MN-3005: Financial Services Mock Open Book Exam
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MN-3005: Financial Services Mock Open Book Exam
Marking Scheme
Question 1
(a) Discuss the main characteristics of insurance and the factors that impact on insurance pricing.
Characteristics: 8 marks
Pooling of losses: Law of large numbers
-Payment of fortuitous losses: unforeseen and unexpected by the insured and occurs as a result of chance
-Risk transfer: pure risk is transferred from the insured to the insurer
-Indemnification: the insured is restored to his/her approximate financial position prior to the occurrence of the loss
Factors: 7 marks
Adverse selection; Moral hazard; Fraudulent (Inflated) Claims
The underwriting cycle: cyclical pattern in underwriting stringency, premium levels, and profitability; (hard vs soft)
Consolidation in the insurance industry: the combining of business organizations through M&A.
Capital market risk-financing alternatives: Securitization of risk e.g. catastrophe bonds, insurance option [15 marks]
(b) Considered you are trading in an order-driven market. Below is a snapshot of the limit order book of stock “Impega” (size in thousand):
|
bid |
size |
ask |
size |
|
53 |
5 |
55 |
2 |
|
53 |
1 |
56 |
2 |
|
52 |
7 |
57 |
9 |
|
51 |
5 |
57 |
5 |
|
50 |
5 |
58 |
4 |
If following orders (limited/market orders) are entered:
|
Sequence |
order type |
sell |
buy |
size |
Instruction associated with the order |
|
1 |
limit |
54 |
|
2 |
- |
|
2 |
limit |
|
55 |
4 |
Cancel whole if not being full executed |
|
3 |
market sell |
|
|
7 |
- |
|
4 |
limit |
|
54 |
7 |
- |
|
5 |
limit |
55 |
|
5 |
- |
(i) Identify each order: whether the order is taking the market or making the market. And calculate the price if order is executed.
First order is standing order making market [2 mark]
Second order is taking the market and the price is 54.5 [2 marks]
3rd order is taking the market and the price is 52.86 [2 marks]
4th order is making the market [2 mark]
5th order is making the market [2 mark] [10 marks]
(ii) Illustrate the order book after the execution of above 5 orders and comment on the impact of those orders on the order book.
|
bid |
size |
ask |
size |
|
|
|
54 |
7 |
|
|
|
55 |
7 |
|
|
|
56 |
2 |
|
|
|
|
|
|
52 |
6 |
57 |
9 |
|
51 |
5 |
57 |
5 |
|
50 |
5 |
58 |
4 |
2 marks for the final order book.
Comments should include comparing bid ask spread and how orders impact on the order book- the balance of the book. 3 marks [5 marks]
(c) Describe a strategy used by hedge fund.
Give example such as:
Long/short equity involves buying one stock long (undervalued) and selling (overvalued) another stock short to exploit pricing anomaly between related (but not identical) assets that are mispriced relative to each other. [5 marks]
Question 2
(a) It is currently the 1st September and ThinkBig Co. has invested in a money market loan of £5 million where the interest rate is LIBOR +120 basis points (1.2%). LIBOR is currently 5.5%. The interest rate is due to be reset on the 1st October. (i.e. LIBOR will be reset). The company wishes to hedge its exposure using short-term interest rate futures contracts (STIRS).
(i) Explain “basis risk” and its impact on the hedge.
Because the factors that impact on the price in the cash market and future market are different, in particular the price in futures market usually incorporates the expectation of movement of interest in the future. Therefore there is price discrepancy between the price in the cash market and future market which is called basis. And it is measured as Cash Price – Futures Price.
Basis declines to zero at the expiration of the futures contract. Before expiration basis is normally non-zero. The risk is basis risk which is the risk that basis will change between the start of the hedge and the end of the hedge and that the end of hedge basis is unknown. Basis risk causes impact hedge. [4 marks]
(ii) Explain what strategy the company should use, if the actual futures price on the 1st September is 94.8.
Basis = (100-5.5)-94.8=-0.3 negative basis implies that the market expects interest rates to decrease in the period up to the date of the futures. Company has invested in a loan therefore need to hedge against potential decrease in the interest. Thinkbig Co would open the hedge on the 1st September by buying 10 (5m/0.5m) contracts and selling 10 contracts on the 1st Oct. [2 mark]
(iii) Following on the question (ii), what is the outcome of the hedge if basis is -0.1 on the 1st October and LIBOR is 4.8%?
Futures price on 1st September = 94.8
Futures price on 1st Oct (not given in Q)
Basis= Cash price – Future price@Oct
-0.1 = (100-4.8) – Future price; Future price@Oct = 95.3
Gain per contract = sell price– buy price = 95.3-94.8=0.5 = 50 ticks [2 marks]
Total gain (assuming 10 contracts used) = 50*10*£12.5 = £6,250 [2 marks]
Loss on interest income on the loan = 0.007*£5m*0.25 = £8,750 [2 marks]
Therefore, an imperfect hedge, and not in the hedgers’ favour due to the basis risk (loss £8,750<gain £6,250). [2 marks] [8 marks]
(b) Gigi Co is an Italian based manufactory company. It has extended its business globally. The company is expected to receive $800,000 from a foreign client and needs to pay $500,000 in 6 months to a foreign supplier. The following exchange rates and interest rates are available in the home country of Gigo Co:
Spot exchange rate: ($/€) 1.1211 –1.1263
Six-month forward exchange rate: ($/€) 1.0512 – 1.0897
Currency Dollar Euro
Deposit rate 2.5% per year 3% per year
Borrowing rate 4.5% per year 5.5% per year
Using the information provided, discuss the strategy that can be used by Gigi Co on hedging its future transactions. Support your discussion with calculations. [8 marks]
Netting off: income received in $: 800,000-500,000=$300,000
Using forward contract: $300,000/1.0897= £275,305.13 [1 mark] half mark if use wrong exchange rate
Using money market hedge:
Borrow Dollars as interest rate is lower compare to Euro and then covert it to € and deposit in the money market for 6 month to pay exact $300,000
First calculate how much dollar you need to borrow in the money market:
?$× (1+0.045÷2)=$300,000 [2 mark] 1 mark if use annual interest
Need to borrow $293,398.5
Then you calculate how much pound you can covert from $293,398.5 (using spot rate; sell dollar to buy euro): 293,398.5 ÷1.1263=€260,497.7 [2 mark] 1 mark for using wrong exchange rates.
And income of this $300,000 in 6 month using money market strategy is €260,497.7 ×(1+3%÷2)= €264,405.1 [2 mark] 1 mark if use annual interest
The best strategy is to use forward contract [1 mark]
(c) Company A and B have been offered the following rates per annum on a £200 million 10-year loans:
|
|
Fixed Rate |
Floating Rate |
|
Company A |
7.0% |
LIBOR+1.5% |
|
Company B |
10.5% |
LIBOR+3.0% |
If Company A wishes to have a variable interest exposure, while Company B wishes to have a fixed interest exposure, design an interest rate swap between Company A and B that is equally beneficial for both companies. [8 marks]
Company A Pay LIBOR Company B pay LIBOR+3%
Pay 7% pay 6.5%
Receive 6.5% receive LIBOR
Overall pay LIBOR+0.5% PAY 9.5%
Save 1% 1%
5 marks for diagram 3 for back check
Question 3
Assume you are tasked to evaluate the trading performance of a fund. One of the strategy the fund used in making profit from the UK big cap equity market is “mean reversion”. The relevant data required for calculations and chart are in the appendix (Table1: Data for Question 4) at the end of the question paper.
(a) Explain “mean reversion” strategy.
Mean reversion is based on the notion that asset prices and returns deviate from its long-run mean and eventually will revert to the long-run mean or average level of the entire dataset. So it is believe that this strategy can make profit by longing when it is indicated below its long-run mean and shorting when it is indicated above its long-run mean. [4 marks]
(b) Explain the significance of “stock index”.
Stock market index serves as benchmarks for evaluating the performance of investment. The return of stock index is often used as a proxy for market return. [4 marks]
(c) Produce a line chart that compares the trend on weekly returns of the investment strategy and the FTSE 100. [3 marks]
(d) Calculate Alpha for the investment. If the parameters cannot be calculated with given data, try to find them on reliable resource available on the internet (reference required). The assumptions and or rationales of the choice of the parameters used in calculating the Alpha need to be briefly discussed. [12 marks]
(e) Calculate Sharpe ratio, Treynor ratio and Calmar ratio respectively. [8 marks]
(f) Briefly comment on the ratios you calculated in (e). [4 marks]
[35 marks in total]
2024-01-08