10. Continued
(b) Determine the impact of an immediate 10% depreciation in the U.S. dollar on
(i) the consolidated surplus of CanCo and TargetCo in Canadian dollars, and
(ii) the net cash flow of TargetCo itself.
(c) Describe the external concerns associated with the purchase that may affect
current and potential CanCo shareholders.
(d) Outline how options and other financial instruments could be used to manage the
foreign exchange exposure of TargetCo’s net cash flow position and compare
TargetCo’s risk exposure under each approach.
(e) Calculate the cost of a European style currency option that would protect
TargetCo’s net cash flow position in U.S. dollars for one year. Assume that the
currency value follows a geometric Brownian motion process and all cash flows
are end-of-year.
COURSE 8: Fall 2003 - 9 - GO ON TO NEXT PAGE
Investment
Afternoon Session
11. (6 points) You are given the following information.
Current index value = 800
Annual volatility of index = 20%
No dividends
Price of 1 month at-the-money European call index option = 25.025
One-month time steps for all calculations
Risk-free rate is the same for all periods
(a) Calculate the risk-free rate implied in the call price using a binomial tree.
(b) Estimate an upper and lower bound on the price of a 2-month American lookback
call.
(c) Calculate the price of a 2-month American lookback call using a binomial tree.
12. (3 points) ABC Life has formulated an ALM strategy whereby the long-term liability
cash flows of its non-participating life block are backed with equities. ABC Life does not
feel that duration is an appropriate metric to measure the interest rate sensitivity of this
asset class. Stochastic modeling techniques are used to measure the likelihood that the
equities will be sufficient to meet the long-term cash flows beyond 20 years.
Critique the use of duration for equities in the ALM strategy for ABC Life.
**END OF EXAMINATION**
MORNING SESSION
COURSE 8: Fall 2003 - 10 - GO ON TO NEXT PAGE
Investment
Afternoon Session
**BEGINNING OF EXAMINATION**
AFTERNOON SESSION
13. (3 points) Describe the key features of derivatives risk management aimed at preventing
derivatives mishaps in an insurance company setting.
14. (4 points) ABC Life is investigating hedging the currency exposure of its international
operations.
(a) Describe the critical factors for identifying the optimal degree of currency
exposure to be hedged.
(b) For each of the critical factors indicate whether the optimal hedge ratio of the
currency exposure increases or decreases as the factor increases.
(c) Explain the two economic theories relating to exchange rates.
(d) Assess the impact on the hedging strategy for the currency risk assuming the
economic theories are:
(i) True
(ii) False
COURSE 8: Fall 2003 - 11 - GO ON TO NEXT PAGE
Investment
Afternoon Session
15. (4 points) Given the following information.
POOL A POOL B
Originator GNMA FNMA
50% 30-Type 30-year fixed year fixed
50% balloon
Weighted Average Coupon 8.0% 9.0%
Weighted Average Maturity 25.6 years 19.2 years
27 years 80% 25 years 20%
22 years 20%
19 years 20%
16 years 20%
Maturity Distribution
20 years 20%
14 years 20%
% Refinance Mortgagors 20% 80%
% Home Purchase Mortgagors 80% 20%
Economic Environment: Strong housing market
Current Yield Curve
1.5%
3.5%
1-year Treasury
10-year Treasury
30-year Treasury 5.5%
Rates for New Issues of 30-Year Fixed Mortgages for Calendar Year 2003 through
November
8.6% July 7.5%
8.4% August 7.0%
8.2% September 6.5%
8.0% October 6.0%
7.9% November 6.5%
January
February
March
April
May
June 7.6%
(a) Describe the four primary structural components of the Goldman Sachs mortgage
backed securities prepayment model including
(i) primary variables that drive change in these components, and
(ii) expected impact of these variables on total prepayments.
(b) Compare and contrast the impact on prepayments in the two mortgage pools for
each of the variables described in (a).
COURSE 8: Fall 2003 - 12 - GO ON TO NEXT PAGE
Investment
Afternoon Session

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