to higher yielding markets.
Page 11
EXAMINATION
1 October 2007 (am)

booklet.
supervisor.
question paper.
SA6 S2007 © Institute of Actuaries
1 You are the investment consultant to a medium sized final salary pension scheme
which has a significant shortfall in its assets compared with the cost of securing the
accrued pension benefits with an insurance company. One of the trustees has attended
a seminar run by an investment manager who has recently launched a range of pooled
funds that apparently are a better investment as they are related to the liabilities of
pension funds. The trustees have asked you to advise whether such a liability-driven
investment approach is suitable for them.
(i) Set out the points you would include in a report for the trustees, explaining:
(a) the concepts of liability driven investment
(b) why such an approach has gained popularity in many countries
(c) the principal liability-related risks that should be considered in pension

fund investment
(d) the extent to which the investment manager’s products are likely to be
suitable for this pension scheme
[24]
The Government of the country has established a Pension Fund Regulator who has
recommended that all pension schemes should have sufficient assets to buy out all
their liabilities with an independent insurance company within 15 years. The
investment manager has provided you with details of a Structured Deficit Repairing
Fund that uses equity derivatives to generate the required returns.
The trustees have asked you to provide a short presentation on how equity derivatives
work and their appropriateness in funding the Scheme’s current shortfall.
(ii) Outline how equity options can be used to alter the shape of the equity return
distribution. [5]
(iii) Draw charts to show the value of a £100 equity investment after 1 year under
both options-based strategies shown below. You may assume that the equity
index is currently 100, and that the options strategies are self-financing.
Dividends may be ignored. [6]
(a) Sell 1 at-the-money European call option.

Buy 2 European put options at a strike price of 80.
(b) Sell 2 European put options at a strike price of 80.

Buy 1 European put option at a strike price of 90.
Buy 1 European call option at a strike price of 110.
Sell 2 European call options at a strike price of 120.
(iv) Explain why an investor might choose to follow the second strategy over a
1 year time horizon, commenting on the impact of the prices of the options.
[4]
SA6 S2007—2
One of the trustees has read that the price obtained by writing a deeply out-of-the-
money call can be lower than the cost of buying a deeply out-of-the money put.
(v) (a) Explain why this might occur.
(b) Outline how would you expect this to change as the calls and puts
move closer to at-the-money. [6]
(vi) Describe why a derivative based product may be a suitable investment for the
pension scheme trustees to consider in helping to reduce the deficit. [10]
[Total 55]
2 You are an investment consultant and have been approached by the Chairman of
Trustees of a UK based charitable foundation supporting local projects. The Chairman
has recently returned from a holiday in China and read that infrastructure
developments in the country have created an excess demand for commodities such as
copper with prices reaching historic highs. While he was on holiday, he met a group
of local property developers in a bar who assured him that the boom was certain to
continue for many years and that smart investors were buying up investments in raw
material supplies to benefit from rising prices due to future demand. He wants you to
prepare a report for the trustees recommending the appropriate allocation of the
foundation’s assets to commodities.
(i) (a) Describe the information you would require on the foundation.
(b) Explain how this information would be used to develop a framework

for assessing the appropriateness of commodities investment for the
foundation’s investment fund.
[12]
Historically the foundation has only invested in Pan-European equities and bonds
with a small allocation to real estate.
(ii) (a) Explain the principal benefits from investing in alternative asset
classes such as commodities.
(b) State ways in which the foundation could invest in commodities.
(c) Outline the benefits and disadvantages of each method.

[12]
SA6 S2007—3 PLEASE TURN OVER

Prior to issuing your report, you meet the trustees for the first time. One of them
argues that the only reason they are considering commodities is the recent holiday
experience of the Chairman. Indeed, he is concerned that they are making a decision
based on sentiments rather than facts and that any recommendation you produce will
be biased.
You have discussed your draft report with a colleague, who identified three possible
biases in your draft:
• anchoring
• framing and question wording
• overconfidence
He suggests that you redraft the introduction to your report and explicitly make
reference to these issues in the context of the proposal and suggest ways in which they
could be overcome.
(iii) Explain the nature of the three biases identified. [9]
(iv) Suggest ways that investors might avoid each bias. [12]
[Total 45]
END OF PAPER
SA6 S2007—4
EXAMINATION
September 2007

EXAMINERS’ REPORT
Introduction
M A Stocker
December 2007
Comments
In this diet, there was a less obvious trend for candidates to score better on one question than
the other with a broad range of scores achieved on both. By contrast very few candidates
scored well on both.
FA – indeed I suspect candidates would be very surprised to see just how tightly distributed
consistency of standard across candidates, subjects and diets.
That said, it was fairly clear where the hurdle should have been set; as a result, the pass rate
for this diet was slightly higher than last time, although the pass mark was lower - indeed the
examiners would have preferred to set a higher hurdle. Indeed it is disappointing that
candidates, who are likely to be working in this most practical of fields given that they have
sat a specialist paper, achieve such low scores. As before, most candidates were able to
reproduce the required bookwork for one or other question, hence the low pass mark reflects
a widespread inability to apply the bookwork knowledge appropriately and demonstrate
practical application and original thinking.
practical application – this is intentional and will continue. Likewise the examination system
does properly allow for prior subject knowledge to be assumed. Investment is a necessarily
practical subject and at this level, the examiners expect candidates to demonstrate a breadth
and depth of competency as would be expected from a practising actuary in what is a
frequently evolving discipline. Hence simple regurgitation of bookwork will not be sufficient
to ensure a Pass grade.
In order to succeed, candidates should ensure they familiarise themselves with the current
investment issues and the general market background facing institutional investors in the 18
months preceding a diet and the solutions (and sources of) being debated by the various
stakeholders. A recurring theme in recent years has been a move towards capital market
rather than purely insurance and asset management solutions – hence a question regarding
banking and derivative approaches to asset and liability risk management or modern
financial theory and commercial applications should be considered likely scope for
examination.
All extenuating and mitigating circumstances were considered in awarding grades.
Page 2
1 (i) A non-exhaustive report should cover/comment on the following. Bonus

marks should be awarded for relevant additional commentary.
Given recent experience, pension scheme trustees and sponsors are faced with
having to make choices between:
• paying more contributions

• reducing benefits/closing schemes
• increasing retirement age
Alternatively there is a belief that many of the risks inherent in pension

scheme investment such as rate duration are “unrewarded” and so could be
better managed.
Fundamental, divisible (and “non-core” for corporate) liability related risks:
• long term interest rates

• future inflation
• future longevity
Longevity risk can only be eliminated/transferred through annuity purchase

although longevity bond structures are being developed by banks to mitigate
risk (albeit an imperfect hedge due to basis risk).
New accounting disclosures are making deficits (surplus) and liabilities part of
the capital structure:
• focus moving from Balance Sheet to Earnings management

• insurance and pensions regulation are merging
• rating agencies penalising companies for poor capital management
Pension Schemes should be treated as a division of the sponsor and financed

and managed as such.
Many “old industry” companies have pension obligations significantly larger

than market capitalisation and so volatility in deficit may have material impact
on earnings.
Rates/inflation volatile hence impact of liability changes more apparent in

countries with frequent reporting.
Risks can and, for most companies, should therefore be “outsourced” or

hedged.
This situation has arisen for a number of reasons as market and

regulatory/accounting frameworks have changed. As this has impacted on
corporate activity then corporate treasury functions have become more
involved in the risk management of the pension fund to be more consistent
with other corporate operations.
Page 3
Some of the drivers for change would be:
• equity volatility
• lower long term yield
• lack of long dated government debt compatible with liability flows
• lack of insurance capital
• inflation expectations
• population longevity
• poor fund management
• globalisation/pooling
This is not just a domestic market issue although the extent of the problem is
driven by history — UK/US pension funds have traditionally had much higher
weightings to equities and overseas investment compared with European funds
who have adopted more insurance like approaches.
Pensions is a global concern
• the essence of the problem is the same

• but regulation, accounting, inflation, longevity and peer group pressures
may differ
We have different cultures
• Japan slow to adopt?

• US — ERISA regulation may restrict effectiveness/implementation of
investment manager products
− Although Pension Protection Act, Department of Labor opinions and
new worldwide accounting standards indicate/influence change
There is a lot of external pressure to change from sources such as:
• International and domestic Accounting disclosure

• Regulators, European Directives, Pension Acts
• UK PPF/ US PBGC (and similar) risk rating and levies
• Credit Rating Agencies/Market analysts
From the sponsor perspective, there is a greater impetus to make changes now
because of impact of any deficit on:
• capital raising and use

• rating considerations
• cash flow
• earnings volatility
• business growth
• quality of covenant
• Employee Relations
• M&A constraints
Page 4
Pension funding deficits still exist, even after another strong year of equity
performance and rising yields.
Main options to repair the deficit and/or manage future risk:
• Increase contributions over an acceptable time frame

− Beneficial (trustees, tax, levy etc) but potential issues of further deficits
or indeed “trapped capital”
− Sponsor may not have further capacity to pay or could better use
capital within own business
• Maintain current equity biased asset allocation (at least in UK/US) and
repair the deficit organically through increased asset values over time
− Risk of increasing the deficit position even further
• Maintain the current asset allocation but hedge against further downside
− Upside potential limited and therefore will take longer to repair the
deficit
− Put protection more expensive than call exposure
• Re-engineer the scheme
− Requires fundamental shift in mentality and the establishment of a
Risk Budget
− This is more than simply improving the portfolio characteristics of any
existing Bond Allocation
− Equity VaR is a major component risk for most schemes — in
allocation and implementation
Issues for sponsor/fiduciaries (and so areas for banks and asset managers to
deliver products)
1. Capital management
• Financing
− Cash, bond raising or asset transfer
2. Pension management
• Liability cash flow management
− Compensation for inadequacies of bond markets
− Separation of longevity risk from rates and inflation
• Deficit reduction
− Regulatory, financial and peer group pressures - worldwide
− “Finite” repair term imposed by many regulators – scope for
absolute return structures
• Surplus control
− Short term “fix” may prove over cautious
− Surplus difficult and tax inefficient to recover
− Hence sponsor disincentive to overfund
− Use captive or derivative structures to mitigate
Page 5
LDI — a process more than a product
• Tailored to individual scheme/sponsor requirements.

• Blend of hedging cashflows or curve to remove unrewarded risk through
better match of duration by tenor.
• Plus deficit repair structure — mix of contributions, asset management,
structured products.
Works for funds in deficit
• Variety of bank derived option strategies available, including zero-cost.

• Can be transacted directly or through third party pricing agent/asset
manager.
• Can be implemented in stages to take account of changes in market pricing
and capacity — but will affect degree of immunisation and VaR reduction.
• Could be used to reduce total VaR without reducing return (could actually
increase allocation to return enhancing products and keep VaR constant).
Why not?
• Universe of physical bonds, size of derivative nominal and liquidity.

• Scheme is too big (or think they are too small).
• Misunderstanding of investment regulations?
• Lack of consultant advice (or no specific authority to advise).
• Misunderstanding of pricing and the law of unintended consequences.
• Not enough fiduciary or corporate understanding/education.
• Lack of communication between company and fiduciaries.
• Irrational fear of derivatives.
To the extent that these issues are overcome then the appropriateness of the
products will come down to issues of acceptable risk, effectiveness in
managing risk, funding objectives/targets, cost and sensitivity to costs, gearing
ratio of scheme to sponsor, balance of power between stakeholders, liquidity
and pricing of structure, ability to monitor positions going forward,
governance structure and sophistication of sponsor/trustees/investment
committee.
(ii) Options are a form of derivative that permits the holder of the option to sell
(put) or buy (call) an equity (or an equity index) at a future date from the
writer of the option, in return for paying a premium.
After paying the option premium, the payoff to a holder of a put is equal to the
strike price less the price of the underlying equity at expiry, subject to a
minimum payoff at expiry of nil.
The reverse applies to the writer of the put.
By combining options with the underlying reference equities, the shape of the
equity return distribution can be changed to a different shape.
Page 6
For example, return outcomes above or below a certain point can be bought or
sold.
This can be done at multiple strike prices, leading to piecewise segments of

the equity return distribution being combined to potentially give very different
return distributions to the equity return distribution,
(subject to liquidity constraints within the equity option markets).
(iii) (a)
120
110
100
60 70 80 90 100 110 120
90
80
70
60
(b)
140
130
120
110
100
60 70 80 90 100 110 120 130 140
90
80
70
60
50
(iv) The investor may want to mitigate the potential loss if equity values fall over
the next year, but may feel there is little likelihood of a significant price fall.
Similarly the investor may feel there is a moderate likelihood of strong returns
Page 7
over the next year, but be unconcerned about the potential loss of upside if
market conditions are extremely favourable.
In practice it is likely that the pricing of the options will have influenced the
choice of strategy,
since this will affect the strike prices and whether the strategy is self-financing
or has a cost.
(v) (a) Due to demand from equity investors with guaranteed liabilities (e.g.
insurance companies), there is significant demand for out of the money
puts. Many of these investors have dynamic hedging programmes to
provide downside protection, since long-term equity options are
expensive and illiquid. This results in a continuing high level of
demand for out of the money puts.
In contrast, there is less structural demand for out of the money calls
since there are no natural buyers ie any buyers are likely to be
speculative and have an expectation of generating a profit over time
from this activity.
(b) This feature of equity options results in the implied volatility being
higher for out of the money puts than calls, and is known as volatility
skew.
As the strike prices move closer to at-the-money the skew reduces.
(vi) Only have assets because of liabilities

Liabilities influenced by rates, inflation and longevity
Regulatory, accounting and risk based levies are encouraging “derisking”
One way to address risk is to build a liability cash flow matching or longer
duration portfolio using suitable bonds.
However, the bond market does not offer sufficient maturities to be able to
match a pension fund’s annual liability profile.
The result is a very staggered profile, leading to considerable reinvestment

risk.
Constructing a portfolio of swaps greatly diminishes the mismatch risk

regardless of what happens to rates.
In this way, the fund could meet its future pension obligations with a high
degree of certainty.
More importantly, the size of any deficit is quantified and stabilised so

creating the scope for using a structured approach or active asset management
approaches to repair the deficit within a finite term whilst eliminating
uncertainty in corporate reported earnings.
Page 8
The Trustees may be interested in taking out an interest rate swap also:
(a) Swap market might offer better value than physical due to
demand/price anomaly.
(b) Overlay strategy to temporarily alter the asset allocation of the

portfolio.
Using hedging in this way “fixes” the size of the deficit. In order to resolve
the deficit then a structured solution involving guaranteed returns from equity,
credit, commodities, currency, real estate or other markets than government
bonds with or without principal protection could be used to generate the
required solution.
2 (i) (a) What are the details of the foundation?
• Size of fund
• Funding position
• Future financial commitments and income
• Appetite for risk
• Regulatory Permitted assets
• Socially responsible, sustainable or ethical investment policies
• Existing asset management arrangements
• Governance and administration structure
• Justification for existing investment policy
How would the exposure to commodities be achieved? [reference to

real estate exposure may give clues to size/management approach]
Would holdings be restricted to long only? Or should short positions

be considered?
Which commodities? Energy/precious metals/base

metals/agricultural/meat and livestock
(b) Matching of liabilities — nature: real / fixed - commodities can be

argued to perform well in inflationary environments hence provide
some inflation matching although they are neither fixed or real in
nature.
Term — can be argued that commodities are short term, not

appropriate for matching longer dated liabilities.
Currency — commodity prices commonly in US dollars, liability £ —

would require currency swap, introducing further element of cost
Certainty — commodity prices can be volatile in both the short and

longer term. There is no direct link between their price movement and
Page 9
the valuation of liabilities. This will introduce volatility into the

funding position.
Commodity holdings do not produce income and are therefore not

suitable for “matching” future cashflow commitments.
It is possible to make significant profits from investing in commodities

in short periods, however there is also the opportunity to lose large
amounts in equally short periods.
Diversification — commodities offer significant real returns that are

produced by doing real economic work within the economy.
The returns accrue to long only investors without the need for active
management but there will probably remain the need for third party
management in terms of selection, market access, trading.
Recommended management approach and costs
Reasoned argument for appropriate size of allocation
(ii) (a) The principal benefits of alternative investments are:
• Potential for higher returns, possibly from increased beta, market

inefficiencies, pricing anomalies or the skill in
selection/management of the investor.
• Diversification due to a lack of correlation with existing assets or
by exposure to underlying risks that are uncorrelated so reducing
the overall portfolio risk.
(b) Should an institution wish to gain exposure to commodity price

movements it can do so in 3 ways:
• Invest in the underlying commodity (or basket of commodities)
• Commodity derivatives which are widely traded on major

exchanges such as LIFFE and the Chicago Mercantile Exchange on
either single commodities or an index.
• Invest in companies whose share price is influenced by commodity

prices such as oil and mining companies.
(c) Comment on management costs and skills, minimum bargain size,

scope for diversification, basis risks with derivatives, volatility,
liquidity and physical settlement/storage/shipping/transportation
Holding individual contracts introduces risk of being delivered against
Disadvantages if companies are used as a proxy for commodity

investment:
Page 10
• It is unlikely that there will be exposure to just one commodity.
• The company’s management may alter the exposure via

acquisitions or disposals or by hedging its position.
• The company’s share price may be influenced by other factors.
• The company will incur various operating expenses which will

dilute the overall return.
• Use of commodity shares (mining, exploration companies) gives

less diversification from equity market than physical would.
(iii)&(iv)
Behavioural finance looks at how a variety of mental biases and decision

making errors affect financial decisions.
Anchoring
Investors are often mentally anchored on a past prices, past market situations
or past practices. As the present situation is usually different, this leads them
to make unsuited decisions.
Usually, anchoring is based on past standards (e.g. a previous stock or index

price or price trend), schemas, practices, information or beliefs. Anchors
are those reference points that people keep in mind and that influence their
decisions.
People adjust insufficiently from anchor values.
Those past standards can come from gradual learning. Sometimes also people
create instantly their mental anchor when they get a first perception of a
market or prices without waiting for enough information. Their mind gets
stuck in their initial understanding whatever new data they get later.
Avoiding the Anchoring Bias
[Award up to 3 marks for any one method of avoiding the bias.]
The first step in protecting oneself against the effects of anchoring is to be

aware of any suggested values that seem extremely high or low.
One way of doing this is to generate an alternative anchor value that is equally
extreme in the opposite direction.
For example, before estimating the value of a stock that seems grossly over
priced, a decision maker might imagine what the value would seem like if the
stock price had been extremely low.
Page 11
Extreme values produce the largest anchoring effects and the effects of
anchoring often go unnoticed.
For these reasons, it is important to realize that a discussion of best-case or

worst-case scenarios can lead to unintended anchoring effects.
For instance, after considering the profitability of a business venture under
ideal conditions, it is difficult to arrive at realistic projections.
Framing & Question Wording
The way people behave depends on the way that their decision problems are
framed.
Framing is a cognitive heuristic in which people tend to reach conclusions

based on the “framework” within which a situation was presented.
The rational theory of choice assumes description invariance: equivalent

formulations of a choice problem should give rise to the same preference
order.
Contrary to this assumption, there is much evidence that variations in the

framing of options (e.g., in terms of gains or losses) yield systematically
different preferences.
Investors realize their gains more readily than their losses. The winning
investments, investors chose to sell, continue to outperform the losers they
hold on to in subsequent months.
Avoiding the Framing Bias
People tend to look for information that is consistent with a hypothesis rather
than information which opposes it.
Ask questions designed to disconfirm what you think is true.
Frame questions to encourage disconfirming answers.
Overconfidence
Overconfidence is the gap between the confidence one attaches to a forecast

and the accuracy of the forecast.
Overconfidence is greatest when accuracy is near chance levels.
Avoiding the Overconfidence Bias
Overconfidence is greatest when judgments are difficult or confidence is

extreme. In such cases it pays to proceed cautiously.
Stop to consider reasons why your judgement might be wrong.
Page 12
Even though you may not change your mind, your judgements will probably
be better calibrated.
Page 13
EXAMINATION
14 April 2008 (pm)

booklet.
supervisor.
5. Attempt all 3 questions, beginning your answer to each question on a separate sheet.
question paper.
In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.
1 You are the newly appointed Chief Investment Officer for a life office that has
previously invested part of its cash portfolio in asset-backed commercial paper and
part of its bond portfolio in collateralised debt obligations (“CDOs”). The office also
invests in a multi-strategy hedge fund. The Compliance Manager is preparing a report
on the investment policy of the office for the Risk Committee and has requested some
information from you regarding these assets, with which she is unfamiliar.
(i) Define asset-backed commercial paper. [2]
(ii) Describe a CDO. [2]
(iii) Explain how a tranched structure can help minimise the cost of finance. [6]
(iv) (a) Explain the “carry” of an asset.

(b) Give two examples of negative carry trades.
[3]
The basic terms of a transaction the hedge fund has completed recently are set out
below:
Hedge fund borrows: 500,000,000 Yen at overnight rate of 0.5% p.a.

Hedge fund invests: Proceeds in 1 month US commercial paper yielding 5.3% p.a.
Exchange rate: 1 US Dollar = 120Yen
Interest rates: Actual/360 convention
(v) (a) Calculate the daily dollar profit from the trade, assuming a constant US
Dollar:Yen exchange rate over the duration of the trade.
(b) Explain what a “haircut” is in the context of collateral against

borrowings.
(c) Describe why a haircut would limit the amount of leverage that could
be applied to this trade.
(d) Calculate the maximum leverage for a haircut of 7.5%.

[7]
Having read the Compliance Manager’s report, the Chief Risk Officer, who chairs the
Risk Committee, is concerned that some of the life office’s investment managers are
following risky investment policies compared with their peers and wishes to impose
new limits on investments.
(vi) Justify on investment grounds why it would be reasonable for a life office to
invest part of its portfolio in CDOs, highlighting potential issues associated
with investing in these securities. [7]
The hedge fund invests its capital equally in ten uncorrelated strategies (each of which
consists of multiple trading positions).
(vii) Discuss why the Compliance Manager might express concerns if the hedge
fund were to apply leverage at close to the theoretical maximum levels. [9]
[Total 36]
SA6 A2008—2
2 A small UK company has a closed and mature final salary pension scheme with assets
of approximately £50 million. After the last actuarial valuation, the scheme’s trustees
were advised to invest the majority of the scheme’s assets in two passively run bond
funds, one index-linked and one corporate, to better “match” the scheme’s mainly LPI
linked liabilities. The remainder, about £5 million, is in an actively run UK equity
portfolio.
The company has now been taken over by a large multinational organisation, which
operates a large final salary pension scheme, in the UK, which is still open to new
entrants. This scheme has assets of £500 million which are managed, in a segregated
fund, by a single external manager, using a balanced mandate with no investment
constraints.
As the newly appointed investment consultant to the smaller scheme you have been
asked to review the rationale for the current investment policy and propose how best
to integrate the smaller scheme into the larger scheme’s segregated fund.
(i) Discuss the possible rationale behind the investment strategy for the smaller
scheme. [10]
(ii) Discuss potential investment issues that will need to be considered in

transferring the assets of the smaller scheme to the larger scheme’s segregated
fund and how these may be overcome. [10]
[Total 20]

3 The chief executive of a multinational company has announced recently a plan to
demerge its domestic and international businesses. As a consequence of a history of
major acquisitions, the domestic business sponsors a very large defined benefit
pension plan of which 80% of the liabilities are in respect of current and deferred
pensioners.
The company has tried to separate their businesses before, but under guidance from
the country’s regulator, the trustees of the pension plan have argued that the sponsor’s
covenant would be weakened by such a transaction and so the company should
increase the level of funding within the pension plan to make it sufficient to enable
the trustees to secure the current and deferred pensioner obligations with an
independent insurance company.
Due to a combination of rising stock markets and long-term bond yields, the corporate
treasurer believes that the funding level of the pension plan is such that he could
convince the company to make up any funding shortfall required to buyout the
deferred and pensioner liabilities and so proceed with the proposed demerger. You
have been approached by the corporate treasurer to assist him to prepare a
presentation for the company’s board that sets out the issues surrounding the possible
transaction and outlines a possible solution to these issues.
(i) Sketch on a graph the liability cashflows of a typical defined benefit pension
scheme over time, illustrating the effects of changes in inflation and longevity.
[4]
(ii) Describe the typical features of a defined benefit pension scheme having
regard to the type of liabilities, funding levels, risks faced and investment
policy. [5]
(iii) Outline the financial risks and considerations that would concern the company
in operating a defined benefit pension fund. [6]
The corporate treasurer has been approached by a number of companies interested in

taking on the assets and liabilities of the pension fund. The treasurer is concerned
that, as investment markets are volatile, the existing assets of the pension fund
together with the special company contribution will not be sufficient in the end to
fully buyout the liabilities.
(iv) (a) List the risks that a defined benefit pension scheme faces. [4]
(b) Describe the adverse scenario for the four principal risks. [4]
(c) Outline how these risks could be managed and the relative cost of
each. [4]
(v) Outline the key financial aspects that the company needs to consider when
deciding whether to transfer their pension scheme liabilities to a third party or
to manage the investment risks internally as now. [17]
[Total 44]
END OF PAPER
SA6 A2008—4

EXAMINERS’ REPORT
April 2008
Introduction
M A Stocker
June 2008
Comments
An often poorly answered paper, with candidates typically answering Question 2 better than
the others. Many candidates appeared to be thrown by the introduction of a third question
and their answers suggested they had left insufficient time to complete the question, even if
they understood the key issues. Even where candidates appreciated the general content the
examiners were looking for, their solutions typically lacked detail and scored lower
accordingly. In particular, candidates appeared to struggle with Question 1(v) where few
were able to calculate either the dollar profit required in (a) or the leverage asked for in (d).
Given the examination is intended to test finance and investment risk and applications, too
much time was spent detailing information on the liabilities and missing the more obvious
scoring points on investment issues (a common failing in Question 2). That said, many
candidates were poor at graphing the liability cashflows.
FA – indeed I suspect candidates would be very surprised to see just how tightly distributed
consistency of standard across candidates, subjects and diets. It was fairly clear where the
hurdle should have been set; as a result, the pass rate for this diet was slightly higher than
last time and, encouragingly, the pass mark slightly higher too, albeit still lower than 2006
and earlier. It continues to be a disappointment that candidates, who are likely to be working
as advisers or asset managers in this most practical of fields given that they have sat a
specialist paper, achieve such low scores. Indeed, it is most astonishing the numbers who
achieve grades of FC and FD since this would imply very little knowledge and
understanding.
and depth of competency as would be expected from a practising actuary or senior student in
a frequently evolving discipline. Hence simple regurgitation of bookwork will never be
sufficient to ensure a Pass grade.
As noted before, in order to succeed, candidates must ensure they familiarise themselves with
the prevailing investment issues and the general market background facing institutional
investors in the 18 months preceding a diet, more so the solutions (and sources of) being
debated by the various stakeholders. A recurring theme in recent years has been a move
towards capital market rather than purely insurance and asset management solutions – hence
questions regarding banking and derivative approaches to asset and liability risk
management or modern financial theory and commercial applications should be considered
likely scope for examination. Likewise the increasing popularity of buyouts in order to
manage pension risks has been a topical issue amongst companies and financial journalists
for many months now.
Page 2
1 (i) Asset backed commercial paper is commercial paper that is issued by a

bankruptcy remote…
…special purpose vehicle (SPV)…
…which then uses the proceeds to invest in a portfolio of assets.
As such it will have maturity of 360 days or less
…although US issues are typically 270 days or less.
(ii) A Collateralised Debt Obligation (CDO) is an investment-grade security

backed by a pool of bonds, loans and other assets. The pool of assets will be
held within a Special Purpose Vehicle (SPV) to make it “bankruptcy remote”
from the manager of the pool, and the SPV will issue CDO securities to
finance the pool.
(iii) Typically the CDO securities will be issued in a tranched manner:
• A bond with fixed coupon rate. This is the most senior security and its
coupons are paid first. It is termed senior debt and might carry a AAA
rating.
• A bond whose coupons are paid as long as there is enough left after the
payments to the senior debt is made. This bond might carry a BB rating,
and is often known as the mezzanine tranche.
• A claim on the residual cash flows from the original portfolio after the two
senior classes are paid. This third tranche can either be structured as a high
yield bond or an equity claim.
By raising finance in this way, it is possible to minimise the cost of finance for
the SPV as 80% or more of the total finance is likely to be senior debt.
This might carry a spread over LIBOR that is comparable or only slightly
higher than that on corporate bonds of a similar credit grade, whereas the
spreads on the mezzanine tranch would be several hundred basis points and
the equity tranch would carry a still higher yield (to reflect the significantly
higher default risk).
Conversely the underlying assets are likely to be sub-investment grade or
unrated issues.
Hence the CDO structure enables these assets to be packaged and financed at
lower cost than if they were issued individually.
(iv) The carry is the return obtained by holding an asset (eg positive carry could be
the yield on a bond, and negative carry could be the storage costs for precious
metals).
Negative carry trade examples: borrowing high-yielding currencies and
lending low-yielding currencies (yield based on overnight interest rates),
borrowing at overnight interest rates to invest in a commodity which is in
contango/has a cost of carry.
Page 3
(v) (a) Profit = 500,000,000 / 120 × (5.3% - 0.5%) / 360 = $555.56 per day
(b) A haircut is the extent of reduction from market value that is applied
when assessing the quality of an asset for collateral purposes. This
figure reflects the possible reduction in value that might occur before
the collateral can be sold, in the event of the borrower defaulting.
(c) Where a trade consists of borrowing and investing the proceeds in a

high quality asset, it would normally be possible to post the asset as
collateral against borrowings. Therefore capital only needs to be placed
to cover the haircut, rather than the full economic exposure, creating
leverage.
(d) The maximum leverage ratio is 1 / 7.5% = 13.3 times.
(vi) These assets may:
Yield more than comparable corporate issues, after allowing for expected
defaults – giving a reserving advantage over corporate issues.
Have a higher expected return than comparable corporate issues, after
allowing for expected defaults – giving a return advantage over corporate
issues.
The correlation of defaults on asset-backed issues with defaults of corporates
may be relatively low (depending on the underlying assets within the CDO or
SPV issuing the commercial paper), creating a diversification advantage for
investment returns.
In summary, these assets have a legitimate place within a diversified portfolio
but the life office will need to “look through” to the underlying pool of assets
to understand the risk exposures, both in terms of concentrations and the
default experience of different underlying assets. Without this understanding,
the case for investment is dubious.
These assets may be less liquid than comparable corporate issues, therefore the
life office will also want to structure its portfolio in a way that ensures
adequate liquidity in the event of liability payments being accelerated
compared to current estimates.
(vii) In practice this level of leverage would not provide any contingency against
overnight losses on the collateral relative to the underlying trade, which would
require additional collateral to be posted to the lender/prime broker. Therefore
some capital needs to be set aside to cover this risk, else the fund would be at
high risk of insolvency through lack of liquidity.
Additional capital would be required to ensure liquidity in the event of
increasing correlations between the trading opportunities that are believed to
be weakly correlated. Correlation tends to increase over short periods across
illiquid and volatile asset classes when there is a shortage of liquidity in the
financial markets, even where the long-term behaviour of asset classes is only
weakly correlated. This reflects the “flight to quality”.
The Compliance Manager will also want to ensure that the hedge fund has
processes in place to monitor the value at risk (VaR) applying to each strategy
on a daily basis to ensure that this does not breach limits for the fund, and this
Page 4
is likely to further reduce the amount of leverage that can be applied. In

addition to the VaR analysis, other tests such as stress testing may also be
applied.
Capital needs to be available to cover the period between a counterparty to a
trade defaulting and the position being closed out. Potentially this can
represent several days of “naked” market risk.
There may also be a desire to ensure that there is some liquidity in the event of
known future withdrawals of capital by investors.
2 (i)
• The main objective would be to match the liabilities as closely as possible
at the lowest cost possible.
• Bonds are a relatively close match to deferred pensioner and pensioner
liabilities, and relatively close cash-flow matching may be possible for the
pensioner liabilities.
• Passive funds are likely to lead to lower expenses, in terms of investment
expenses, management involvement and the costs of external advisers.
• A combination of Index linked bonds and corporate bonds is a good match
for LPI liabilities because:
- With IL the risk is that inflation is <0% i.e. deflation.
- With corporate bonds (or conventional gilts) an assumed rate of
inflation needs to be set. The risk is that actual inflation turns out to be
greater than the assumed rate.
• The Trustees and Company have decided not to mismatch their liabilities
by investing in equities to the extent that many other pension funds have
because they are risk-averse.
• The plan may have a low funding level so is not able to mismatch its
liabilities.
• The Company’s covenant may not be sufficiently strong to justify
mismatching liabilities for a fund this size.
• The Company may be concerned about ensuring that the pension asset or
liability shown in its FRS17 disclosures is not excessively volatile.
• The fund could have considered winding-up, so adopting a matched
investment strategy would reduce the uncertainty of the cost of a buy out
in the future.
• The investment benchmark reflects the investment policy, and a peer
group benchmark or some other measure is unlikely to be
relevant/appropriate.
(ii)
• The main objective is to transfer the assets into the larger fund as quickly
and efficiently as possible.
• The segregated fund’s investment policy may be distorted a little for a
period of time after the transfer due to the increased allocation to bonds.
However size of new assets is small.
• This may be resolved either by a switch in investments, or by investing
new contributions from the open plan in equities and other non-bond asset
classes.
Page 5
• Need to decide on whether cash or in-specie transfer is appropriate.

• For a transfer of this size it may be possible to arrange an in-specie transfer
to the segregated fund.
• A transfer of a few selected equities may be possible in respect of the £5m
of UK equities.
• This will avoid buying and selling costs.
• Stamp Duty Reserve Tax (0.5%) will be incurred if any new holdings of
UK equities are purchased (but not UK bonds or cash, or non-UK assets).
• If cash is transferred need to consider fully the risk of being out of the
various markets.
• The exact time of realisation of cash out of the pooled funds and
settlement periods needs to be established.
• Consider buying futures ahead of receiving assets in order to maintain
exposure or run down cash in the main segregated fund.
• An alternative to an asset transfer may be to reassign the pooled fund
holdings from the plan into the segregated fund without transferring stocks
or cash; realisation can be done at a later date.
3 (i)
Cashflow profile of a typical DB pension scheme
LIABILITY CASH FLOW

(Higher inflation vs assumptions)
LIABILITY CASH FLOW

(Longevity improves) vs
assumptions)
2010 2020 2030 2040 2050 2060
Page 6
(ii)
• Extremely long-dated Liabilities often linked directly or indirectly to
inflation (Salaries, RPI/CPI and LPI)
• Scheme deficit on a realistic or insurance basis
• High exposure to Equities, credit and non-fixed income investments
• Rewarded risk, but
• No interest rate immunising characteristics
• Too few interest rate sensitive assets (bonds)
• Bonds held often with a passive manager or actively exposed to credit or
duration risk
• Too expensively “managed” for market exposure and available reward
• Too few inflation-linked assets
• No longevity risk protection
• The nominal and real rate bonds that are held are too short in duration in
any case (due to lack of real supply)
• Leads to ineffectiveness in liability “matching” and so “curve” risk
- Pension scheme exposed to changes in the level and shape (and
volatility) of the nominal and real yield curves
• This is unrewarded risk
(iii)
• Shareholders want companies to increase revenues, reduce costs and
manage their risks
• Company has very significant and disproportionate risks to earnings and
balance sheet from pension fund exposure
- The pension risk may be high relative to the size of the business
- Even if pension risk exposures are manageable, the pension fund is a
non-core business activity and consumes management time and
potentially capital/cash at unpredictable times
• Any future demerger or corporate activity is hampered by need for trustee
approval
- Pension scheme members want security, affordable benefits and
understanding of their position
- Trustees and employees concerned about strength of changing sponsor
“covenant”
- Pensions regulators are likely to support any call for full funding at
“Insurance Buy Out” level (viz Alliance Boots, Sainsbury)
• Direct costs arise from risk-based levy payments to funds such as the UK’s
Pension Protection Fund (“PPF”) or US Pension Benefit Guaranty
Corporation (“PBGC”) with potential increases in the cost of capital from
poor risk management
- Risk reduction and control should have direct financial benefit to
company from reduced levy
• Funding level of pension scheme is highly sensitive to changes in nominal
and real interest rates and asset risks
• Historically transferring risk was seen as expensive relative to typical
funding and accounting valuation measures
- Insurance buyout market is becoming more competitive due to new
entrants, but overall capacity is still limited
Page 7
- Market developments (interest rate and inflation swaps, fledgling

mortality swap market) provides greater transparency about the true
cost of maintaining a closely hedged low risk strategy for a pension
scheme without transferring risk
• These cash and balance sheet risk arguments mean that it may be desirable
to inject cash into the fund to facilitate a risk transfer to an insurance
company
- This is particularly the case for former employees (current and deferred
pensioners) where corporate is simply the guarantor of liabilities, but
has no current link to the scheme members
(iv) (a)
• Interest rates
• Inflation
• Asset (equity)
• Longevity
• Currency
• Credit
• Market
• Event
• Legal
• Operational
• Reputation
(b)
• Interest Rates: Risk that interest rates decrease i.e. rates used to
discount the liabilities fall resulting in a higher present value of
benefits
• Inflation/Salary: Risk that inflation increases, thus increasing
benefit levels. Uncertainty on salary increases
• Equity: Risk of a decline in the value of the assets thus not having
enough to secure the benefits
• Longevity: Uncertainty in people’s life expectancy – more people
are living longer but also how much longer and what is the rate of
improvement? Increases the term over which benefits are paid
(c) Interest Rates:

• Unrewarded risk i.e. significant risk with no corresponding return
potential
• Very easily removed in a cost effective way
Inflation:
• Unrewarded risk i.e. significant risk with no corresponding return
potential
• Easily removed in a reasonably cost effective way
Equity:
• Increased deficit could also impact leverage of the sponsor
• Rewarded risk i.e. significant risk but potential for higher returns
• Easily removed in a reasonably cost effective way
Page 8
Longevity:
• Standalone risk with no “matching” assets
• Difficult to remove cost-effectively without full risk transfer
(v) Asset and liability risks can be:

• Reduced (by changing investment policy but may increase long term cost
to sponsor)
• Managed (by hedging unrewarded risks)
• Transferred (to insurance market)
Barriers to success
• Pension governance process moves much slower than capital market
repricing
• Risk transfer requires clean data – and so time to restore
• If Scheme has significant investments in equity markets, unattractive to
insurer
• If Scheme has significant investment in illiquid assets, unattractive to
insurer
• All insurance companies are backed by same regulatory structure so
should be indifferent on “quality”
- Established insurers could sell their annuity book so that “brand value”
is lost
- Hence it is reasonable to go for cheapest quote, assuming same
liabilities are being secured
- Insurance company will guarantee basis of calculation, not level
• There could be cheaper “non-insured” alternatives
• Equity and credit markets remain volatile
- Further fall could make funding buyout “gap” untenable
• Long-term Interest rates remain volatile
- Ongoing pension fund and insurance company demand for limited
supply could make buyout unaffordable again
• Insurance company needs to invest in riskless assets to satisfy its regulator
- Insurance company will not have natural “matching” investments so
will need to source externally
- large trade will have market impact if implemented insensitively or too
quickly
- But slow implementation increases risk of asset inadequacy – and this
will be priced in to quotes
• Need to consider also
- Scope to hedge funding level quote to maintain affordability while risk
is priced
- Cost and ability to raise funds to bring Scheme to overall buyout
funding level
- Ability to pre-position investments ahead of buyout date or use overlay
strategy to close the gap between what the Scheme has and what the
preferred insurer needs
- Blackout period needed to effect asset transition
- Probably will appoint a transition manager or bank to work with
preferred insurer to optimise realisation of existing assets and establish
new investment policy
Page 9
- How to derisk any retained assets and liabilities for active members
- When and how to disclose pension solution to market
Page 10
EXAMINATION
22 September 2008 (pm)

booklet.
supervisor.
5. Attempt all three questions, beginning your answer to each question on a separate
sheet.
question paper.
1 A well established asset manager has traditionally invested on a “long only” basis.
The organisation has decided that they should launch a Global Equity Long/Short
fund for investors within the next six months to capitalise on the interest of
institutional investors for alternative investments.
The Chief Executive Officer has read that so-called “Extended Alpha” or “Relaxed
Long-only” funds are proving more popular and suggests that the organisation
develops a 130/30 product instead of the Global Equity Long/Short fund.
(i) (a) Describe the term long/short.
(b) Explain how this is different from a traditional equity fund.

[2]
(ii) Outline the sources of additional returns and risks a long/short fund has
compared with a long-only fund. [3]
In the marketing material the fund is described as a “bottom-up” fund.
(iii) Define the term “bottom-up”. [1]
The new fund is a “best ideas” fund which will have only 30 stock positions and will
have a target return of 6% above the MSCI Global Equity Index with a tracking error
expected to be about 12% per annum on average. The expected return of the MSCI
Global Equity Index is forecast to be 10% per annum over the next five to ten years.
(iv) (a) Describe and set out the formula for the term tracking error.
(b) Calculate the expected return and range of returns the fund could
generate if all the assumptions above are correct.
(c) Comment on the expected return target and suggest other ways it could
be achieved.
[5]
(v) Describe the factors that will influence the tracking error of the fund relative
to the index. [3]
(vi) Define and calculate the expected information ratio of the portfolio. [2]
(vii) Explain what is meant by a 130/30 fund. [2]
(viii) Outline the reasons why a 130/30 fund would be more popular than the Global
Equity Long/Short fund. [8]
(ix) Outline the difficulties in managing a 130/30 fund. [4]
(x) List the key considerations in determining the constituents of the short
portfolio. [6]
(xi) Outline the key factors to be taken into account when deciding how the short
portfolio should be managed. [2]
SA6 S2008—2
The Chief Executive is concerned that the organisation’s lack of a track record in
managing hedge funds will make investors reluctant to commit to a new 130/30
product.
(xii) Compare the relative merits of traditional asset managers and hedge fund
managers in offering a 130/30 fund. [10]
[Total 48]
2 The government of an overseas country wants to increase the number of owner

occupied households. In order to achieve this objective the government issues
mortgages directly to the people, usually for 100% of the market value of the house.
Due to the demographics of the country a large percentage of the mortgages are
described as sub-prime debt. The government sells the mortgages to a Special
Purpose Vehicle (SPV) and you have been offered the opportunity to invest in the
SPV.
(i) (a) Define the term sub-prime.
(b) Explain how the default rate, risk and return characteristics of sub-
prime debt differ from investment grade debt.
[3]
(ii) Explain what securitisation is and why the government may wish to utilise a
SPV to securitise assets. [5]
(iii) Describe how securitisation is usually structured within a SPV and the
characteristics of the tranches offered to investors. [6]
The overseas country enters a period of recession.
(iv) Describe how the risk characteristics of the tranches within the SPV may
change as a result of a recession. [6]
[Total 20]
3 You are an investment consultant to pension funds and have been contacted by a trade
journalist who has recently started in the pension and investment media. The
journalist is writing an article on structured products and how they can improve the
pattern of returns achievable. They have approached you to better understand the
terminology and the reasons why pension funds should use structured products.
(i) Explain, by defining and with reference to the traditional asset classes used by
pension funds and derivatives, what structured products are. [10]
(ii) State the features that can be used to classify different types of structured
product. [5]
(iii) State the principal needs of pension funds from their investments. [3]
(iv) Explain with examples the reasons why pension funds would consider
investing in structured products. [14]
[Total 32]
END OF PAPER
SA6 S2008—3

EXAMINERS’ REPORT
September 2008
Introduction
R D Muckart
December 2008
General comments
A better answered paper than previous diets, reflected in a higher pass rate despite a higher
pass mark. Candidates typically answered Question 2 better than the others, perhaps
reflecting the worldwide topicality of the subject with Question 3 attracting the worst
responses. Although structured products are less widely employed in final salary pension
schemes, they are popular retail investments and so may see greater take-up in defined
contribution arrangements. Hence a wider “general knowledge” could be employed to
generate marks over and above the syllabus content.
This was the second diet to feature a third question and some candidates may have left
insufficient time to complete the question, even if they understood the key issues. Given the
diversity of issues affecting institutional investors and the direction of the paper to address
practical solutions, then it is quite likely that future papers will also feature three questions.
Many candidates seemed to understand the key issues being examined and so appreciated the
general content of solutions that the examiners were looking for – however those that were
unsuccessful will find their solutions lacked sufficient (and often the most basic) detail and
scored lower accordingly. Worse, some candidates deviated from the topic and included
irrelevant material – although candidates will not be explicitly penalised for this, it gives an
impression of a lack of understanding and, more importantly, wastes valuable time. Where
candidates made relevant points in other parts of their solutions, the examiners have used
their discretion as to whether to recognise these answers or not.
Again there were many candidates close to the pass mark whom were awarded an FA – most
candidates would be very surprised to see just how tightly distributed the marks are; deciding
where the pass mark falls will have a material impact on the numbers of candidates who are
successful and the examiners take great care to ensure a consistency of standard across
candidates, subjects and diets. It was fairly clear where the hurdle should have been set; as
a result, the pass rate for this diet was slightly higher than last time and, encouragingly, the
pass mark slightly higher too, continuing the recent trend. However the pass mark still
remains lower than the examiners feel ought to achievable by candidates, who are likely to be
working as advisers or asset managers in this most practical of fields. Although no
candidate was awarded an FD in this diet (which is a further positive improvement in the
overall standard), the examiners remain concerned by the numbers of candidates still
achieving only an FC grade since this too would imply little knowledge and understanding.
Candidates are reminded of a bias in the paper towards recognising higher level skills and
Page 2
likely scope for examination. New asset classes and ways of investment will themselves
generate new types of risk and so the need for new ways of monitoring and management.
Page 3
1 (i) Traditional fund invests in shares. If don’t like a share then no holding.
For long/short can also sell shares which the fund doesn’t currently hold
(going short) which fund believe will decrease in value to generate additional
returns.
(ii) Returns – can benefit from performance of shorted shares if they decrease in
value as can buy in market and sell on for profit.
Risks – If shorted shares increases in value then make additional losses

(unlimited downside potential) compared with long only fund. Increase in
operational risks associated with administration of shorted shares.
(iii) Looking for the best value individual investment irrespective of their
geographic or sectoral spread.
(iv) (a) Tracking error is the percentage difference in total return between a
fund and the benchmark the fund is being measured against, usually
termed active risk.
The ex-post Tracking Error formula is the standard deviation of the

active returns, given by:
∑iN=1 ( X i − X )2
T .E . =
N −1
where Xi is the difference between the fund return and the index return
for period i, that is, if di is the return for the asset in period i, and bi is
the return for the benchmark period in i, then Xi = di − bi. N is the
number of observations, and
∑iN=1 X i
X=
N
(b)
• The expected return is 6% above index of 10% so would expect
return of 16%
• Tracking error is 12% per annum, so range of returns could be
−2% to 22% based on expected returns.
(c) A long-short equity fund would typically aim to be “market-neutral”,

i.e. it would have a beta of close to zero.
Therefore a target return of MSCI + 6% would seem to be
inappropriate, and similarly a tracking error of 12%.
Long short funds typically have targets expressed in absolute/real
terms, for example a target return of RPI + 6% and a target volatility of
12% might be more reasonable.
[Credit available for discussion on equitised long-short funds]
Page 4
(v)
• The degree to which the portfolio and the index have common stocks
• Difference in country, market cap, sector, investment style of fund relative
to index
• Difference in weighting of individual stocks relative to benchmark
• Volatility of the benchmark
• Beta of portfolio
(vi) Information ratio is defined as excess return of portfolio/tracking error. For the
fund it would be 6/12 = 0.5
(vii) Long-only – potentially inefficient as limits the manager’s scope to add value
via underweight stances.
A 130/30 fund invests 130% long & 30% short
(viii)
• From an investors perspective:
- Increased performance: maybe
- Reduced Risk: almost certainly
- Better risk-weighted returns: should be
• From an Asset Managers Perspective:
- Current popularity will increase AUM
- High net fees due to Incentives
- Better staff retention
• Take advantage of regulatory changes
• More efficient ways to deliver Alpha
• Access to Hedge Fund style
• Wider acceptance of “Alternatives”
• Fear of reduced Equity premium
• Risk budgeting
(ix)
• Assumes manager equally good long & short
• Additional costs of shorting
• Expertise in mitigating costs of shorting
• 160% exposure – increased risk?
• Differential Fees – Incentive Fees
(x)
• Return Generation or Hedging?
• Indices
- Simple to trade
- Low granularity
• Stocks
- Highly specific
- Requires significant research/analysis
• Sector shorts – indices versus individual
- Which markets
- Need high diversity levels within market
Page 5
- Low index weight

(xi)
• Familiarity & skill at shorting stocks
• Cost efficient manner
• Derivative structures – CFDs
(xii) Is fund management an art form?

• Vague connection between skill & Alpha
• Skills can be identified
• Skills can be objectively analysed
• Manager track records only show how funds have performed against target
benchmark
• Don’t tell us about manager’s investment process, strengths or weaknesses
• Poor guide to the future
• Track records are a quantitative measure
• Say little about manager’s fundamental skill
• Timing skill important as selection
- Ability to tell if a stock will do well or badly
- Time the buying & selling decisions well
- Have courage in their own convictions
- Overweight winners
- Managers are better buyers than sellers
- Timing is very important – 100bps+
- Different attitude to risk when buying than selling
- Risk averse in profit – risk takers in loss
• Behavioural factors
- Each position viewed separately
- Potential winners sold too early
- Poor performers retained too long
- Fail to run winners & cut losers
- Managers value stocks more when they own them
- More time devoted to research of stocks owned
Traditional Hedge Funds

Skilled at longs & shorts Limited Evidence Proven quality
Good risk management Well developed Under development
Operationally efficient Should be Larger players only
Ability to implement good product High OK
structure
Scalability Good
Page 6
2 (i)
• Sub-prime debt is graded less than BBB, also often referred to as junk
bonds. Sub-prime attracts a rate higher than prime debt.
• The “spread” over treasury or investment grade securities may vary
significantly according to the environment and the perception of future
default rates.
• The expected default rate for sub-prime debt is higher than investment
grade debt
• Sub-prime debt is expected to be riskier than investment grade and
therefore, expected return investors seek is higher than investment grade
debt.
(ii)
• Securitisation is term used to describe conversion of a bundle of assets into
a structured bundle of assets which can be sold.
• Government may wish to use SPV to reduce exposure to sub-prime
mortgages, the structure of the vehicle means that the debt becomes
bankruptcy remote.
• Packaged into a tradable security might make it more attractive to
investors in terms of diversity of holdings, exposure to market sectors not
so easily accessible, improved pricing, valuation, comparability with other
investments and monitoring or pledgable as collateral or as the base for
some other structure
• Alternatively it is possible to sell tranches or securities with different
features to different classes of investor based on the pool of underlying
assets.
(iii)
• Senior debt, AAA rated, fixed rate, paid first, attract lowest coupon rate
• Mezzanine, BB rated, paid out after senior debt, higher coupon than senior
• Third tranche, high yield debt, paid out after other two tranches, highest
coupon due to risk
• Other tranches/structures are possible
(iv)
• Senior debt still likely to be fully payable, however in a hard hit recession
may have some default risk attached.
• Mezzanine, due to high risk underlying assets maybe subject to some
default risk or pre-payment risk
• Third tranche, subject to high risk of default risk as people unable to keep
up mortgage payments in recession. Likely to suffer from losses.
• Although the default rate may vary and so the riskiness of the underlying
asset pool resulting in the suggested payoff profile, much also depends on
the ability of the SPV to finance its ongoing obligations and changes in the
credit terms extended.
• As in many issues of credit, perception of future creditworthiness may be
more important than actual and markets may appear “irrational” in pricing
and impacts for extended periods of time
Page 7
• In addition, it is important to distinguish between a “local” recession and

the impacts of a worldwide malaise since this may impact the term and
depth of any recession and its consequences.
3 (i) Bonds issued by governments, banks and companies provide income in the
form of regular coupons for a specified period of time until the face value of
the bond (the “principal”) is paid back.
Coupons and/or principal can be linked to an inflation index or more
commonly fixed in nominal terms.
Bonds provide a high degree of certainty in terms of how much money will be
paid and when it will be paid.
Equity is an investment in the future profit stream of a company.

The investor buys a “share” of the company and receives dividends from the
company until such time that the equity is sold.
Neither the dividends nor the future sale price of the share are known at the
time of purchase, so the anticipated return is very uncertain.
History tells us that equities have the potential to provide much higher returns
than bonds, if held for long periods of time.
It has on occasions, however, taken in excess of 30 years for this to happen!
Derivatives are financial contracts between two parties that “derive” their
value from the performance of one or more underlying investments.
Structured products are financial instruments that combine various

investments and derivatives to create a unique asset, which meets particular
investment requirements.
The most common example seen in the world of retail investment is the
“capital protected equity plan”. This structure typically involves:
A bond bought to guarantee part or all of the original investment
Derivative contracts (typically equity index call options) which provide a
return in addition to the bond.
The range of available Structured Products has expanded considerably in
recent years in response to different investors’ particular needs.
Page 8
(ii) Structured products can be classified by:

• Investment objective e.g. income generation, capital growth/protection
• The underlying investment e.g. equity, interest rates, credit, foreign
exchange, commodities, property etc.
- A product may derive its return from more than one asset, so called
“hybrids”.
• Maturity date
• View on market e.g. high/low volatility, positive/negative view of future
etc.
• Amount of principal repaid at maturity (alternatively, a “cancellable”
structure guarantees capital throughout the product life)
• Amount of leverage
(iii) Needs of all pension funds:

• Maximising returns with an appropriate level of risk for the corporate
sponsor and members
• Balancing affordability for the employer and security for the members
• Diversification (i.e. avoiding concentration of risk in a particular security,
sector, asset class)
• Ensuring sufficient liquidity or income generation exists to meet short-
term liability obligations (e.g. pension payments)
• Capital growth and income at a level that ensures that total returns are
sufficient to meet the funding objective (which should have regard to
realistic prospective returns on the assets held)
(iv) Increasing security: Pension funds can benefit from future market growth
from their “risky” investments, whilst removing or reducing other risks e.g.
higher inflation.
Maximising returns: Normally you can’t increase returns without increasing

risks – however some risks are not associated with increased returns!
Removing these “unrewarded risks” can help the scheme to take risk where
the rewards are greatest.
For eaxmple – equity-linked products that turn into high yielding fixed income
investments once they have secured some profits may be particularly attractive
e.g. a structure that pays out coupons equal to the capped positive performance
of the underlying equity markets, so long as those markets don’t fall below
their starting levels.
Even in a falling market scenario, the pension scheme still gets its initial
investment back. The typical “cap” on the annual return is surprisingly high –
higher than the average long term return from equity and probably higher than
most scheme sponsors’ accounting assumptions.
Diversification: It is generally accepted now that getting the best risk/return

balance involves spreading your investments among a wide range of different
asset classes, rather than attempting to pick individual investments with the
most attractive individual return potential. Pension schemes can use
Structured Products to access a wider variety of markets or economic factors
in order to complement their existing investments.
Page 9
Easier access: Barriers to direct investment in an asset class, such as physical

availability, taxes, lack of liquidity, regulation, make access difficult or simply
unaffordable.
However a pension scheme wishing to diversify into the German industrial
property market can achieve this through a structure which offers a payout in
line with the German property sector index – with capital guaranteed.
Cash flow match: Pension funds are looking to remove duration and inflation
risks from their pension obligations – and many are now using structured
products to do just this.
A pension scheme which needs £1m a year, increasing in line with the retail
price index to pay pensions for the next 30 years, can invest in a 30 year
structured product that does just that.
The product could also be structured to increase payments when mortality
rates improve.
Reduce costs: Products, once structured, need little maintenance or

underlying trading so management costs fall significantly.
A pension scheme that wants exposure to FTSE100 equities could invest in a
fund that “passively” tries to replicate the FTSE100 index. Management and
rebalancing costs are charged against returns as the manager needs to
continuously rebalance the fund to keep proportions in line with the index.
Alternatively the scheme could buy a product that guarantees that return (or
even a small outperformance) for an initial fee much lower than the costs of
the managed fund.
Flexibility/Customisation: Structured products are sufficiently flexible to be

tailored to any individual pension fund’s risk appetite or to satisfy a particular
regulatory target affecting the whole sector.
For example, pension schemes may need to pay pension increases subject to a
cap – there are no long-dated government bonds that pay out like this, but the
scheme could buy a structured product that did.
Alternatively the sponsor might like to limit the potential size of any reduction
in surplus (or increase in the deficit) for their scheme to a specific value (to
say £50m) during the year or over a period of years.
Page 10
EXAMINATION
27 April 2009 (pm)

booklet.
2. You have 15 minutes before the start of the examination in which to read the
questions. You are strongly encouraged to use this time for reading only, but notes
may be made. You then have three hours to complete the paper.
supervisor.
sheet.
question paper.
1 Your firm is replying to an invitation to tender to provide investment advisory
services to the University Endowment Fund, which had total assets of €2,500 million
as at 31 December 2008. In recent years the Endowment Fund has grown
significantly through the adoption of a highly diversified investment strategy
focussing on illiquid, skill-based investments, and through a number of successful
finance-raising campaigns.
The Endowment Fund has the following broad objectives in its governing
documentation:
• to increase assets after distribution at a rate higher than inflation

• to contribute to the University’s budget in a sustainable manner
• to avoid sudden changes in the monetary level of spending
The following information has been provided to you regarding the Endowment
Fund’s finances:
Year ended Spending by % of total Gifts to Investment

Endowment University Endowment return
income
31/12/2008 €240m 38% €50m (€400m)

31/12/2007 €220m 36% €125m €250m
31/12/2006 €170m 29% €115m €275m
31/12/2005 €160m 31% €75m €200m
31/12/2004 €150m 30% €70m €200m
Asset allocation at 31/12/2008:
Asset class %
Absolute return equities 20%

Market neutral equity hedge funds 20%
Credit hedge funds 5%
Commodity funds 10%
Other active management strategies 10%
Private equity 10%
Illiquid assets — timber, infrastructure 15%
Inflation-linked bonds 5%
Cash and short term bonds 5%
You have been advised that the University has very little flexibility to reduce its
expenditure in the next three to five years, and that the short-term outlook for gifts is
weak due to the current economic climate.
(i) Describe the various factors that should be considered in determining the level
of investment risk that should be adopted by the Endowment Fund. [6]
(ii) Analyse the experience of the Endowment Fund, having regard to the financial
objectives listed above. [9]
SA6 A2009—2
(iii) (a) Explain whether the University’s increasing dependence on the
Endowment Fund should necessitate the adoption of a lower-risk
investment strategy. [8]
(b) Recommend a target allocation to bonds consistent with your answer to

part (a). [4]
[Total 12]
The University is subsequently offered a gift of €500m in five equal annual payments.
The donor has requested that his gift is used for long-term purposes and capital
expenditure only, and not used to meet other expenditure in the next five years. He is
also extremely concerned that his gift should not fall in value in the short-term and he
has therefore suggested that the first payment could be invested in a principal
protected note marketed by a bank that has a five year term and provides at maturity
the following payment:
⎛ FTSE100 Price Index @1/4/2014 ⎞

€100m × max⎜⎜1, ⎟⎟
⎝ FTSE100 Price Index @1/4/2009 ⎠
(iv) Explain how the issuer of such a note would invest the proceeds to provide
this payout. [3]
(v) Explain:
(a) why such a note carries counterparty risk
(b) where the note would rank within the capital structure of the bank
[4]
(vi) (a) Describe two alternative ways of generating the same payout that
would avoid loss of principal in the event of the issuing bank failing.
(b) Explain how issuer risk has been mitigated for each alternative in (a).
(c) Describe any residual risks that remain.

[8]
As part of its investment process, the Endowment Fund carries out scenario testing
based on specific shocks to different industry sectors. These are in addition to the
more typical scenarios that would be investigated for risk management purposes.
The Chief Investment Officer has asked you to consider the impact of global
overcapacity within the automobile industry sector, assuming a neutral economic
climate in terms of economic growth and interest rates, with stable commodity prices
and price inflation and wages.
(vii) Comment on the potential impact on the various parts of the portfolio of this
particular scenario. [10]
[Total 52]

2 Describe the financial behaviours exhibited by a non-professional investor who:
(a) Continues to hold shares in a company which has lost 60% of its value in the
last 12 months and the general market consensus is that the share price will
fall further.
(b) Buys stock in his favourite car company based on one positive research note
written by a non-professional, whereas all other broker notes are negative
towards the stock.
(c) Buys a stock in MakemeMoney (an internet retailer) which has risen in value
from £20 to £40 per share over the last two years. MakemeMoney has been
successful at winning new customers. However, the market is becoming more
competitive and it is likely that MakemeMoney will lose customers. The
investor continues to hold the stock as he believes that, based on past
performance and his own research, the share price will double again over the
next two years.
(d) Buys a bond with a 5% per annum guaranteed return. The alternative
investment he could have made was in a bond with a 20% probability of a 0%
return and an 80% chance of a return greater than 10% per annum. When
discussing the bond investment with his wife, he states “we can either invest in
a bond which will guarantee 5% each year or in a bond where there is a 20%
chance we will not make any money”.
[16]
3 A developed economy has experienced significant problems with its banking industry
following the collapse of a property boom in its domestic economy, and the exposure
of the banking industry to bad loans resulting from this. The problems in the banking
industry have significantly impacted confidence and bank liquidity been significantly
reduced.
Similar problems are also occurring in other economies. However, in order to prevent
a meltdown in its banking industry, and consequently to help the broader domestic
economy, the government has decided to purchase the most illiquid mortgage debt
from banks. This will involve doubling the fiscal deficit.
(i) Discuss the effectiveness of the government’s proposal in helping the broader
economy, including its effects on the country’s exchange rate. [14]
(ii) Discuss another action that the government could take to alleviate the
problems in its banking industry. [4]
The regulators are considering changing the accruals accounting policies, and
introducing an embedded value reporting regime for its domestic mortgage banks.
This would involve estimating the “future value” of a mortgage bank’s mortgage
book, and basing profitability on the annual change in this value, along with income
accrued during the year.
In this economy all mortgages sold are “tracker” type mortgages, with rates fixed at
100 basis points (bps) over the base interest rate set by its central bank.
SA6 A2009—4
(iii) Calculate and discuss the likely implications of this proposal, in an
environment where inter-banking lending rates have increased significantly
following the banking crisis.
In your discussion, include a hypothetical numerical example of a typical

mortgage bank, assuming that inter-bank lending rates have increased from
20bps over the central bank rate to 120bps over the central bank rate, and that
the mortgage bank’s costs are 40bps. [8]
(iv) Explain the main argument against implementing the proposal in this
circumstance. [2]
An actuary has just been appointed as the chief banking regulator in this economy.
(v) Describe two changes that the actuary is likely to propose to the banks. [4]
[Total 32]
END OF PAPER
SA6 A2009—5

EXAMINERS’ REPORT
April 2009
Introduction
R D Muckart
July 2009
Comments
Disappointingly, this was a generally worse answered paper than the previous diet, reversing
what had been an encouraging trend, resulting in a lower pass rate despite a slightly lower
pass mark.
There was no question answered better than the others, but the range of responses for each
question was wider than before, particularly Question 3. Given the global topicality of the
subject, although the marking schedule reflects the most likely solution reflecting recent
experience, full credit was given for well thought through alternative solutions to an issue
which is affecting everyone personally, publically and professionally.
Behavioural finance has been a feature of many recent papers and, again, very topical as
markets have behaved increasingly “irrationally”, hence I would have expected Question 2
to be answered better than it was. Candidates were either confused between the different
behavioural biases or were unable to identify which were the most likely to be relevant.
This was the third diet to feature a third question, yet still some candidates seem to have left
insufficient time to complete their last question, even if they understood the key issues.
Given the diversity of issues affecting institutional investors and the direction of the paper to
address practical solutions, then it is quite likely that future papers will also feature three
questions. Time and priority management are also key skills actuaries need to have.
Many candidates seemed to understand the key issues being examined and so appreciated the
general content of solutions that the examiners were looking for – however those that were
unsuccessful will find their solutions lacked sufficient (and often the most basic) detail and
scored lower accordingly. Worse, some candidates deviated from the topic and included
irrelevant material – although candidates will not be explicitly penalised for this, it gives an
impression of a lack of understanding and, more importantly, wastes limited time. Where
candidates made relevant points in other parts of their solutions, the examiners have used
their discretion as to whether to recognise these answers or not.
As in previous diets, there were many candidates close to the pass mark whom were awarded
an FA – most candidates would be very surprised to see just how tightly distributed the marks
are; deciding where the pass mark falls will have a material impact on the numbers of
candidates who are successful and the examiners take great care to ensure a consistency of
standard across candidates, subjects and diets. The pass mark still remains lower than the
examiners feel ought to achievable by candidates, who are likely to be working as advisers or
asset managers in this most practical of fields, particularly given the improving trend in ST5.
Although no candidate was awarded an FD in this diet (which is a further positive
improvement in the overall standard), the examiners remain concerned by candidates
achieving only an FC grade since this would imply little knowledge and understanding.
Candidates are reminded of a bias in the paper towards recognising higher level skills and
Page 2
likely scope for examination. New asset classes and ways of structuring investment will
themselves generate new types of risk (such as operations, liquidity, credit and counterparty),
so the need for new ways of monitoring and management. Similarly we will be looking for
candidates to be able to apply theory appropriately for non-pension fund situations.
All extenuating and mitigating circumstances were considered in awarding grades and,
where there was a genuine cause, credit given.
Page 3
1 (i) The actual scope to take investment risk will be a complex decision, and there
will be a range of reasonable answers that can be justified.
Relevant factors will include:
University constraints
• University’s level of dependence on the endowment (% of funding from

this source)
The higher this is, the less scope there is to take investment risk in the
endowment
• University’s ability to secure other sources of funding in the event of the

endowment spending less (e.g. tuition fees, gifts, government funding,
sponsorships)
The higher this is, the more scope there is to increase investment risk in
the endowment
• University’s ability to reduce expenditure (short-term and long-term scope

may differ)
The more scope there is to reduce expenditure, the more scope there is to
increase investment risk within the endowment
• University’s other assets

Potentially these might permit more investment risk to be taken within the
endowment.
Endowment constraints
• The higher the level of annual spending, as a proportion of assets, the less
scope there is to take investment risk
• Future commitments (e.g. undrawn commitments to private equity

programs) may mean part of the endowment needs to be held in liquid,
realisable assets
• Some existing assets will be illiquid, so changes in asset allocation will

need to be deferred until exit opportunities from existing investments arise.
Governance/other constraints
• There may be restrictions on particular asset classes due to social or other

factors, e.g. within the constitution of the University
• The University may request the endowment not to make investments

where there is a risk of reputational damage (e.g. arms manufacturers)
Page 4
(ii) Quantitative analysis:
Year ended Assets y/e Annual change in Assets / spending by University Annual
endowment endowment income change
spending
(a) (b) (c) (d) (e)
31/12/2008 2500 9.1% 10.4 632 3.3%
31/12/2007 3090 29.4% 14.0 611 4.2%
31/12/2006 2935 6.3% 17.3 586 13.6%
31/12/2005 2715 6.7% 17.0 516 3.2%
31/12/2004 2600 17.3 500
31/12/2003 2480
Formulae:
(a) Start of year assets = End of year assets + Spending – Gifts –

Investment Return
(b) Annual change
(c) Ratio of endowment assets to endowment spending in current year
(d) University income = Endowment spending / % of total University

income
(e) Annual change
Commentary
The University is highly dependent on the endowment at the present time as

shown by the increasing proportion of total income provided by the
endowment.
In a climate of falling gifts and rapidly growing expenditure it is likely that

short-term dependence on the endowment will increase further (unless capital
expenditure has been a key factor in recent spending).
Recent spending by the endowment has not been matched by increases in gifts
and investment returns, unlike the position up to 2006 when assets and
spending were increasing by similar amounts each year.
The University should be concerned that the ratio of endowment assets to

endowment spending has fallen so far in the past two years, to a level that is
no longer sustainable.
The endowment was meeting the all of the three financial objectives (asset
growth, sustainable spending, stable spending) between 2004 and 2006.
Since 2007 both of the first two financial objectives have been breached,
although this may reflect temporary circumstances (e.g. an expansion of the
Page 5
university) and short-term financial difficulties (weak level of giving, and poor
investment returns).
A further source of concern is that only 10% of assets are in liquid asset
classes (bonds and cash) at a time of low donations, which could lead to
forced asset sales at a time of low asset valuations.
(iii) Analysis
Arguably the endowment’s spending is becoming increasingly guaranteed in

nature, particularly in the short to medium term. This is because as the
proportion of University income derived from the endowment increases, it
becomes more difficult to replace this source of income. In the longer term it
may be possible for the University to access other sources of funding or
reduce expenditure to reduce dependence on the endowment.
For a guaranteed liability, the perfect matching asset in x years time is a zero
coupon risk-free bond with term x.
This would suggest an increased weighting to short to medium duration bonds

to match future planned spending.
However the endowment does not have sufficient assets to meet the current
nominal level of spending in perpetuity, before allowing for expected future
increases (which would require a still larger asset base).
The endowment also has the objective of growing its asset base in real terms
over time.
Without an increase in gifts or a reduction in the level of spending, it will not

be possible to simultaneously maintain the real value of the endowment over
time and distribute the desired amounts with a high degree of certainty over an
extended period. Increasing investment risk (in the aim of achieving higher
expected returns) will increase the long-term expected growth rate, but will
also increase the probability of the endowment needing to reduce its spending
in the event of poor investment returns.
ALM analysis can help find an appropriate balance between these objectives.
With a larger asset base, it would be possible to reconcile these objectives by

investing in a mix of growth-oriented assets (as currently) and liquid assets to
cover short-term spending.
Recommendation
On strategic grounds, it would be desirable to increase the allocation to bond

assets to perhaps 30–50% of assets (to cover 3–5 years spending) as the
University will not be able to obtain additional funding from elsewhere over
this period. From a tactical perspective it will be difficult to achieve this
without selling assets at low valuations. This is a particular issue for the assets
Page 6
held in illiquid assets, although it should be possible to realise a high

proportion of assets held in skill-based strategies (e.g. equity market neutral,
TAA or active currency) without being unduly concerned about this issue.
Therefore a medium-term target of 30-50% coupled with a short-term target of
20% bonds may be more realistic, investing new funds or returns of capital
from existing strategies into bonds. If investment returns and/or gifts are
healthy over the next few years this may enable the medium term target to be
lowered to 20–30% bonds whilst still covering 3–5 years spending.
(iv) This type of structure is typically invested in a zero coupon bond plus an
equity call option to provide the equity upside. For example at an interest rate
of 6% pa over 5 years, around 75% (=1.06−5) of the initial investment needs to
be invested in the bond, leaving 25% (including expenses) to finance the
purchase of a 5 year FTSE100 at-the-money call.
(v) If the issuing bank becomes insolvent, then the entire payment due at maturity
will become an unsecured liability of the bank.
It will rank equally with other unsecured creditors such as deposit-holders and
potentially some of the bond-holders, and rank behind creditors with security.
Most bond-holders and all equity shareholders will rank below the purchaser
of a note.
In such an event, it is likely that less than a full return of principal will occur,
and potentially there could be a total loss of principal (although historically
losses have been well under 50% in most cases).
(vi) The endowment could invest in a FTSE100 index fund or an ETF to obtain the
equity exposure without counterparty risk (as funding is not being provided to
a bank).
To obtain the desired payoff profile, an equity dividend swap will need to be
entered into, which will finance the purchase of an at-the-money put to
provide principal protection on the FTSE100 price index.
Provided the put and dividend swap are written under documentation that
provides for frequent collateralisation (e.g. daily), there will be no direct
counterparty risk.
An alternative approach would be to invest in a secured deposit with one or

more banks and buy the equity call under documentation that provides for
collateralisation.
Under either of these strategies there will be replacement risk for the
derivatives in the event of failure of the bank(s) writing the derivatives, as the
derivatives would be closed out at their current value and replacement
derivatives would need to be found in the markets for the remaining term (or
an unhedged position continued). However the underlying principal would be
protected.
Page 7
(vii) Overcapacity is likely to lead to lower margins on car production, and possibly
some restructuring activity (redundancies, plant closures). This will lead to
poor profitability within the auto production sector (manufacturers and
suppliers) and below-average profitability within the auto finance sector.
Equity holders in these companies will suffer a much greater loss of value than
bond holders, although some much of this information may already be priced
into asset values.
Whilst debt/equity ratios are relatively low within the auto sector, these
businesses often have very large unfunded pension and healthcare liabilities,
creating a much higher implied leverage ratio.
Therefore bond holders may be more exposed to downside risks than the
leverage ratio suggests, although this information may be captured in credit
ratings.
Within the endowment’s assets, the following asset classes are most likely to
have direct exposure to the auto sector: absolute return equities, market neutral
equity hedge funds, credit hedge funds, private equity.
Although the auto industry only makes up some 10% of the global economy,
the proportionate exposure may be higher if for example:
• the equity managers are overweight the sector, or are overweight to

companies with more underutilised capacity relative to the average
• the equity hedge funds have a net long exposure to auto sector, or a
material long exposure to companies with more underutilised capacity
relative to the average
• the credit hedge funds have a net long exposure to auto sector, or a
material long exposure to companies with more underutilised capacity
relative to the average
The commodity funds, skill-based strategies, illiquid assets and the rest of the
bond portfolio should have very limited exposure to the issue of overcapacity
within the auto sector, unless the reduction of capacity in the auto sector
results in a significant reduction in car production which could impact the
wider economy through consumer and industrial demand, or monetary or
fiscal policy.
Page 8
2 (i)
• Anchor and adjustment – Has view about stock and continues to hold view
even where news outlook is negative.
• Confirmation bias – look for evidence to confirm their views even though
the market says something different
• Regret aversion – by retaining the existing arrangement will not suffer

from regret if they sell share and the value actually goes up rather than
down
• Status Quo bias – people have preference to keep things as they are
(ii)
• Confirmation bias – looks for evidence that confirms their point of view
• Anchor and adjustment – has pre-defined idea of stock, it is favourite

company, so doesn’t matter what people say they will continue to believe
it will do well.
(iii)
• Anchor and adjustment – has view of stock and uses past performance to
make judgement. View on growth is anchored on past performance
• Overconfidence – investor overconfident in their ability to predict future

cashflows
• Availability – easier to imagine future returns based on past experience
(iv)
• Framing – although the actual expected return of the alternative bond is
higher the investor has framed the decision in such a way as to make the
alternative bond seem poor value even though it offers the better return.
• Regret aversion – if hold the alternative investment and the return actual is
0% will regret not holding the guarantee return.
• Risk adverse/myopic loss aversion – prefers to hold a guarantee return as

places more weight on the downside return of the alternative investment
rather than the upside
• Representative Heuristics – by having a guarantee return they place a

higher value than an alternative that involves chance. By adding further
probabilities into the scenario the return profile becomes more difficult to
understand
Page 9
3 (i) Effectiveness of the government’s proposal
Confidence
For the government action to make a significant impact, it will need to

regenerate confidence in the banking industry. There may be a time lag before
this happens also.
Exchange rate
Exchanges rates are largely determined by a combination of the interest rate

differentials between two economies and by sentiment about the likely
prospects for economic growth in the two economies. Countries with
relatively higher interest rates should see positive flows from exchange rate
markets, and countries with higher growth prospects should also see positive
flows from exchange rate markets.
Countries with relatively high government borrowing requirements are likely

to see relatively lower demand for their currencies.
The effect that the government’s proposal will have on the country’s exchange
rate will depend on the perspective taken by the market.
If the market views it as a positive development, the better sentiment about the
economic prospects in the country may result in a greater inward investment
demand, and consequently a stronger exchange rate.
The movement in the exchange rate will also depend on the market’s
perspective on the outlook for other economies. If the market views that the
situation is worse in this country than in others, the exchange rate will fall, and
vice versa. Also if the market views the governments move as being a quick
and decisive action, and consequently that other countries are slower to act,
and so will be slower to reap the rewards, then the country’s exchange rate
should appreciate.
If there were rumours of the government’s action before it was announced, the
size and structure of the action compared to what had been rumoured will also
impact the exchange rate.
Economic growth
There are likely to be a number of negative effects on economic growth.
The government has stated that their proposal would double the fiscal deficit.
Implicitly, they are planning to borrow the monies needed to implement the
proposal. The extra borrowing required will probably increase the yield payable
on government bonds issued from that country.
The extra borrowing, and higher yields, may “crowd out” private consumption,
and private investment.
Page 10
The borrowing will have to be paid back by future taxation which will dampen
economic growth in the future.
There are likely to be a number of positive effects on economic growth also.
Should the actions succeed in freeing up bank’s balance sheets and reviving
confidence in the banking sector, this is likely to enable banks to lend more
freely. The resultant increase in credit growth should enable an increase in
investment spending which should increase economic growth.
Effectiveness of the proposal
How effective the proposal will depend on its ability to restore bank liquidity, and
enable banks to fund the creation of new lending in the economy.
The proposal involves reducing the banks’ assets by purchasing their most illiquid
assets. This should indirectly increase the banks’ capital ratios, enabling greater
future lending.
The increased liquidity that may be created will reduce the illiquidity risk
premiums in some parts of the markets improving market efficiency.
Other answers may also be acceptable
(ii) Recapitalizing the banks’ balance sheets
The collapse of the property boom is likely to have generated significant bad
property debts for the banks. The losses resulting from these bad debts will reduce
the banks’ capital.
With less capital, the banks will have to do a combination of scaling back their
assets/lending (because they have less capital to support it) and also reduce future
lending/asset growth.
Providing extra funds for banks’ capital, through say a rights issue underwritten
by the government, or the issuing of new preference shares, would directly enable
the banks to fund future lending/asset growth.
(iii) Implications of the proposal and argument against it
Typical Mortgage Bank
Pre-crisis
ACB Mortgage Bank
Net annual profit p.a. = (1 % − 0.2% − 0.4%) * (Net mortgage loans)

net revenue funding costs other costs = 0.4% * (Net mortgage loans)
“Embedded value” = the discounted present value of the net annual profit.
Page 11
Post-crisis
ACB Mortgage Bank
Net annual profit p.a. = (1% − 1.2% − 0.4%) * (Net mortgage loans)
net revenue funding costs other costs = minus 0.6% * (Net mortgage loans)
The above example is simplified and effectively assumes lapse rates are zero.
In the context of the above example, a typical mortgage bank will have seen
its “embedded value” on its existing business to have approximately reversed
sign following the banking crisis.
Consequently, the proposal is likely to show the typical mortgage bank in the
country to be insolvent.
(iv) Reporting that mortgage banks are insolvent is likely to cause runs on these
banks. This may be considered against the interest of maintaining confidence
in the banking system.
(v) Possible regulatory changes
The new regulator may call for the introduction of fixed rate mortgages which
are funded by fixed rate borrowings with terms that match the expected
mortgage terms.
Alternatively he/she could call for new tracker mortgages to be funded by

Floating Rate Note borrowings by banks, with rates a fixed percentage above
inter-bank borrowing rates.
These proposals would reduce the mis-match interest rate risk of the banks on
new mortgages.
Other reasoned examples should score similarly.
Page 12
EXAMINATION
6 October 2009 (pm)

booklet.
2. You have 15 minutes before the start of the examination in which to read the
questions. You are strongly encouraged to use this time for reading only, but notes
may be made. You then have three hours to complete the paper.
supervisor.
sheet.
question paper.
1 You are the consultant to the trustees of a defined benefit pension fund sponsored by a
water utility company. Like many pension funds, this one has maintained a very high
exposure to global equity markets. Three years ago, the fund purchased £100m of
over-the-counter long duration interest rate swaps from High Risk Bank. Under the
swap arrangement the pension fund received a fixed rate payment stream to mirror
part of its expected pensioner payments over the next thirty years, based on
assumptions about future economic and demographic experience. In return, the
pension fund was required to pay a floating rate payment stream based on the
National Inter-bank Lending Rate known as NIBOR. Due to a major recession and
lack of liquidity in financial markets and following significant losses on its
proprietary trading book, High Risk Bank has recently declared itself bankrupt.
(i) Describe the risks and possible losses the pension fund has been exposed to
through this investment. [8]
(ii) Discuss how different assets can be used as collateral to mitigate the pension
fund’s or the bank’s future exposure to losses. [10]
Following the collapse of High Risk Bank, Stable Bank has offered to take on the
interest rate swap arrangement and assume responsibility for future payments. In
order to help the trustees meet their requirement to generate a floating payment rate,
Stable Bank offers two alternatives:
• investment in their Target Cash Fund which aims to outperform NIBOR by

0.5% p.a.
• a Guaranteed Deposit which will pay NIBOR plus 0.2% p.a. for the next ten years.
(iii) (a) Compare the two alternative investments offered by Stable Bank. [5]
(b) State with reasons which one of the two alternative investments offered
by Stable Bank you would recommend to the trustees. [3]
As a result of losses on the swap arrangement and a general fall in global equity
markets over the summer months, the pension fund is facing an increased deficit that
the corporate sponsor will have to reflect in their accounts. At a meeting in early
December, Stable Bank has proposed to the sponsoring company’s treasurer that the
current market environment offers the pension fund an opportunity to invest in
corporate credit which is now yielding equity-like returns.
(iv) Describe the uses, characteristics and pricing of a credit default swap. [9]
Stable Bank has suggested that the pension fund can switch into a more favourable
(risk/return) portfolio of corporate bonds while maintaining the overall expected
return on the portfolio (and so not undermine the sponsor’s accounting position).
They have also suggested that the credit risk can be mitigated by carefully choosing
the corporate bonds from a low risk sector such as utilities, whose default statistics do
not justify the spreads over government bonds that these companies have to pay
currently to attract new investors. They have encouraged the trustees to make an
investment in the next two months to maximise their possible investment return.
SA6 S2009—2
The following information has been provided by Stable Bank.
Industry Company Rating Currency Amount Maturity Yield

Outstanding (Local
(Local Currency)
Currency) %
Electric A A GBP 500m 2028 7.97
Gas B AA− GBP 400m 2038 7.02
Water C A− EUR 500m 2016 6.26
Electric D A USD 40m 2037 7.72
Gas E A GBP 700m 2028 6.71
Water F BBB+ GBP 330m 2028 7.21
Historical Default Rates for the Utilities vs. all Sectors
4.0%
3.5%
Utilities All sectors
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006
The chairman of the trustees has asked you to prepare a report for next week’s
investment committee meeting. The investment committee is comprised of trustees,
including the independent chairman and the sponsoring company’s treasurer and
finance director. The chairman reminds you that “past performance is no guide to the
future” and has queried whether the returns are sustainable over the longer term to
meet the pension fund needs, especially as the default rates data given by Stable Bank
are not strictly comparable with long term levels until the 1980’s, given utility
companies were largely state-run until then.
(v) Describe the likely profile of the assets and liabilities of the pension fund. [6]
(vi) (a) Explain the differences in Local Currency yields.

(b) Discuss how the pattern of default rates may evolve over the next few
years. [7]
(vii) Describe the factors that the trustees need to consider in assessing this
proposal and getting exposure to the required investments. [6]
[Total 54]
SA6 S2009—3 PLEASE TURN OVER

2 An investor has agreed to invest £200m in an Emerging Markets Fund offered by a
large well established international investment manager. The investor is offered the
following three management fee options:
• A flat fee of 40 basis points per annum.
• A flat fee of 10 basis points per annum with 10% of any outperformance of the
benchmark return on a quarterly basis. Outperformance is calculated on an
arithmetic return basis.
• A flat fee of 10 basis points per annum with 15% of any outperformance of the
benchmark return on a quarterly basis. A high watermark is applied to the
performance related fee element.
The high watermark agreement states that a performance fee is only payable when the
cumulative level of the Emerging Markets Fund outperformance of the benchmark is
greater than the previous highest level recorded.
The subsequent performance of the Fund and its benchmark is as follows:
Benchmark return Emerging Markets

Fund return
Q1 Year 1 5% 8%
Q2 Year 1 5% 5%
Q3 Year 1 −2% 0%
Q4 Year 1 8% 12%
Q1 Year 2 0% −2%
Q2 Year 2 −5% −4%
Q3 Year 2 8% 4%
Q4 Year 2 −5% −10%
Q1 Year 3 10% 10%
Q2 Year 3 5% 5%
Q3 Year 3 10% 10%
Q4 Year 3 2% 2%
Notes
A cashflow of £50m was received at the end of Q2 Year 2.
Flat fees are calculated based on the investor’s asset value at the end of each year.
Any performance related fees are based on asset values at the end of each quarter.
(i) Evaluate the Fund’s performance and the total fees payable over three years
under each option. [10]
SA6 S2009—4
(ii) (a) Comment on the strengths and weaknesses of each management fee
option from the investor’s viewpoint.
(b) Explain which management fee option would be preferred by the

investor for:
1. a passive emerging market investment

2. a fund with highly volatile returns
[6]
Another investor is considering a similar investment in the same fund. However this
investor’s local currency is the Euro and they wish to hedge the currency exposure in
the emerging markets equity holding.
(iii) Explain how this investor might hedge their currency exposure themselves on
either an active or passive basis. [4]
(iv) Describe the difficulties this investor might experience in managing a passive
overlay portfolio against the Emerging Market Fund. [3]
As an alternative, both investors have been offered a segregated emerging markets

equity account to be managed by a small boutique asset manager that has been
successful in managing a number of small segregated accounts for US pension funds
and is looking to develop its business in Europe.
(v) Outline the respective advantages of the two investment management options
for getting exposure to emerging markets. [9]
[Total 32]
3 The government of a European country issues carbon emissions allowances to

companies domiciled in its country. These emissions allowances limit the amount of
carbon dioxide that a company can emit during the course of their business activities.
It is normal for the amount of carbon dioxide emissions planned by a company to be
either more or less than the quota issued to that company, and hence a market has
arisen for the trading of these allowances. Speculative investors have now begun
buying and selling these allowances.
(i) Explain why a speculative investor might wish to buy tradable emissions
allowances. [4]
(ii) Describe the risks there might be for a speculative investor in buying tradable
emissions allowances. [6]
The government has announced its plans to raise additional corporation taxes from
companies that exceed their allowances to demonstrate their environmental
credentials.
(iii) Outline the issues the government should consider in setting such a policy. [4]
[Total 14]
END OF PAPER
SA6 S2009—5

September 2009 examinations
EXAMINERS’ REPORT
Introduction
R D Muckart
December 2009
Comments for individual questions are given with the solutions that follow.
©Faculty of Actuaries
©Institute of Actuaries
1
(i) Basis risk – cash flows received may not match actual liability requirements
(this could be a function of interest rate/inflation or longevity risk changing the
nature and tenor of the liability cashflows compared with the model
predictions)
Liquidity risk – pension is unable to earn NIBOR leading to a performance
drag or loss, potentially due to a function of real interest rate risk, asset/credit
risk or currency risk depending on what the underlying NIBOR generating
investments are.
Investment risk – requirement to post collateral may force pension fund to
realise assets at an inopportune time. This will also incur trading costs.
Credit risk is risk due to uncertainty in a counterparty's ability to meet its
obligations.
Collateral risk – the assets posted may decline in value more than
compensated for by the initial haircut, leading to a further margin call.
This can (and has been) a function of a general market risk, coupled with a
specific event and/or counterparty/operational risk.
If 'in the money' then loss on actual investment when bank defaults as will not
be entitled to that loss– realised loss.
Trading costs of repurchasing the swap in the market.
Opportunity costs associated with not being invested in swap for full duration.
There may also be a reputational risk associated with the frustration of the
contract.
Counterparty would still have gone into default (as could other counterparties)
which leads to loss where Collateral not sufficient to cover the gain.
(ii) Each counterparty marks to market their exposure on a regular basis ie they
record the price or value of a security, portfolio, or account on a regular basis,
to calculate profits and losses or to confirm that margin requirements are being
met.
Collateralisation is the process whereby assets are pledged by a counterparty to
secure a loan or other credit, and subject to seizure in the event of default.
Collateralisation takes place on a (daily/weekly/monthly) basis to cover any
unrealised gains/losses reflected in the variation margin. To make the process
manageable, there will be an agreement on the minimum threshold amount
before collateral needs to be posted to the other party and a minimum transfer
amount.
In addition to an agreement (often based on a market/international standard
e.g. ISDA) which sets out the terms of the transaction, the obligations of each
party and the events that will lead to default and termination, there needs to be
an agreement also on the acceptable assets to be pledged as collateral, typically
cash or bonds. In order to protect the receiver from further deterioration in the
value of the collateral posted, pledged securities are subject to a Haircut, being
Page 2
the percentage at which collateral is discounted for valuation purposes to allow

for volatility and default. The haircut applied will vary according to the
organisation and its perception/tolerance of risk, competitive levels across
other counterparties and the general market conditions i.e. haircuts set out in
new contracts, even for government bonds, will have risen in 2007/8.
The agreement will also cover what the holder can do with collateral received
and whether this can be pooled with other assets or needs to be held in a
separate account.
The more risky the collateral in terms of potential default and volatility of
price movement, both absolute and relative to the particular swap transaction,
the higher the haircut that would be applied, i.e. the larger the discount factor
applied. In decreasing order of haircut applicable, the most likely assets that
are posted would be:
Equity – highest price volatility.
Corps – price volatility and default higher than Government bonds.
Government bonds – more price volatility than cash.
Cash – also can use cash to make additional returns by collateral re-
investment.
Concentration risk can occur where portfolio is not well diversified and
consequently has large exposure to one counterparty, asset class or individual
stock. To reduce this risk can be reduced when accepting collateral there will
be maximum limits set in terms of asset class, individual name or country
exposure of the collateral received.
Similarly an entity’s risk can be further reduced by ensuring contracts are
diversified across counterparties i.e. a pension fund should transact with
multiple counterparties rather than on an exclusive basis.
(iii)
a. Target cash fund does not guarantee a return above NIBOR – apart from
market performance and manager’s selection capability, the fund
management and transaction costs will act as a drag on performance.
Many such cash funds have actually underperformed their benchmarks.
In part this is down to the fact that they don’t actually invest in just cash
deposits but in also short dated corporate notes and other investments,
which are subject to the same credit risks as all corporate bonds. There
are also issues such as general market liquidity, widening of spreads and
the universe of available securities to consider. There may be tax
considerations, for example in terms of any deductions applicable to
income on the underlyings.
The guaranteed fund will meet the required obligation with some profit
potential on top net of costs but there is a reinvestment risk – what
happens at the end of ten years – and is reliant on the ongoing
creditworthiness of Stable to underpin the guarantee. There is also the
increased concentration risk from bundling all hedges with Stable.
Page 3
The liquidity terms of the cash fund are likely to be better than the
guaranteed deposit. The latter is more likely to have a lock-up period of
MVA applied if the guarantee bites against the bank, whereas the cash
fund will usually be daily liquid at fund NAV (albeit, possibly showing a
capital loss) – the investor must weigh up capital protection and
illiquidity against the converse.
b. You can make a case for either depending on the attitude to risk of the
trustees, the availability of other assets/cash flow to make good the
trustees’ obligation, the size of the commitment, the perception of Stable
Bank’s future credit worthiness, the current state and prospects for the
short paper market etc.
(iv) CDS are a swap designed to transfer the credit exposure of fixed income
products between parties.
CDS have the following two uses.
A CDS contract can be used as a hedge or insurance policy against the
default of a bond or loan. An individual or company that is exposed to a
lot of credit risk can shift some of that risk by buying protection in a CDS
contract. This may be preferable to selling the security outright if the
investor wants to reduce exposure and not eliminate it, avoid taking a tax
hit, or just eliminate exposure for a certain period of time.
The second use is for speculators to “place their bets” about the credit
quality of a particular reference entity. With the value of the CDS market,
larger than the bonds and loans that the contracts reference, it is obvious
that speculation has grown to be the most common function for a CDS
contract. CDS provide a very efficient way to take a view on the credit of a
reference entity. An investor with a positive view on the credit quality of a
company can sell protection and collect the payments that go along with it
rather than spend a lot of money to load up on the company's bonds. An
investor with a negative view of the company's credit can buy protection
for a relatively small periodic fee and receive a big payoff if the company
defaults on its bonds or has some other credit event. A CDS can also serve
as a way to access maturity exposures that would otherwise be unavailable,
access credit risk when the supply of bonds is limited, or invest in foreign
credits without currency risk.
A combination of a government or high grade bond coupled with a CDS can
also be used to access/maintain liquidity. Likewise, an investor can actually
replicate the exposure of a bond or portfolio of bonds using CDS and
government bonds. This can be very helpful in a situation where one or several
bonds are difficult to obtain in the open market. Using a portfolio of CDS
contracts, an investor can create a synthetic portfolio of bonds that has the
same credit exposure and payoffs.
Characteristics
Page 4
The buyer of a credit swap receives credit protection, whereas the seller of the
swap guarantees the credit worthiness of the product. By doing this, the risk of
default is transferred from the holder of the fixed income security to the seller
of the swap.
It is similar to insurance because it provides the buyer of the contract, who
often owns the underlying credit, with protection against default, a credit
rating downgrade, or another negative “credit event.”
The seller of the contract assumes the credit risk that the buyer does not wish
to shoulder in exchange for a periodic protection fee similar to an insurance
premium, and is obligated to pay only if a negative credit event occurs. It is
important to note that the CDS contract is not actually tied to a bond, but
instead references it. For this reason, the bond involved in the transaction is
called the “reference entity”. A contract can reference a single credit, or
multiple credits.
The buyer of a CDS will gain protection or earn a profit, depending on the
purpose of the transaction, when the reference entity has a negative credit
event. When such an event occurs, the party that sold the credit protection
and who has assumed the credit risk may deliver either the current cash value
of the referenced bonds or the actual bonds to the protection buyer, depending
on the terms agreed upon at the onset of the contract. If there is no credit
event, the seller of protection receives the periodic fee from the buyer, and
profits if the reference entity’s debt remains good through the life of the
contract and no payoff takes place. However, the contract seller is taking the
risk of big losses if a credit event occurs.
CDS contracts are regularly traded. A trader in the market might speculate that
the credit quality of a reference entity will deteriorate some time in the future
and will buy protection for the very short term in the hope of profiting from
the transaction. An investor can exit a contract by selling his or her interest to
another party, offsetting the contract by entering another contract on the other
side with another party, or offsetting the terms with the original counterparty.
The market for CDSs is OTC and unregulated, and the contracts often get
traded so much that it is hard to know who stands at each end of a transaction.
There is the possibility that the risk buyer may not have the financial strength
to abide by the contract's provisions, making it difficult to value the contracts.
The leverage involved in many CDS transactions, and the possibility that a
widespread downturn in the market could cause massive defaults and
challenge the ability of risk buyers to pay their obligations, adds to the
uncertainty.
Pricing
The value of a CDS contract fluctuates based on the increasing or decreasing
probability that a reference entity will have a credit event. Increased
probability of such an event would make the contract worth more for the buyer
of protection, and worth less for the seller. The opposite occurs if the
probability of a credit event decreases.
CDSs are traded over the counter (OTC), involve intricate knowledge of the
market and the underlying assets and are valued using complex computer
Page 5
pricing algorithms and models, so they are better suited for institutional rather
than retail investors, accepting the latter may use models too. Dealing costs
are likely to deter retail investors too, given likely volumes.
(v) Assuming it is a large, mature pension fund (given by the size, nature of the
swap profile prop), then probably we can reckon that the scheme has:
Extremely long-dated (50+ years) Liabilities often linked directly or
indirectly to inflation (Salaries, RPI/CPI and LPI), typical duration 20
years or more, probably biased in favour of pensioner and deferred
members, especially if scheme closed or future accrual ceased.
Scheme deficit on a realistic or insurance buy out basis.
High but probably decreasing exposure to (global) Equities.
- Rewarded risk, but
- no interest rate immunising characteristics
- probably actively managed
May have exposure to alternative assets such as hedge funds, private
equity and real estate – offers a more stable return profile due to relatively
infrequent mark to market.
Too few interest rate sensitive assets (bonds).
- Often held with a passive manager.
Too few inflation-linked assets (government bonds predominantly but may
be some corporate issuance e.g. utilities).
No material longevity risk protection unless partial buyout/buy-in or OTC
swap.
The nominal and real rate bonds that are held are too short in duration in
any case (lack of real supply).
- Leads to ineffectiveness and “curve” risk.
- Pension scheme exposed to changes in the level and shape of the yield
curve.
- This is unrewarded risk.
Increasing exposure to derivatives either to hedge liabilities or currency
exposure or protect principal. This could require a significant
cash/collateral pool to be held to meet obligations.
Cash may be held as collateral to meet future margin calls or as a
defensive asset in its own right (or to mirror short term obligations).
(vi)
a. Variation is due to security (credit worthiness, size of issue outstanding,
availability/liquidity of comparables at each tenor), local market levels
(bonds and other assets) and other factors impacting currency
Page 6
movements/differentials, type of utility, geographical bias, there may be

tax considerations but these, if any, would be minor.
Need to also consider history and prospects of defaults by security,
sector, issuer – refer to comment that utilities were nationalised
previously
b. Need to consider relevance of past yields as prospective indicator and

whether historical data is long enough to reflect different economic
circumstances and what period/data is most comparable.
Comment on economic cycle, relative regional/sector prospects and so
future earnings/asset cover, market regulation, supply and demand,
pricing/rating of securities/issues, perspective/regulation/operations of
rating agencies (may tend to be over conservative now – as a reaction to
perceptions of prior lack of caution – and so overstate prospective risk,
downgrade issues accordingly so actual default rates per banding will
reduce).
(vii)Although the candidate is not required to recommend or otherwise the

proposal, a discussion of the relevant considerations should encompass:
Strategic considerations – existing assets, funding objectives, sponsor
covenant, regulatory and constitution controls, existing agreed investment
principles/restrictions and guidance and so benchmark strategy target.
Tactical/timing/implementation/portfolio management considerations (new
managers needed?).
Sponsor opinion
Independent expert advice
Internal resource requirements
Alternatives (proposals/investment/counterparty) including “do nothing”
and how you would rate/compare them.
Due diligence
Legal structure
Counterparty exposure
Liquidity – can this be unwound, how, when, with whom and what cost
Valuation
Concentration risks
Costs of transition and investment
Ongoing governance and monitoring commitments
Any tax considerations
Page 7
2
(i) See spreadsheet = £350,522,460
Cashflow is invested prior to Q3 so get full return
The Benchmark return for each individual year
Year 1 =1.05*1.05*0.98*1.08 = 16.69%
Year 2 = 0.95*1.08*.95 = -2.53%
Year 3 = 1.10*1.05*1.10*1.02 = 29.59%
The fee payable under each fee arrangement for each yea
See spreadsheet for calculations
Flat fee of 40 basis points £3,500,088
Flat fee 10 basis points and 10% outperformance £3,231,664
Watermark fee £4,051,518
(ii)
a.
Base fee
Simple, easy to understand and check that correct fees being paid.
Have more certainty as to level of fee to be/being paid.
Will not pay more than 40 basis points regardless of performance.
Does not encourage excessive risk taking as much as a performance related
fee.
Pay high fee even when investment manager underperforms.
Does not align the investment manager’s interests with the investor, lack of
incentive to outperform.
Performance no watermark
Low fee if investment manager underperforms.
Incentivise the manager to seek out additional returns as the manager paid
more if returns greater.
There is no cap on the level of fee payable.
May encourage excessive risk taking.
May pay out for one quarter of performance while next quarter the manager
might underperform the benchmark but would have still received a
performance fee.
Page 8
Can be complex (e.g. smoothing fees at the start and end of mandates),
difficult to understand. For exceptional performance, could cause cashflow
issues for the investor if it has to meet a substantial fee invoice from existing
assets.
Performance with watermark

Low fee if investment manager underperforms.
Incentivise the manager to seek out additional returns as the manager paid
more if returns greater.
Watermark means for manager that has underperformance they will not be
paid outperformance fee until returns over benchmark return to prior level and
therefore, not pay for outperformance multiple times.
There is no cap on the level of fee payable.
May encourage excessive risk taking.
Conversely, after period of material underperformance, the manager has less
incentive to perform as the performance fee could become unattainable.
Can be complex (e.g. smoothing fees at the start and end of mandates),
difficult to understand. For exceptional performance, could cause cashflow
issues for the investor if it has to meet a substantial fee invoice from existing
assets.
b.
1. A passive investor is looking to achieve benchmark return. Paying
a performance related fee would be the cheapest option as the base
fee is lower. However, as the purpose of the investment is to track
an index, including a performance related fee might incentivise a
manager to seek additional returns. The usual basis is to pay the
flat fee, although the current fee of 40bps looks high for a passive
manager for a £200m investor and would look to reduce.
2. The investor would prefer the performance related fee with high
watermark. If returns are highly volatile that might well be periods
of negative performance relative to the benchmark. Under this
arrangement the investor only pays for the performance above the
benchmark over the long term rather than pay for performance in
one quarter which could be lost during the next quarter.
(iii) Passive exposure

A passive management of currency means the investor is looking to hedge
the holdings to Sterling on a mechanical basis and not looking to make a
profit.
Investor needs to decide the hedge ratio they want to use.
Investor could trade using futures or forward contracts.
Page 9
The investor would need to short the currency of the actual holding and be
long the equivalent value in Sterling if they wanted to manage currency on
a passive basis.
To do this the investor would need to decide how frequently they want to
manage the exposure (every trade) or on a periodic basis (weekly, monthly
etc.) as a proxy.
To manage the investor would need to get the holdings from the
investment manager.
Need to check that the fund does not already hedge to a base currency as
then the investor only needs to hedge to the base currency and not the
individual holdings.
Could ask the investment manager to open a Sterling hedge version of the
fund.
Active exposure
The same as above applies for active manager.
In addition active management of currency exposure means the investor is
looking to profit from currency decisions.
Would need to set limits for under and over exposure to any currency.
Need access to research/data in order to make decisions on which currency
to under or over expose.
Active currency is not a particularly good strategy if the investor is looking
to hedge investments back to Sterling.
(iv)
● For emerging markets there might not be a suitable future/forward contract
for the currency of the underlying investment.
Investor would need to have access to trading platform/broker network for
foreign exchange.
Investor would need to have access to liquid assets for margin
requirements or for closing out contracts at a loss.
Investor would need the technology to ensure can keep track of exposures
and trades.
Would require a considerable amount of time which the investor might not
have to spare.
Delays in receiving the holdings data from the investment manager which
will mean that hedge is not to actual holdings.
If the hedge is only carried out on a periodic basis, at anytime the hedge
will be overhedged or underhedged relative to the actual holdings as the
investment manager will be making trades and reinvesting income etc.
Page 10
If the manager is carrying out some hedging in the fund then possibly
doubling of wanted currency exposure.
(v) Pooled Fund/large manager advantages

Large manager likely to have long performance track record, boutique
manager will not have a track record for European clients.
Likely to be financially stable with strong infrastructure and strength in
depth of investment team. Boutique manager by very nature is smaller and
usually less well capitalised.
Has history of dealing with client accounts, boutique manager is breaking
into a new market so does not have experience of managing assets for
European clients.
Pooled fund easier to invest as buying units in a fund and not underlying
investments.
Larger pooled fund would likely have greater diversification of
underlyings.
No need for custodian for holding assets and processing corporate events
and dividend payments.
Overall costs are likely to be lower in pooled fund than segregated
investment.
Have client service infrastructure which is probably not in place for
boutique manager only just starting to offer European investments.
Segregated account/boutique manager

Boutique manager likely to have incentives more aligned to investors as
employee ownership tends to higher in boutique so rewards are linked to
performance of funds.
Client has more freedom on type of investment in segregated fund as not
pooled with other investors.
Boutique manager more likely to be flexible on performance target.
More flexibility on restricting certain types of stock.
May get a better fee deal in order for manager to attract assets.
Credit was given for other relevant points made.
3
(i) An investor would buy a tradable allowance because they would expect the
price of it to rise in the future…
…so that they could then sell it at a profit.
Page 11
In a growing economy, it is likely that there will be a higher demand for

carbon emissions, so the tradable price of the quota allowances may rise (i.e.
price rises due to increased demand).
In addition, with ever increasing environmental pressures on governments…
…it is likely that the government of this country will seek to reduce, or at least
hold steady, the total emissions allowance…
…therefore creating an artificial scarcity…
…with the aim of forcing industry to reduce and become more efficient in its
emissions but which may also inflate prices of the tradable allowances (i.e.
price rises due to limited or reduced supply).
Unlikely to be a speculative requirement, but this would give an opportunity to
diversify from other investment types if it was felt the overall portfolio was
too risky.
It’s an opportunity to gain equity style exposure to industry and country (more
economic growth implies higher prices for emissions; shares in industrial
companies may not yet be widely tradable if the country is an emerging
economy).
Excess profits may be available given it is an inefficient market (new
investment type, so not much experience).
There may be tax advantages compared with other investments (may be
initially low tax charge).
(ii) The demand for emissions allowance may fall in times of economic weakness.
The supply is decided by politicians, and politicians can change their minds
depending on many different factors, none of which are in the control of the
investor…
…and many of which cannot be foreseen by the investor…
…hence the supply of emissions allowances may be increased, which would
make prices fall…
Also, the system only works if the government polices companies to ensure
they stick to their quota of emissions allowances they have been allocated or
purchased.
So if the government is unable to police it…
…or politically unwilling to police it…
…then again the price of the tradable allowances will fall.
Trading in emissions allowances is a very new asset class, and therefore it
cannot be well-understood at this stage of its development…
…so that investing in it could be seen as a very risky enterprise…
…particularly as it is very difficult to quantify the risk and so understand the
likely risk/return pay-off.
Page 12
Trading in sufficient lot sizes may be infrequent so lack of liquidity may

prevent realisation of profits and/or at high cost.
Government may change tax regime to manipulate market and impact
profitable opportunity.
(iii) Candidates need to consider “why” (or why not) the government should
engage as well as how.
Governments generally say they don't like to take an active role in the
securities market (except for regulating it); however, there are methods and
policies by which the government's actions may have an indirect influence on
the market.
Current level of industrial activity and carbon output – ability and propensity
to change (and over what time level), perspective on other
country/government commitments
Limiting emissions could slow economic growth.
Letting companies exceed their allowance by purchasing unused allowances
from other companies may maximise economic growth while still letting the
government achieve its overall target.
Current economic/political situation – can we afford to be green? Will it be a
vote winner (or are jobs more important?).
What is role of government within this market and what is relative exposure of
government sponsored/nationalised industry (could government activity crowd
out/distort market, positively or negatively?).
Fiscal policies that affect the taxation of capital gains, dividends and interest
gains may eventually have an effect on market activity.
The market can be affected by the bills and laws passed by the various levels
of government. This can occur for those laws directed specifically at the
securities market or those that have an indirect affect.
Taxing emissions may be effective if the government wants to encourage the
growth of a service economy rather than an industrial economy.
Taxing emissions may encourage companies to invest in more
environmentally-friendly technology.
Balance between achieving financial and non-financial objectives, free market,
influence and regulation i.e. a compromise between profit, equality and
ecological concerns.
END OF MARKING SCHEDULE
Page 13

Examination: Subject SA6 Investment Specialist Applications

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Examination: Subject SA6 Investment Specialist Applications

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Faculty of Actuaries Institute of Actuaries

5 April 2005 (am)

Subject SA6 Investment

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

4. Mark allocations are shown in brackets.

6. Candidates should show calculations where this is appropriate.

AT THE END OF THE EXAMINATION

(i) Discuss the advantages and disadvantages of the use of:

(a) a fixed benchmark for a regional asset split

(iv) Suggest reasons why this can occur. [8]

Subject SA6 Investment

Mortality is unpredictable and generally non-investible although mortality bonds

Duration can be matched in a large scheme where cashflows are relatively

Salary growth is not investible, nor predictable.

Inflation is investible, although inflation itself is not predictable.

forward starting swaps

Discussion of income profile from each asset

Other strategies are possible, with description

2 (i) Fixed Benchmarks:

They have a solid basis of a long term asset allocation policy.

They have a propensity to re-balance towards value forces selling of rising

However, this may prove to be a disadvantage where there is a longer term

Can be used to improve diversification.

Capitalisation weighted benchmarks based on market size:

Will be affected both by breadth of market and also by stock prices.

They will automatically capture new developments in markets e.g. public to

Can lose diversification

Re-balancing due to constituent changes and capital changes will be an issue

This will grant greater economic exposure in a portfolio to countries which

With globalisation of companies, the country of quotation may not be relevant

Increases risk of being incorrectly weighted to smaller markets

All of the above have advantages and disadvantages, these is no absolutely

(ii) Unquoted Securities

Diversification, although if the unquoted companies operate in the similar

It will be difficult to value.

The company may be more dependent on one person.

Investment in commodities would provide diversification for the pension fund.

It is possible to make significant profits from investing in commodities in

Use of commodity shares (mining, exploration companies) gives less

Institutions do not invest directly in commodities as this would involve

(iii) Unquoted companies

In order to diversify the risk a portfolio of unquoted securities need to be

The collective vehicle may be quoted e.g. an investment trust.

Or it may itself be unquoted.

If unquoted then liquidity is likely to be very low.

And valuations will be infrequent.

Should an institution wish to gain exposure to commodity price movements it

Options and futures are also available.

Alternatively institutional investors do invest in companies whose share price

Typical examples of this is the oil and mining companies.

Investing in these companies also overcome the problems of investing directly

There are, however, a number of disadvantages if these companies are used as

It is unlikely that there will be exposure to just one commodity.

The company s management may alter the exposure via acquisitions or

The company s share price may be influenced by other factors.

When the VC buys the company the market may be depressed.

The capital structure may need to be changed, possibly returns need to be

When the company is floated it may be more liquid either as a result of