26-30. Questions 26 through 30 consist of an assertion in the left-hand column and a reason in the
right-hand column. Code your answer to each question by blackening space:
(A) If both the assertion and the reason are true statements, and the reason is a correct
explanation of the assertion.
(B) If both the assertion and the reason are true statements, but the reason is NOT a
correct explanation of the assertion.
(C) If the assertion is a true statement, but the reason is a false statement.
(D) If the assertion is a false statement, but the reason is a true statement.
(E) If both the assertion and the reason are false statements.
26.
ASSERTION
Mean reverting interest rate
generators tend to produce interest
rates at or close to their upper or
lower bounds.
BECAUSE
REASON
Mean reversion factors tend to
increase volatility.
27.
ASSERTION
Under FASB 115, reported
earnings from assets classified as
available-for-sale will be impacted
by unrealized gains or losses.
BECAUSE
REASON
Under FASB 115, assets classified
as available-for-sale are valued on a
market value basis.
28.
ASSERTION
In equilibrium, it is rare for
collateralized mortgage obligations
(CMOs) to trade rich compared to
collateral.
BECAUSE
REASON
Collateral spreads quickly tighten as
more CMOs are issued.
29.
ASSERTION
Reducing the C-2 component of
risk-based capital (RBC) through a
YRT reinsurance agreement may
not decrease the total RBC
requirements of a life insurance
company.
BECAUSE
REASON
The covariance adjustment between
the C-1, C-2 and C-3 components
of the RBC requirements can be
negative for a life insurance
company.
30.
ASSERTION
The valuation of derivatives
generally assumes that the derivative
security can be replicated using a
self-financing portfolio of traded
securities.
BECAUSE
REASON
Derivative valuation models generally
assume that there are market frictions
such as transaction costs.
**END OF MORNING SESSION OF THE EXAMINATION**
COURSE 6
AFTERNOON SESSION
SECTION C-WRITTEN ANSWER
Course 6: Spring 2003 - 1 - GO ON TO NEXT PAGE
**BEGINNING OF THE AFTERNOON SESSION OF THE EXAMINATION**
8. (4 points) You are given the following with respect to shares of Bre-XYZ:
State of Economy Probability Share Price on May 1, 2004
Boom 0.20 100
Normal Growth 0.65 50
Recession 0.15 20
•share price on May 1, 2003: 45
•semi-annual cash dividend: 2
•rate of inflation: 2.5%
(a) Calculate the expected holding-period return.
(b) Calculate the standard deviation of the holding-period return.
(c) Calculate the purchasing power of 1,000 to be received in 10 years.
Show all work.
Course 6: Spring 2003 - 2 - GO ON TO NEXT PAGE
9. (8 points) You are given the following with respect to European style options on a common
stock:
•strike price: 100
•current market price of the underlying stock: 95
•standard deviation of the underlying stock returns: 0.14
•dividend rate of the underlying stock: 3% payable continuously
•time to maturity for the options: 3 months
You are also given the following selected values from the Standard Normal Cumulative
Distribution Function:
Z N(Z)
0.1 0.5398
0.2 0.5793
0.3 0.6179
0.4 0.6554
0.5 0.6915
0.6 0.7257
0.7 0.7580
0.8 0.7881
0.9 0.8159
1.00 0.8413
The risk-free rate is 3%.
(a) List the assumptions underlying the Black-Scholes option model.
(b) Calculate the value of the call option ignoring the dividend.
(c) Calculate the value of the put option ignoring the dividend.
(d) Calculate the value of the call option including the dividend.
(e) Calculate the value of the put option including the dividend.
Show all work.
Course 6: Spring 2003 - 3 - GO ON TO NEXT PAGE
Course 6: Spring 2003 - 4 - GO ON TO NEXT PAGE
10. (6 points) You are given the following with respect to an option-free bond portfolio:
•the value of the bond portfolio using the current yield curve is 800
•the value of the bond portfolio using the current yield curve with a parallel shift
upwards of 20 basis points is 788
•the value of the bond portfolio using the current yield curve with a parallel shift
downwards of 20 basis points is 813
(a) Using the methodology outlined in the Fabozzi textbook, estimate the value of the bond
portfolio for a parallel shift upwards of 200 basis points in the yield curve.
(b) Explain how the inclusion of convexity impacts your estimate.
Show all work.
11.
(a) (4 points) Describe the issues and practical considerations in immunizing a portfolio of
insurance liabilities.
(b) (1 point) Describe cash flow matching.
(c) (1 point) Describe contingent immunization.
12. (6 points)
(a) With respect to corporate bonds, describe the role of the corporate trustee.
(b) Differentiate the levels of security offered by various corporate bonds.
Course 6: Spring 2003 - 5 - GO ON TO NEXT PAGE
Course 6: Spring 2003 - 6 - GO ON TO NEXT PAGE
13. (6 points) You are given the following for an insurance company that currently offers term
insurance and fixed deferred annuities:
•corporate pre-tax target return on capital of 18%
•risk-based capital (RBC) formula:
1 5 . * asset default risk component d 2 mortality risk component 2 i
Asset Default Risk Component (C-1)
Asset Class Amount (millions) RBC Factor
Historical
Mean Return
Bond 600 1% 7%
Real Estate 300 7% 8%
Common Stock 100 20% 10%
Mortality Risk Component (C-2)
Amount (millions) RBC Factor
Net Amount at Risk 10,000 0.1%
The industry-wide ratio of C-1 to C-2 is 1.5.
The risk-free rate is 6%.
(a) Describe the shortcomings of this RBC formula.
(b) Calculate the RBC-adjusted spread for this company’s asset portfolio.
(c) Evaluate the competitive advantage of the company’s product lines from a cost of
capital perspective.
Show all work.
Course 6: Spring 2003 - 7 - STOP
14. (4 points)
(a) Describe and compare the various prepayment models used to evaluate a block of
mortgage-backed securities (MBS) pass-throughs.
(b) Describe the effects of prepayment rates on the cash flows of MBS pass-throughs.
**END OF EXAMINATION**

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