Chapter 19: Actuarial Techniques

Question 1

Explain what is meant by asset pricing

state the two main functions of asset pricing models

Answer 1

Asset pricing

Systematic determination of prices of risky assets, such as equities bonds and derivatives

Price equals expected discounted payoff from asset
Functions of asset pricing models

+To determine whether asset is mispriced (and represents trading opportunity)
+To determine of asset when there is no market price eg unquoted asset

Question 2

Distinguish between absolute asset pricing and relative asset pricing

Give an example of each approach

Answer 2

Absolute asset pricing

Prices assets in terms of risky macroeconomic factors that influence asset prices, eg inflation, interest rates etc
Eg consumption based model, CAPM

Relative asset pricing

Finds price of one asset in terms of price of another. Doesn’t say where other asset price comes from
eg Black Scholes

Question 3

List the main stages in an asset liability modelling (ALM) exercise

Answer 3

+Clarify key objectives of investment and funding policy

+Agree suitable assumptions to use in ALM exercise

+Collect data to carry out projections

+Consider overall nature of liabilities

+Analyse how fund might progress in future under different investment strategies

=Analyse different asset mixes in more detail to assess the risk (relative to liabilities) and rewards of each alternative

+Summarise and present results, often graphically

Question 4

List the advantages and disadvantages of using shortfall probabilities to choose between investment strategies

Answer 4

Advantages

+Simple to calculate
+simple to understand
+benchmark can be chosen to reflect attitude to risk
Disadvantages

+Ignore extent of shortfall
+ignore extent of upside
+difficult to estimate accurately
+cannot place value on investment strategy
+Ignore impact of investment strategy on external stakeholders in investment fund

Question 5

Explain what is meant by

Asset liability mismatch reserving
resilience testing

Answer 5

Asset liability mismatch reserving

Projects emerging asset and liability position under range of possible conditions to establish extent to which assets and liabilities mismatch
Appropriate supplementary reserves then set up to cover possible levels of shortfall identified
Resilience testing

Assesses resilience of investor to sudden changes in market conditions
eg immediate fall of 25% in equity prices and immediate increase/decrease of 1% in bond yields