Chapter 19: Actuarial technique

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 pispriced (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 liabilit modelling (ALM) exercise

Answer 3

• Clarify key objectives of investment and funding prolicy
• Agree suitable assumptions to use in ALM exervcise
• Collect data ato 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 shortfull probailities to choose between investmennt strategies

Answer 4

Advantages

• Simple to calculate
• simple to understand
• benchmark can be coosen 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 conidtions to establish extent to which assets and liabilities mismatch
• Appropriate supplementary reserves then set up to cover possible levels of shortfall identified

Resilence 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