Actuary Certification ACTUARY Finance and Economics 3 — Questions and Answers
Question 1: A callable bond is most likely to be called by the issuer when:
- Interest rates rise significantly
- Interest rates fall significantly (Correct answer)
- The bond approaches its maturity date
- Credit spreads widen
Correct answer: Interest rates fall significantly
Issuers call bonds when rates fall so they can refinance at lower rates, which is why callable bonds are typically priced below equivalent non-callable bonds.
Question 2: The concept of immunization in fixed-income portfolio management aims to:
- Maximize coupon income regardless of rate changes
- Match the duration of assets and liabilities to protect against interest rate risk (Correct answer)
- Eliminate credit risk through diversification
- Maximize convexity to benefit from rate volatility
Correct answer: Match the duration of assets and liabilities to protect against interest rate risk
Immunization matches asset and liability durations so that changes in interest rates affect both sides equally, protecting the surplus.
Question 3: Which of the following best describes 'moral hazard' in insurance economics?
- Adverse selection before the insurance contract is written
- The tendency for insured parties to take greater risks because they bear less of the cost (Correct answer)
- The risk that an insurer becomes insolvent
- Systematic underpricing of catastrophic events
Correct answer: The tendency for insured parties to take greater risks because they bear less of the cost
Moral hazard arises post-contract when insured individuals change behavior because the insurer absorbs the consequences of their risk-taking.
Question 4: Under the Capital Asset Pricing Model (CAPM), the expected return on an asset with a beta of zero equals:
- The market return
- The risk-free rate (Correct answer)
- Zero
- The asset's historical average return
Correct answer: The risk-free rate
CAPM states E(R) = Rf + β(Rm - Rf); when β = 0, the risk premium term drops out and only the risk-free rate remains.
Question 5: In a perfectly competitive market, long-run economic profit equals:
- A normal rate of return
- Zero (Correct answer)
- The accounting profit
- The marginal revenue
Correct answer: Zero
In long-run competitive equilibrium, entry of new firms drives economic profit to zero while firms still earn a normal accounting profit.
Question 6: The Fisher equation relates nominal interest rates, real interest rates, and which other variable?
- GDP growth rate
- Expected inflation (Correct answer)
- Currency exchange rate
- Default risk premium
Correct answer: Expected inflation
The Fisher equation is: (1 + nominal rate) = (1 + real rate)(1 + expected inflation), linking all three components.
Question 7: Which option strategy profits when the underlying asset price remains within a narrow range?
- Long straddle
- Short straddle (Correct answer)
- Long call
- Protective put
Correct answer: Short straddle
A short straddle (selling both a call and put at the same strike) earns maximum profit if the underlying price stays near the strike at expiration.
