SOCIETY OF ACTUARIES Advanced Portfolio Management Exam APM MORNING SESSION Date: Friday, April 27, 2012 Time: 8:30 a.m. – 11:45 a.m. INSTRUCTIONS TO CANDIDATES General Instructions Written-Answer Instructions 1. This examination has a total of 120 points. It consists 1. Write your candidate number at the top of each sheet. of a morning session (worth 60 points) and an afternoon Your name must not appear. session (worth 60 points). 2. Write on only one side of a sheet. Start each question a) The morning session consists of 8 questions on a fresh sheet. On each sheet, write the number of numbered 1 through 8. the question that you are answering. Do not answer more than one question on a single sheet. b) The afternoon session consists of 9 questions numbered 9 through 17. 3. The answer should be confined to the question as set. The points for each question are indicated at the 4. When you are asked to calculate, show all your work beginning of the question. Questions 1 - 3 pertain to including any applicable formulas. the Case Study, which is enclosed inside the front cover of this exam booklet. 5. When you finish, insert all your written-answer sheets into the Essay Answer Envelope. Be sure to hand in all 2. Failure to stop writing after time is called will result in your answer sheets since they cannot be accepted later. the disqualification of your answers or further Seal the envelope and write your candidate number in disciplinary action. the space provided on the outside of the envelope. Check the appropriate box to indicate morning or 3. While every attempt is made to avoid defective afternoon session for Exam APM. questions, sometimes they do occur. If you believe a question is defective, the supervisor or proctor cannot 6. Be sure your written-answer envelope is signed because give you any guidance beyond the instructions on the if it is not, your examination will not be graded. exam booklet. Tournez le cahier d’examen pour la version française. © 2012 by the Society of Actuaries Printed in the U.S.A. 475 N. Martingale Road Exam APM-Front Cover Schaumburg, IL 60173-2226 CASE STUDY INSTRUCTIONS The case study will be used as a basis for some examination questions. Be sure to answer the question asked by referring to the case study. For example, when asked for advantages of a particular plan design to a company referenced in the case study, your response should be limited to that company. Other advantages should not be listed, as they are extraneous to the question and will result in no additional credit. Further, if they conflict with the applicable advantages, no credit will be given. **BEGINNING OF EXAMINATION** Morning Session Questions 1-3 pertain to the Case Study. Each question should be answered independently. 1. (8 points) Peter Fish believes that a 30-year zero-coupon bond issued by company XYZ is underpriced relative to bonds from other companies with equivalent risk profile. Based on his research, it has been underpriced by the market for a long time. He recommends taking advantage of this opportunity and asks you to develop an arbitrage strategy. (a) (1 point) Describe an arbitrage strategy that attempts to profit from this opportunity in the short term. (b) (2 points) Identify and explain theoretical and practical limitations to this arbitrage strategy. (c) (2 points) Explain the behavioral biases that may influence Peter’s recommendation. (d) (2 points) Give a rationale why the Investment Committee might accept and a rationale why they might reject his recommendation if: (i) Peter’s compensation is dependent on the projected long term performance of the company. (ii) Peter’s long term track record shows below market gains, but his short term track record shows above market gains. (e) (1 point) Critique whether this arbitrage strategy would be appropriate for Wonka’s Guaranteed Investment Contract product line. Exam APM – Spring 2012 - 1 - GO ONTO NEXT PAGE Advanced Portfolio Management Morning Session Questions 1-3 pertain to the Case Study. Each question should be answered independently. 2. (8 points) At Wonka Life, the objective of the employees’ pension plan is to maximize the asset return and minimize cash contributions over the long-term. You are an investment actuary and have been asked by the new CFO to assess a liability-relative asset allocation policy. (a) (1.5 points) List and describe your role and responsibilities as an investment actuary. (b) (1.5 points) Justify the role of equities in the pension plan. (c) (2 points) (i) Compute the expected liability-relative return on surplus. (ii) Compute the expected asset return and estimate the asset duration required for a Minimum-Surplus-Variance (MSV) portfolio. (d) (1 point) Recommend how you will change the current asset portfolio to minimize surplus variance. The CFO realized that the asset-only frontier and surplus efficient frontier were very close and challenged the importance of making the distinction. (e) (2 points) Explain why you might make investment decisions based on the surplus efficient frontier. Exam APM – Spring 2012 - 2 - GO ONTO NEXT PAGE Advanced Portfolio Management Morning Session Questions 1-3 pertain to the Case Study. Each question should be answered independently. 3. (7 points) The CFO of Wonka Life has asked you to use the liquidity management framework proposed by Hugh Dodo to calculate the company’s liquidity ratio for 12/31/2010. (a) (2 points) Calculate the Liquidity Ratio under both the Normal and Panic Scenarios. (b) (1 point) Identify three shortcomings of the liquidity measurement framework mentioned above. (c) (1 point) List key qualitative questions to address when assessing liquidity risk. (d) (1 point) List the steps necessary to forecast the quantity of stand-by liquidity available in a given scenario. The Chief Investment Officer suggests moving the entire cash position to asset-backed commercial paper to increase the portfolio earned rate. He adds that this move would not affect Wonka’s liquidity ratios as measured by Byrd. (e) (1 point) Describe the risks involved with asset-backed commercial paper. (f) (1 point) Critique the CIO’s suggestion. Exam APM – Spring 2012 - 3 - GO ONTO NEXT PAGE Advanced Portfolio Management Morning Session 4. (11 points) Your company, an insurer, issues health insurance in a foreign market. Premiums and benefit payments are made in the foreign currency. (a) (1 point) Explain the foreign exchange (FX) risk exposures your company may have from this business. (b) (1 point) Explain why your company might want to manage its FX exposure. The chief actuary is concerned about the potential loss from this business compounding with foreign exchange risk. You are given the following information (all units expressed over a 1-year time horizon): S = spot exchange rate = 1.2 (foreign currency units per home currency unit) F/U E[i ]=expected foreign inflation rate = 4% F E[i ]=expected home country inflation rate = 2% H r =foreign country risk-free interest rate = 5% F r =home country risk-free interest rate = 2% H (c) (2 points) Explain the theoretical basis, and calculate the implied 1-year forward foreign exchange rate for each of the following assumptions: (i) Full interest rate parity (ii) Full purchasing power parity (d) (1 point) Identify and describe three different instruments that your company could use to hedge FX risk. Exam APM – Spring 2012 - 4 - GO ONTO NEXT PAGE Advanced Portfolio Management Morning Session 4. Continued For the purpose of calculating solvency capital, your company uses the following correlation matrix to aggregate different marginal loss distributions: FX Morbidity FX 1 0.05 Morbidity 0.05 1 The Chief Actuary suggests using the above matrix to set the pricing for this line of business. (e) (2 points) Assess the Chief Actuary’s suggestion. (f) (3 points) Contrast alternative approaches to the approach in (e) for aggregating FX and morbidity risks, identifying advantages and disadvantages. (g) (1 point) Identify the possible challenges you may face when validating the suggested risk aggregation method. Exam APM – Spring 2012 - 5 - GO ONTO NEXT PAGE Advanced Portfolio Management Morning Session 5. (10 points) You are managing a $500 million endowment for Coruscant University and are considering a strategic allocation to direct equity real estate. (a) (1 point) Identify issues with direct equity real estate investing from the perspective of the university’s endowment. The overall investment objective for the university endowment is to preserve the inflation-adjusted value of the assets after spending. To prepare for a presentation to the university’s board of trustees, you review the following information: • The endowment’s spending rate has been 4% of the 12-month average assets • Risk-free interest rate: 3.0% • Forecasted inflation rate in the next year is 1.5% An initial analysis of two different proposals with strategic allocations to direct real estate yields the following forecasts: Proposal 1 Proposal 2 Expected Return 5.40% 5.70% Standard Deviation of Return 9.50% 11.50% (b) (1.5 points) Recommend Proposal 1 or Proposal 2 for the endowment and justify your recommendation. During the meeting with the board, one of the trustees makes the following statement: “We should not be considering direct real estate. If we want exposure to real estate we should invest in REITs, which usually provide risk diversification comparable to direct real estate while offering substantially more liquidity.” (c) (1 point) Compare the features of direct property markets and REIT public markets. (d) (1.5 points) Explain with which part of the trustee’s statement you would agree or disagree. Exam APM – Spring 2012 - 6 - GO ONTO NEXT PAGE Advanced Portfolio Management Morning Session