CT8 Pu 15

CT8: CMP Upgrade 2014/15
Page 1
Subject CT8
CMP Upgrade 2014/15
CMP Upgrade
This CMP Upgrade lists all significant changes to the Core Reading and the ActEd
material since last year so that you can manually amend your 2014 study material to
make it suitable for study for the 2015 exams. It includes replacement pages and
additional pages where appropriate.
Alternatively, you can buy a full replacement set of up-to-date Course Notes at a
significantly reduced price if you have previously bought the full price Course Notes in
this subject. Please see our 2015 Student Brochure for more details.
This CMP Upgrade contains:
all changes to the Syllabus objectives and Core Reading
changes to the ActEd Course Notes, Series X Assignments and Question and
Answer Bank that will make them suitable for study for the 2015 exams.
The Actuarial Education Company
IFE: 2015 Examinations
Page 2
Changes to the Syllabus Objectives and Core Reading
1.1
Syllabus Objectives
No changes have been made to the syllabus objectives.
1.2
Core Reading
No changes have been made to the Core Reading.
Page 3
Changes to the ActEd Course Notes

Chapter 13
Page 24
The second sentence in the section headed Step 2: Starting at State (1,2) has been
corrected to say:
Starting from State (1,2), the possible derivative payoffs at time 2 are c2 (1) = 0 and
c2 (2) = 0 .
Page 4
Changes to the Q&A Bank

Q&A Part 1
Question 1.5
The bullet points at the end of the solution to part (ii) have been rephrased as follows to
make them clearer.
Hence, as Colins wealth decreases the:
absolute amount of his investment in risky assets will increase (as his absolute
risk aversion decreases as his wealth decreases)
[1]
proportion of his wealth that is invested in risky assets will increase (as his
relative risk aversion decreases as his wealth decreases).
[1]
Page 5
Changes to the X assignments

Assignment X1
Question X1.7
In the middle of the solution to part (i), an extra % sign has been added to the E [ AB ]
term. So, the solution now says:
E [ A] = 6.0%
E [ B ] = 6.1%
E [ AB ] = 19%%
[1]
Assignment X2
Question X2.5
The wording in (i) has been changed to the following:

Explain why, in economic terms, the value of the US Dollar is likely to increase
when rd > re .
The solution to the question is unchanged.
Question X2.6
The solution to part (i) has been changed to the following:

Standard Brownian motion is a continuous-time stochastic process with state space R .
[]
It has:
independent increments
[]
stationary increments
[]
continuous sample paths.
[]
The distribution of the increments Bt - Bs ( 0 s < t ) is given by:

Bt - Bs ~ N (0, t - s)
[]
Page 6
B0 = 0 .
[]
[Total 3]
QuestionX2.7
The wording to part (iii)(a) has been changed to make it clearer what is required. It
now says:
Explain whether the longitudinal and cross-sectional properties will be the same or
different for the following two data sets:
(a)
the monthly share prices
(b)
the log returns over the next month.
The solution to the question is unchanged.
Assignment X3
Question X3.5
The wording in part (i) has been changed and now says Explain what is meant by a
replicating portfolio. The solution is unchanged.
Question X3.9
The first phrase in the solution to part (iv) has been edited and now simply says We
can use put-call parity:.
Page 7
Assignment X4
Question 4.2
Part (i) of this question has been expanded a little and is now as follows.
The price of a non-dividend-paying stock at time 1, S1 , is related to the price at time 0,
S0 , as follows:
S1 = S0u with probability p and
S0 d with probability 1 - p .
The continuously compounded rate of return on a risk-free asset is r.
(i)
(a)
Determine the replicating portfolio for a European call option written on

the stock that expires at time 1 and has a strike price of k, where
dS0 < k < uS0 . You should give expressions for the number of units for
each constituent in the portfolio.
(b)
Use your expressions in (i)(a) to find a formula for the price of the
European call option.
(c)
Use put-call parity to derive a formula for the price of the corresponding
European put option, with the same strike price and strike date.
(d)
Show that the price of the European call option in (i)(b) can be written as
the discounted expected payoff under a probability measure Q. Hence
find an expression for the probability, q, of an upward move in the stock
price under Q.
[7]
Part (ii) of the question is unchanged. The revised solution to part (i) is as follows.
(i)(a) Replicating portfolio of European call option
We have two possibilities for the price at time 1:
S0 u
S1 =
S0 d
if the price goes up

if the price goes down
Page 8
We can hold an amount f of the stock, and amount y of cash at time 0 with the
intention of replicating a derivative whose payoff at time 1 is cu if the stock price goes
up and cd if the stock price goes down.
We equate the value of the portfolio at time 1 with the payoffs on the call option at
time 1 and solve the simultaneous equations:
f S0u +y er = cu
f S0 d +y er = cd
cd u - cu d
u - d
y = e- r
giving
and
cu cd
S0 (u d )
[1]
[]
[]
By the no-arbitrage principle, the value of this portfolio at time 0, V0 , must also be the
value of the derivative contract at that time.
Finally, we are actually asked to replicate a European call with strike price of k. This
implies that cu = uS0 - k and cd = 0 since we are told that dS0 < k < uS0 . Substituting
in our expressions for f and y gives:
f=
and
S 0u - k
S0 (u - d )
- ( S 0u - k ) d
S u-k
= -e - r 0
d
u - d
u-d
y = e- r
[]
[]
[Total 3]
Note that we could have alternatively worked with the explicit expressions for the payoff
from the start. In this question it wouldnt have really mattered; perhaps the maths is
slightly easier just dealing specifically with the call option, although at least with cu
and cd you get answers that should be familiar from Core Reading. In addition, if the
question had asked later for the corresponding expressions for a put, then the method
presented here would have saved you a considerable amount of time. It often pays to
read all the parts of a question before starting it.
Page 9
(i)(b) Price of European call option

By the no-arbitrage principle, the price of the European call option is given by:
V0 = f S0 + y
[]
Substituting the expressions for f and y from (i)(a) into this gives:
V0 = S0 + =
er d
( S u k ) d r
S 0u k
S0 e r 0
= e ( S0u k )
S0 (u d )
ud
ud
[1]
[Total 1]
(i)(c) Price of European put option using put-call parity
Put-call parity says that for European calls and puts with the same strike price and date:
p0 + S0 = c0 + ke - r
[]
So:
p0 = c0 + ke - r - S0
er - d
= e - r ( S0 u - k )
+ ke - r - S0
u-d
=
ie
e- r
S0 ue r - S0 ud - ke r + kd + ku - kd - S0 ue r + S0 de r
u - d
=e
-r
er - u
( S0 d - k ) u - d
[1]
[Total 1]
(i)(d) Price of European call under risk-neutral measure Q

As in part (i(a)) we could work with the general case using cu and cd but its quicker
to use the explicit expressions because cd = 0 simplifies matters.
We want to show that:
V0 = f S0 +y = e - r EQ (C | F0 ) = e - r q ( S0u - k )
Page 10
where C is the call option payoff at time 1 and q is the required (risk-neutral)
probability of an upward stock price movement.
[]
Now, comparing the pricing formula for the call option in (i)(b) to:
e - r EQ (C ) = e - r q ( S0u - k )
gives us:
q=
er - d
u-d
[]
[Total 1]
A new question has been added on the Merton model as follows. (Note that all of the
existing questions are still relevant.)
Question
An analyst is using the Merton model, together with the following information, to value
the five-year zero-coupon bonds (ZCBs) issued by a company:
The nominal value of ZCBs issued is $100 million.
The companys shares have a market capitalisation of $118.46 million.
The volatility of the companys underlying assets has been estimated to be

25% pa.
The five-year risk-free force of interest is 5% pa.
(i)
Calculate the price per $100 nominal of a five-year risk-free ZCB.
(ii)
Using your answer to (i) to obtain an initial estimate, and then applying linear
interpolation, estimate the value of the companys assets (to the nearest $10,000)
and hence show that the value of its ZCBs is $76.47 million.
[5]
(iii)
(a)
State the formula for the delta of a European call option based on the
Black-Scholes formula (assuming no dividends) and use it to derive a
formula for the delta of the ZCBs with respect to the value of the
companys assets.
(b)
Estimate the numerical value of delta using your calculations in part (ii)
and use it to estimate the new value of the ZCBs following a $10 million
fall in the value of the companys assets.
[1]
(c)
Page 11
The actual value of the ZCBs following a $10 million fall in the value of
the companys assets is $76.16 million. Give a possible reason for the
discrepancy between your estimated value of the ZCBs and the actual
value.
[5]
[Total 11]
Solution
(i)
Price of risk-free zero-coupon bond
Price = 100 e -50.05 = $77.88

(ii)
[1]
Value of companys assets and ZCBs
Adding together the value of the company shares and the risk-free ZCBs gives a starting
value for the value of its assets of:
Ft = 118.46 + 77.88 = $196.34m
[]
Recall the Merton model for the current value of the shares:
Et = Ft F( d1 ) - L e - r (T -t ) F(d 2 ) ,
where d1 =
F
log t + r + s 2 (T - t )
L
s T -t
, d 2 = d1 - s T - t
[]
So, substituting the starting value of 196.34 for Ft into this formula, together with:
the outstanding term of the ZCBs, T - t = 5

the volatility of the companys assets, s F = 0.25
the risk-free force of interest, r = 0.05

the nominal value of the ZCBs, L = 100
gives:
d1 =
196.34
log
+ 0.05 + 0.252 5
100
0.25 5
= 1.9336
[]
Page 12
d 2 = 1.9336 - 0.25 5 = 1.3746
[]
and hence:
Et = 196.34 F(1.9336) - 100 e -0.055 F(1.3746) = $119.832m
0.97342
[]
0.91537
This is (about 1.37) greater than the observed market capitalisation and delta (the
change in the share price with respect to the total asset value) is positive. So, try a
lower estimate for the total asset value.
[]
Note also that as the option represented by the shares is very in-the-money (as Ft is
much greater than L = 100 ), delta is close to one.
So, in order to reduce the market capitalisation by about 1.37, we need to try a value of
Ft a bit more than 1.37 less than 196.34. So, we next try Ft = 194.90 . This gives:
d1 =
194.90
log
+ 0.05 + 0.252 5
100
0.25 5
= 1.9205
d 2 = 1.9205 - 0.25 5 = 1.3614

and hence:
Et = 194.90 F(1.9205) - 100 e -0.055 F(1.3614) = $118.431m
0.97260
0.91331
This is just below the market capitalisation of $118.46 (and delta is close to one), so
lets try an asset value that is slightly higher, eg Ft = 194.95 . This gives:
d1 =
194.95
log
+ 0.05 + 0.252 5
100
0.25 5
= 1.9209
d 2 = 1.9209 - 0.25 5 = 1.3619
Page 13
and hence:
Et = 194.95 F(1.9209) - 100 e -0.055 F(1.3619) = $118.479m
0.97263
0.91338
Finally, linear interpolation between 194.90 and 194.95 gives:
Ft = 194.90 + 0.05
118.46 - 118.431
= $194.93m
118.479 - 118.431
[2 for correct Ft via appropriate interpolation]
Alternatively, trying Ft = 195.00 gives:
d1 =
195.00
log
+ 0.05 + 0.252 5
100
0.25 5
= 1.9214
d 2 = 1.9214 - 0.25 5 = 1.3624

and hence:
Et = 195.00 F(1.9214) - 100 e -0.055 F(1.3624) = $118.528m
0.97266
0.91346
So, linear interpolation between 194.90 and 195.00 gives:
Ft = 194.90 + 0.10
118.46 - 118.431
= $194.93m
118.528 - 118.431
[2 for correct Ft via appropriate interpolation]
Hence, the value of the companys ZCBs must be:

Bt = 194.93 - 118.46 = $76.47m
[]
[Maximum 5]
(iii)(a) Delta of the ZCBs

If the underlying asset pays no dividends then, according to the Black-Scholes formula:
D call = F(d1 )
[]
Page 14
In the Merton model:

Ft = Et + Bt
[]
Differentiating this equation partially with respect to Ft gives:

1 = DE + DB
ie
DB = 1 - DE
[]
So, recalling that the Merton model suggests that the companys shares are effectively a
European call option on its underlying assets, we have:
D B = 1 - F(d1 )
[]
[Total 2]
(iii)(b) Numerical value of delta

D B = 1 - F(d1 )
So, using F(d1 ) 0.97262 from part (ii) we have:
D B = 1 - 0.97262 = 0.02738
[]
Markers: Please accept any value for D B between:

D B = 1 - 0.9726 = 0.0274
and
D B = 1 - 0.9727 = 0.0273
Estimated fall in the value of the ZCBs
If the value of the companys assets falls by $10 million, the value of the ZCBs will
therefore fall by approximately:
10 D B = 10 0.02738 = $0.2738m
[1]
Bt' = 76.47 - 0.2738 = $76.196m
[]
to:
[Total 2]
Page 15
(iii)(c) Reason for discrepancy between estimate and actual value

The difference between the estimated value and the actual value stems from the fact that
delta is not constant but varies with the change in the value of the companys assets. [1]
In other words, the difference arises because gamma is non-zero.
Alternatively, the values may differ because the values of one or more of the other
parameters (eg the volatility) may have changed.
[1]
[Maximum 1]
In fact, partially differentiating the formula for delta gives:
GB =
2 Ft
Et2
=-
f (d1 )
<0
Fts T - t
which tells us that delta decreases as the value of the companys assets increases and
conversely that it increases with a fall in the value of the companys assets. So, in this
instance, assuming delta is constant means that the fall in the value of the ZCBs is
under-estimated. Hence, the estimated ZCB value is greater than the actual value.
Page 16
Other tuition services

In addition to this CMP Upgrade you might find the following helpful with your study.
5.1
Study material
We offer the following study material in Subject CT8:
Online Classroom
Flashcards
Sound Revision
Revision Notes
ASET (ActEd Solutions with Exam Technique) and Mini-ASET
Mock Exam
Additional Mock Pack.
For further details on ActEds study materials, please refer to the 2014 Student
Brochure, which is available from the ActEd website at www.ActEd.co.uk.
5.2
Tutorials
We offer the following tutorials in Subject CT8:
a set of Regular Tutorials (lasting two or three full days)
a Block Tutorial (lasting two or three full days)
a Revision Tutorial (lasting one full day)
Live Online Tutorials (lasting three full days)
Live Online Revision Tutorials (lasting half a day or a whole day).
For further details on ActEds tutorials, please refer to our latest Tuition Bulletin, which
is available from the ActEd website at www.ActEd.co.uk.
5.3
Page 17
Marking
You can have your attempts at any of our assignments or mock exams marked by
ActEd. When marking your scripts, we aim to provide specific advice to improve your
chances of success in the exam and to return your scripts as quickly as possible.
For further details on ActEds marking services, please refer to the 2015 Student
Brochure, which is available from the ActEd website at www.ActEd.co.uk.
5.4
Feedback on the study material

ActEd is always pleased to get feedback from students about any aspect of our study
programmes. Please let us know if you have any specific comments (eg about certain
sections of the notes or particular questions) or general suggestions about how we can
improve the study material. We will incorporate as many of your suggestions as we can
when we update the course material each year.
If you have any comments on this course please send them by email to CT8@bpp.com
or by fax to 01235 550085.
All study material produced by ActEd is copyright and is sold

for the exclusive use of the purchaser. The copyright is owned
by Institute and Faculty Education Limited, a subsidiary of
the Institute and Faculty of Actuaries.
Unless prior authority is granted by ActEd, you may not hire
out, lend, give out, sell, store or transmit electronically or
photocopy any part of the study material.
You must take care of your study material to ensure that it is
not used or copied by anybody else.
Legal action will be taken if these terms are infringed. In
addition, we may seek to take disciplinary action through the
profession or through your employer.
These conditions remain in force after you have finished using
the course.

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CT8: CMP Upgrade 2014/15

This CMP Upgrade contains:

all changes to the Syllabus objectives and Core Reading

The Actuarial Education Company

IFE: 2015 Examinations

CT8: CMP Upgrade 2013/14

Changes to the Syllabus Objectives and Core Reading

IFE: 2015 Examinations

The Actuarial Education Company

CT8: CMP Upgrade 2014/15

Changes to the ActEd Course Notes

The Actuarial Education Company

IFE: 2015 Examinations

CT8: CMP Upgrade 2013/14

Changes to the Q&A Bank

IFE: 2015 Examinations

The Actuarial Education Company

CT8: CMP Upgrade 2014/15

Changes to the X assignments

The wording in (i) has been changed to the following:

The solution to part (i) has been changed to the following:

continuous sample paths.

The distribution of the increments Bt - Bs ( 0 s < t ) is given by:

The Actuarial Education Company

IFE: 2015 Examinations

CT8: CMP Upgrade 2013/14

the monthly share prices

the log returns over the next month.

The solution to the question is unchanged.

IFE: 2015 Examinations

The Actuarial Education Company

CT8: CMP Upgrade 2014/15

Determine the replicating portfolio for a European call option written on

if the price goes up

The Actuarial Education Company

IFE: 2015 Examinations

CT8: CMP Upgrade 2013/14

IFE: 2015 Examinations

The Actuarial Education Company

CT8: CMP Upgrade 2014/15

(i)(b) Price of European call option

(i)(d) Price of European call under risk-neutral measure Q

We want to show that:

The Actuarial Education Company

IFE: 2015 Examinations

CT8: CMP Upgrade 2013/14

The nominal value of ZCBs issued is $100 million.

The companys shares have a market capitalisation of $118.46 million.

The volatility of the companys underlying assets has been estimated to be

The five-year risk-free force of interest is 5% pa.

Calculate the price per $100 nominal of a five-year risk-free ZCB.

IFE: 2015 Examinations

The Actuarial Education Company

CT8: CMP Upgrade 2014/15

Price of risk-free zero-coupon bond

Price = 100 e -50.05 = $77.88

Value of companys assets and ZCBs

Ft = 118.46 + 77.88 = $196.34m

the outstanding term of the ZCBs, T - t = 5

the risk-free force of interest, r = 0.05

The Actuarial Education Company

IFE: 2015 Examinations

CT8: CMP Upgrade 2013/14