Part 5 / 6

Question 1

Purchasing power parity (PPP)

Answer 1

two currencies are in equilibrium or at par when a basket of goods (taking into account the exchange rate) is priced the same in both countries.

Question 2

Total return that investors require on any asset class

Answer 2

Required return = required risk-free real rate of return + expected inflation + risk premium

Question 3

Expected return of any asset can be analysed as

Answer 3

Expected return = initial income yield + expected capital growth

where capital growth occurs either due to

• income growth
• change in the initial income yield (discount rate)

Question 4

Dividend discount model

Answer 4

V = D / ( i - g )

Question 5

Total expected return from equities

Answer 5

d + g

where

• d is the income stream (i.e. the dividend yield)
• g is the expected capital gain (i.e. the expected annual growth in dividends)

Question 6

Total expected return for property investments

Answer 6

renatal yield + expected growth in rents

Question 7

Required return for conventional government bonds

Answer 7

required risk-free real yield + expected inflation + inflation risk premium

Question 8

Required return for corporate bonds

Answer 8

required risk-free real ield + expected inflation + bond risk premium

Question 9

Required return for equities

Answer 9

required risk-free real yield + expected inflation + equity risk premium

Question 10

Yield gap

Answer 10

equity gross dividend yield - gross redemption yield on a long-dated benchmark bond

Question 11

Revers yield gap

Answer 11

Reverse yield gap

= Gross redemption yield - gross dividend yield

= inflation risk premium (IRP) - equity risk premium (ERP) + expected capital gain

= IRP - ERP + expected inflation + expected real dividend growth

Question 12

Most practical definition of investment risk

Answer 12

Probability of failing to achieve the investor’s objective

Question 13

Relative performance risk

Answer 13

Risk of underperforming competitors

Question 14

Who has the ultimate decision on how much risk is acceptable?

Answer 14

• Trustees for a pension fund
• Directors for insurance companies

Question 15

The risk appetite of an institution will depend on

Answer 15

• The nature of the institution
• the constraints of its governing body and documentation
• legal or statutory controls

Question 16

How to deal with uncertain liabilities in investment strategy

Answer 16

Hold marketable assets (cash, money market instruments)

Question 17

Investment benchmark

Answer 17

Matches liabillities by

• nature
• currency
• term

Question 18

Different sets of liabilities to match simultaneously

Answer 18

• the “realistic” liabilities they need to match on an ongoing basis
• the statutory basis for providing solvency

Question 19

Two main factor determining preference for income or capital growth

Answer 19

• tax
• cash flow requirements

Question 20

Factors to be considered before making a tactical asset switch

Answer 20

• expected extra return to be made relative to the additional risk
• constraint on the changes
• expenses of making the switch
• the problems of switching a large portfolio of assets

Question 21

Difference between strategic and tactical asset allocation

Answer 21

• Strategic investment decisions involve setting the relatively long-term structure of a portfolio (e.g. deciding on the percentage allocation between different asset classes). Tactical decisions involve short-term switching between investments in pursuit of higher returns.Strategic investment decisions involve setting the relatively long-term structure of a portfolio (e.g. deciding on the percentage allocation between different asset classes).
• Tactical decisions involve short-term switching between investments in pursuit of higher returns.

Question 22

Main factors that influence a long-term investment strategy

Answer 22

• S – Size of the assets (in relation to liabilities and in absolute terms)
• T – Tax (both the treatment of the asset and the investor)
• R – Risk appetite for the institution
• E – Existing asset portfolio
• S – Statutory valuation and solvency
• S – Strategy followed by other funds
• E – Expected long-term return from various asset classes
• D – Need for diversification
• F – Future accrual of liabilities
• O – Objectives of the institution
• R – Restrictions (statutory, legal or voluntary) on how the fund may invest
• T – Term of the existing liabilities
• U - Level of uncertainty of the existing liabilities (both in amount and timing)
• N – Nature of existing liabilities
• E – Currency of existing liabilities

Question 23

Definitions of investment risk

Answer 23

• Probability of default
• Expected variability of returns
• Risk of underperforming compared to competitors
• Probability of failing to achieve the investor’s objective

Question 24

The main factors that an individual should consider before investing

Answer 24

• The characteristics of their assets and liabilities (and matching)
• Their cash flow requirements
• Risks arising, in particular the variability of market values
• Returns from different asset classes
• Investment constraints
• Practical considerations

Question 25

Nature of an individual’s liabilities

Answer 25

mostly real and domestic

Question 26

Level of risk an individual can take on

Answer 26

• Level of excess assets of the individual
• the uncertainty of future income and outgo
• the risk appetite of the investor

Question 27

Principles for investments

Answer 27

A provider should select investments that are appropriate to the

• Nature
• Term
• Currency, and
• Uncertainty

Of the liabilities, and

• The provider’s appetite for risk

Question 28

Net liability outgo

Answer 28

• Benefit payments
• • expense outgo
• • premium / contribution income

Question 29

4 types of benefit payments

Answer 29

• Guranateed in money (nominal) terms
• guaranteed in terms of an index
• discretionary
• investment-linked

Question 30

Measuring active risk

Answer 30

• Historic tracking error (standard deviation of the difference between portfolio return and benchmark return)
• Forward-looking tracking error (estimate of the standard deviation of returns, relative to the benchmark)
• Active money position (Difference between the actual position and the benchmark portfolio)

Question 31

Risk budgeting process

Answer 31

• Deciding how to allocate the maximum permitted overall risk between
  
  • Total fund active risk
  • Strategic risk
• Allocating the total fund active risk across the component portfolios

Question 32

Liability hedging

Answer 32

assets are chosen in such a way as to perform in the same way as the liabilities

Question 33

Immunization

Answer 33

Investment of the assets in a way that the present value of the assets less the present value of the liabilities is immune to a general small change in the rate of interest.

Question 34

Redington immunization theory - conditions

Answer 34

1. The present value of the liability outgo and asset proceeds is equal
2. The discounted mean term (DMT) of the value of the asset proceeds must equal the discounted mean term of the value of the liability outgo
3. The spread about the discounted mean term of the value of the asset proceeds should be greater than the spread of the value of the liability outgo

Question 35

Mean variance portfolio theory with liabilities

Answer 35

Minimize variance of surplus for a given expected return, where surplus is defined as follows:

Question 36

Overall investment risk

Answer 36

“sum of”:

• active risk (difference between actual portfolio and benchmark)
• strategic risk (conscious deviation from minimum risk)
• structural risk (mismatch between aggregate of the portfolio benchmarks and the total fund benchmark)