MidtermOne_Fall2009_Answers - ACTUARIAL SCIENCE 445/845:...

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ACTUARIAL SCIENCE 445/845: Asset Liability Management Midterm One - Fall 2009 Aids: Calculator, Answer all questions in the space provided. Show your work. Name: ____________________ Marks: _____________________/40 ID#: _____________________ Course (445 or 845):___________ Concept Questions 1. [6 marks] Aside from interest rate risk, fixed income securities face numerous other sources of risk. State and briefly explain three of these additional sources of risk. Answer: There were many acceptable answers, including: Reinvestment risk: The return obtained when reinvesting the cash flows produced by a FIS depends on the interest rates prevailing when these cash flows are reinvested. The risk is that the interest rates will be low when the cash flows become available for reinvestment. Credit risk: The risk of loss due to the default (or credit rating migration) of the issuer of the fixed income security. Inflation, or purchasing power, risk: Inflation affects the value of future cash flows, when we measure this value in terms of purchasing power. Unless the bond contains an inflation‐ adjustment clause, the investor is exposed to this risk. For other possible answers, see either the lecture notes or the slides on Risks Associated with Investing in Fixed Income Securities. 2. [6 marks] State and briefly explain three shortcomings of duration as a measure of interest rate risk. Answer: Again, there were many possible answers, including the following. Duration only measures sensitivity to small changes in the yield curve. Since it is based on a first order Taylor expansion of the security price as a function of the yield, duration only measures the effects of small yield changes. Using the duration approximation to calculate price changes of bonds with respect to large changes in yield can be inaccurate.
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This note was uploaded on 12/12/2010 for the course ACTSC 445 taught by Professor Christianelemieux during the Fall '09 term at Waterloo.

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MidtermOne_Fall2009_Answers - ACTUARIAL SCIENCE 445/845:...

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