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IFoA SA7 practice questions

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Question 1Investment environment, asset classes and financial markets

An insurer holds a large portfolio of index-linked gilts. Which risk is most directly reduced by this holding relative to holding conventional gilts of the same maturity?

  1. Currency risk on overseas assets
  2. Credit risk of the sovereign issuer
  3. Inflation risk on the real value of liabilities Correct answer.
  4. Liquidity risk in the secondary market

Explanation

Index-linked gilts have coupons and redemption values linked to an inflation index, so their cash flows rise with prices. This matches real liabilities and hedges the erosion of purchasing power that conventional fixed-cash-flow gilts suffer. Sovereign credit and currency risk are not addressed by the index link.

Question 2Investment environment, asset classes and financial markets

A fund manager expects the yield curve to steepen via a rise in long-term yields while short rates stay unchanged. Which position best expresses this view in government bonds?

  1. Buy short-dated bonds and sell long-dated bonds Correct answer.
  2. Buy both short-dated and long-dated bonds in equal amounts
  3. Sell both short-dated and long-dated bonds in equal amounts
  4. Buy long-dated bonds and sell short-dated bonds

Explanation

A steepening driven by long yields means long-dated bond prices fall relative to short-dated ones. Selling long-dated and buying short-dated bonds profits from the widening yield spread. A duration-neutral or parallel view would not isolate the curve move.

Question 3Investment environment, asset classes and financial markets

Which statement best describes the role of a central counterparty (CCP) in cleared over-the-counter derivative markets?

  1. It sets the interest rate used to discount collateral balances
  2. It acts as market maker, quoting two-way prices to end users
  3. It interposes itself between buyer and seller, becoming counterparty to both sides Correct answer.
  4. It guarantees the credit quality of the underlying reference entity

Explanation

A CCP novates each trade so that it becomes the buyer to every seller and the seller to every buyer. It manages counterparty risk through margin and a default fund rather than by guaranteeing reference entities or quoting prices. Discounting conventions are set by market practice, not by the CCP's core role.

Question 4Investment environment, asset classes and financial markets

An investor buys a 5-year corporate bond at a yield of 6% and expects the credit spread to narrow by 80 basis points with the risk-free curve unchanged. Ignoring convexity, what is the approximate capital gain per 100 nominal if modified duration is 4.2?

  1. 3.36 Correct answer.
  2. 0.80
  3. 4.20
  4. 6.72

Explanation

A spread tightening of 80bp lowers the yield by 0.008. The approximate price change is duration times the yield change, 4.2 x 0.008 = 0.0336, i.e. about 3.36 per 100 nominal. Convexity would add a small second-order gain, so 3.36 is the first-order estimate.

Question 5Investment environment, asset classes and financial markets

Which feature most clearly distinguishes a securitisation from a covered bond as a funding instrument for a bank?

  1. Covered bonds transfer the credit risk of the pool to investors without recourse
  2. Securitisations are only issued by sovereigns rather than banks
  3. Covered bonds are always floating rate while securitisations are fixed rate
  4. Securitised assets are sold to an SPV and removed from the issuer's balance sheet Correct answer.

Explanation

In a true sale securitisation, the underlying receivables are transferred to a bankruptcy-remote SPV and investors look to that pool. In a covered bond the assets remain on the issuer's balance sheet and investors have dual recourse to the issuer and the cover pool. Coupon type and issuer type do not distinguish the two.

Question 6Investment environment, asset classes and financial markets

Under the standard Basel market risk framework, which approach allows a bank to use its own internal models to compute market risk capital, subject to supervisory approval?

  1. The internal models approach Correct answer.
  2. The advanced measurement approach
  3. The basic indicator approach
  4. The standardised approach

Explanation

The internal models approach permits approved firms to use their own VaR-type models, subject to backtesting and regulatory multipliers. The standardised approach uses prescribed risk weights and parameters. The basic indicator and advanced measurement approaches relate to operational risk, not market risk.

Question 7Investment environment, asset classes and financial markets

A UK pension scheme has liabilities with a long duration and holds mostly equities. Which asset swap would most directly reduce its funding-level volatility against interest rate moves?

  1. Sell equities and buy high-yield corporate bonds
  2. Sell equities and buy long-dated index-linked gilts Correct answer.
  3. Sell equities and hold the proceeds in cash
  4. Sell equities and buy short-dated treasury bills

Explanation

Long-duration liabilities are sensitive to real interest rates, so matching with long-dated index-linked gilts hedges that sensitivity. T-bills, cash and high-yield bonds have short duration or credit risk that does not match the liability profile. The swap reduces mismatch between asset and liability interest rate exposure.

Question 8Investment environment, asset classes and financial markets

Which best explains why a corporate bond's credit spread typically widens during a liquidity crisis even if the issuer's default probability is unchanged?

  1. Rating agencies automatically downgrade all issuers in a crisis
  2. Investors demand compensation for reduced liquidity and higher expected transaction costs Correct answer.
  3. The issuer's coupon payments are suspended during the crisis
  4. The risk-free curve always shifts upward in a crisis

Explanation

Credit spreads contain a liquidity premium in addition to default and recovery components. In a crisis, bid-ask spreads widen and it becomes harder to trade, so investors require extra yield. Default probability need not change for the spread to widen.

Question 9Investment environment, asset classes and financial markets

An investor holds a convertible bond. Which combination best describes its payoff characteristics?

  1. Corporate bond exposure plus a call option on the issuer's equity Correct answer.
  2. Government bond exposure plus a put option on the issuer's equity
  3. Pure equity exposure with no fixed income component
  4. A floating rate note with no equity linkage

Explanation

A convertible bond pays coupons and principal like a corporate bond but can be converted into shares, giving the holder an embedded call on the equity. This makes its value sensitive to both credit spreads and the share price. It is not a pure equity or a plain floater.

Question 10Investment environment, asset classes and financial markets

A bank's trading book holds a large position in an emerging market sovereign bond denominated in a foreign currency. Which risk does a simple VaR model most likely understate?

  1. Reinvestment risk on coupon payments
  2. Prepayment risk on the bond
  3. Currency risk arising from an adverse move in the exchange rate Correct answer.
  4. Inflation risk on domestic liabilities

Explanation

A foreign-currency bond exposes the holder to both the bond's local price move and the exchange rate move. A VaR model calibrated only on local bond returns will miss the currency component. Coupon reinvestment and inflation are secondary for a traded sovereign bond.

Question 11Investment environment, asset classes and financial markets

Which statement accurately describes the relationship between a bond's price and its yield?

  1. Price and yield move inversely, and the price-yield curve is convex Correct answer.
  2. Price and yield move inversely, and the curve is concave
  3. Price and yield are unrelated for fixed-coupon bonds
  4. Price and yield move directly, and the curve is linear

Explanation

When yields rise, the present value of fixed cash flows falls, so price and yield are inversely related. The relationship is convex, meaning price gains from a yield fall exceed price losses from an equal yield rise. This convexity is a second-order effect captured by the convexity measure.

Question 12Investment environment, asset classes and financial markets

A fund wants exposure to a broad basket of investment-grade credit without taking single-name default risk. Which instrument is most suitable?

  1. A credit default swap index such as a mainstream CDX or iTraxx investment-grade series Correct answer.
  2. A single-name CDS on a large bank
  3. An equity index option
  4. A government bond futures contract

Explanation

A CDS index references a diversified basket of investment-grade names, so idiosyncratic default risk is diversified away while systematic credit spread exposure remains. Single-name CDS concentrates default risk, and government futures and equity options do not provide credit exposure.

Question 13Investment environment, asset classes and financial markets

Which best explains why the swap spread, the difference between the fixed rate on an interest rate swap and the yield on a government bond of similar maturity, can become negative?

  1. Swap contracts have no counterparty risk
  2. Government bond yields fall below swap rates when demand for safe assets drives bond prices up Correct answer.
  3. Government bonds carry more credit risk than swaps
  4. Swap rates are always set below government yields by regulation

Explanation

Swap spreads reflect relative supply and demand for government bonds versus swaps, plus balance sheet and collateral costs. In flight-to-quality episodes, strong demand for government bonds can push their yields below swap rates, producing a negative spread. Regulation does not mandate a sign for the spread.

Question 14Investment environment, asset classes and financial markets

Which asset class typically offers the strongest inflation pass-through to investors over the long run, according to standard investment theory?

  1. Cash deposits
  2. Fixed-rate corporate bonds
  3. Nominal government bonds
  4. Real assets such as infrastructure and property Correct answer.

Explanation

Real assets generate revenues and values that tend to rise with inflation, giving long-run pass-through. Nominal bonds and cash have fixed or slowly adjusting returns that are eroded by inflation. This is why real assets are used to hedge inflation-linked liabilities.

Question 15Investment environment, asset classes and financial markets

An insurer issues a guaranteed annuity product with a floor on payments. Which market instrument most directly hedges the interest rate risk embedded in this guarantee?

  1. A short position in a commodity index
  2. A receiver interest rate swaption struck at the guarantee level Correct answer.
  3. An equity total return swap
  4. A payer interest rate swap with a high fixed rate

Explanation

The guarantee behaves like a floor on interest rates, so a receiver swaption struck at the guarantee level gains value when rates fall below the strike. This offsets the higher cost of meeting the annuity promise. A payer swap gains when rates rise, which is the opposite exposure.

Question 16Investment environment, asset classes and financial markets

Which statement best describes the difference between primary and secondary markets?

  1. Both markets refer only to exchange-traded instruments
  2. Secondary markets are restricted to government bonds
  3. New securities are issued to investors in the primary market and subsequently traded in the secondary market Correct answer.
  4. Primary markets trade existing securities and secondary markets issue new ones

Explanation

The primary market is where issuers raise capital by selling new securities to investors. Once issued, those securities trade between investors in the secondary market, which provides liquidity and price discovery. The distinction applies across asset classes, not just government bonds.

Question 17Investment environment, asset classes and financial markets

A portfolio has 60% in equities with expected return 8% and volatility 18%, and 40% in bonds with expected return 3% and volatility 5%. If the correlation is 0.2, what is the portfolio volatility?

  1. About 9.0%
  2. About 18.0%
  3. About 13.0%
  4. About 11.5% Correct answer.

Explanation

Portfolio variance is 0.6^2 x 0.18^2 + 0.4^2 x 0.05^2 + 2 x 0.6 x 0.4 x 0.18 x 0.05 x 0.2. This gives 0.011664 + 0.0004 + 0.000864 = 0.012928, whose square root is about 11.4%, closest to 11.5%. Diversification lowers volatility below the weighted average because correlation is below one.

Question 18Investment environment, asset classes and financial markets

Which characteristic most distinguishes hedge funds from traditional long-only mutual funds?

  1. Daily dealing with full transparency
  2. Guaranteed capital protection
  3. Use of leverage and short selling within a wider mandate Correct answer.
  4. Restriction to investment-grade bonds

Explanation

Hedge funds typically employ leverage, short selling and derivatives within flexible mandates to pursue absolute returns. They do not usually offer capital protection, and they often have limited liquidity and transparency compared with mutual funds. Their mandates are not restricted to investment-grade bonds.

Question 19Investment environment, asset classes and financial markets

An investor expects implied volatility to fall but wants to keep exposure to the direction of the underlying equity index. Which strategy best fits?

  1. Buy a call and sell a put with the same strike
  2. Sell a straddle and delta-hedge the position Correct answer.
  3. Buy a straddle and hold it unhedged
  4. Buy a strangle and hold it unhedged

Explanation

Selling a straddle profits when implied volatility falls and realised volatility is low, but it carries directional risk. Delta-hedging removes the directional exposure so the position isolates the volatility view. Buying options would lose value if implied volatility falls.

Question 20Investment environment, asset classes and financial markets

Which of the following best describes the function of a repo transaction in money markets?

  1. A collateralised borrowing and lending of cash against securities Correct answer.
  2. An unsecured interbank loan
  3. An outright sale of securities with no repurchase obligation
  4. A swap of fixed for floating interest payments

Explanation

In a repo, one party sells securities and agrees to repurchase them later at a set price, which is economically a collateralised loan. The securities act as collateral, reducing credit risk relative to unsecured lending. It is not an outright sale or an interest rate swap.

Question 21Investment environment, asset classes and financial markets

A life insurer's liabilities are long-dated and it holds a large portfolio of short-dated government bonds. Which risk is it primarily running?

  1. Default risk on the government bonds
  2. Reinvestment risk from having to roll over maturing bonds at uncertain future rates Correct answer.
  3. Currency risk on the bond portfolio
  4. Equity risk from the bond holdings

Explanation

Short-dated bonds mature frequently and must be reinvested at whatever rates prevail then, creating reinvestment risk. If rates fall, the insurer may be unable to earn enough to meet long-dated liabilities. Government bonds have low default risk and no equity exposure.

Question 22Investment environment, asset classes and financial markets

Which statement best describes the role of a market maker in a bond market?

  1. Underwriting new government bond auctions on behalf of the sovereign
  2. Continuously quoting bid and offer prices and holding inventory to facilitate trades Correct answer.
  3. Guaranteeing the creditworthiness of issuers
  4. Setting the official central bank policy rate

Explanation

Market makers provide liquidity by quoting two-way prices and standing ready to trade, holding inventory to absorb order flow. They do not set policy rates or guarantee issuer credit. Underwriting is a separate function, typically performed by primary dealers.

Question 23Investment environment, asset classes and financial markets

A corporate pension scheme holds a portfolio of UK equities and wants to reduce its exposure to a market fall over the next six months without selling the shares. Which approach achieves this most directly?

  1. Buy call options on the same equity index
  2. Buy put options on a suitable equity index Correct answer.
  3. Sell put options on the same equity index
  4. Buy additional equities on margin

Explanation

Buying index puts provides downside protection while retaining the shares and any dividend income. If the market falls, the puts gain value and offset portfolio losses. Buying calls or selling puts would increase rather than reduce downside exposure.

Question 24Investment environment, asset classes and financial markets

Which best explains why high-yield bonds exhibit higher correlation with equities than investment-grade bonds?

  1. They are always issued by companies with listed equities
  2. They have longer duration than investment-grade bonds
  3. They are exempt from credit rating analysis
  4. Their default risk and valuations are more sensitive to the economic cycle Correct answer.

Explanation

High-yield issuers are more sensitive to economic downturns, so their default probabilities and spreads move with the business cycle. This makes high-yield returns behave more like equities, which are also cyclical. Duration and rating coverage do not explain the correlation.

Question 25Investment environment, asset classes and financial markets

A bank issues a floating rate note paying a reference rate plus a spread. What is the main interest rate risk for the investor holding the note?

  1. Basis risk between the reference rate and the investor's funding cost Correct answer.
  2. Default risk of the reference rate administrator
  3. Currency risk if the note is in the domestic currency
  4. Reinvestment risk on a long fixed coupon

Explanation

A floater's coupon resets with the reference rate, so its price is relatively stable against parallel rate moves. The remaining risk is basis risk, the mismatch between the reference rate and the investor's own funding or liability rate. Domestic-currency notes carry no currency risk, and the administrator's default is not the main exposure.

Question 26Investment environment, asset classes and financial markets

An investment analyst is comparing how equities and government bonds have behaved during sharp risk-off episodes. Which statement best describes the typical observed behaviour of these two asset classes in such episodes?

  1. Both equity and government bond prices usually rise together because central banks always cut rates immediately.
  2. Both equity and government bond prices usually fall together because liquidity dries up across all markets.
  3. Equity prices usually rise while government bond prices usually fall as investors rotate into growth assets.
  4. Equity prices usually fall while high-quality government bond prices usually rise as investors seek safe-haven assets. Correct answer.

Explanation

In risk-off episodes investors tend to sell growth-sensitive assets such as equities and buy assets perceived as safe, principally government bonds of strong sovereigns. This flight to quality pushes bond prices up and yields down, producing the negative return correlation often relied on for diversification. The pattern is a tendency rather than a law, since inflation shocks can move both assets down together.

Question 27Investment environment, asset classes and financial markets

A UK defined benefit scheme holds a large portfolio of long-dated index-linked gilts. Which risk is most directly reduced by holding these bonds rather than conventional fixed-coupon gilts of the same maturity?

  1. Exposure to real interest rate movements affecting the present value of inflation-linked liabilities. Correct answer.
  2. Exposure to short-term volatility in the sterling exchange rate.
  3. Exposure to equity market drawdowns in the scheme's growth portfolio.
  4. Exposure to changes in the scheme's own mortality assumptions.

Explanation

Index-linked gilts have cash flows that rise with realised inflation, so their prices and yields respond to real rather than nominal interest rates. For a scheme whose liabilities are inflation-linked, holding them aligns asset and liability sensitivity to real rate changes. They do nothing for mortality risk, currency risk or equity risk.

Question 28Investment environment, asset classes and financial markets

An investment manager notes that the yield curve for a major sovereign market is inverted, with short-dated yields above long-dated yields. Which interpretation is most consistent with standard term structure theory?

  1. Markets expect policy rates to fall and possibly future recession, so long yields price lower expected short rates. Correct answer.
  2. Long-dated bonds are always less liquid, so their yields must exceed short-dated yields in every curve shape.
  3. Markets expect inflation to accelerate sharply, so investors demand the largest compensation at the short end.
  4. The sovereign has defaulted on short-dated debt, so investors require a premium only on near maturities.

Explanation

Under expectations-based interpretations, an inverted curve signals that investors anticipate lower future short-term rates, often linked to expected easing or weaker growth. Long yields are an average of expected future short rates plus term premia, so they can sit below current policy-driven short yields. Inflation-acceleration expectations would normally steepen rather than invert the curve.

Question 29Investment environment, asset classes and financial markets

A fund invests in emerging market local-currency government bonds. Which combination of risks most distinguishes this exposure from holding developed market government bonds in the fund's home currency?

  1. Basis risk only, arising from the difference between two floating reference rates.
  2. Currency risk from the local currency plus heightened sovereign and political risk. Correct answer.
  3. Interest rate risk alone, since all government bonds carry identical credit exposure.
  4. Equity risk, because local-currency bonds are legally a form of equity claim.

Explanation

Holding emerging market debt denominated in the issuer's currency exposes a home-currency investor to depreciation of that currency as well as to sovereign, political and liquidity risks that are typically greater than in developed markets. These risks are additional to ordinary interest rate risk. Developed market government bonds in the home currency carry no currency mismatch for that investor.

Question 30Investment environment, asset classes and financial markets

An analyst is assessing the liquidity of a corporate bond issue. Which set of characteristics most reliably indicates lower liquidity risk in the secondary market?

  1. Large outstanding issue size, an active dealer community and inclusion in broad indices. Correct answer.
  2. A long maturity, a single specialist dealer and a private placement structure.
  3. Small outstanding issue size, a narrow investor base and bespoke covenants.
  4. A floating coupon, a sinking fund and a restriction on transfers between investors.

Explanation

Secondary market liquidity improves with issue size, because larger issues attract more dealers and investors and are more likely to enter indices that generate benchmark-driven demand. An active dealer community narrows bid-offer spreads and shortens the time needed to trade size. Features such as small size, private placement and transfer restrictions all reduce the pool of willing counterparties.

Question 31Asset-liability modelling and investment strategy for insurers and pension schemes

An insurer's asset-liability model projects cash flows for a with-profits fund. Which pairing of asset and liability discount bases is most consistent for valuing guaranteed benefits under a market-consistent framework?

  1. Discount both assets and liabilities using the fund's expected long-term earned rate
  2. Value assets at market and discount fixed guaranteed liabilities using the risk-free yield curve Correct answer.
  3. Value assets at market and discount liabilities at the risk-free curve plus an illiquidity premium
  4. Discount liabilities at the assumed asset return and hold assets at amortised book value

Explanation

Market-consistent valuation requires assets to be marked to market and guaranteed, non-discretionary liability cash flows to be discounted at the risk-free curve, because the guarantee is a fixed promise independent of asset performance. Using asset-earned rates to discount guarantees embeds a circularity and hides the cost of the guarantee.

Question 32Asset-liability modelling and investment strategy for insurers and pension schemes

A defined benefit pension scheme is heavily underfunded and the sponsor covenant is weak. Which investment strategy is most likely to be recommended by an ALM exercise?

  1. Reduce risk and lock in funding gains through liability-driven investment in long-dated bonds and swaps Correct answer.
  2. Shift entirely into cash to eliminate volatility in the funding level
  3. Increase allocation to growth assets to close the deficit through higher expected returns
  4. Increase allocation to alternative assets with high expected returns and illiquid profiles

Explanation

When the sponsor covenant is weak, the scheme cannot rely on future contributions to absorb risk, so the priority is protecting the funding position by matching liabilities with LDI. Chasing returns with growth or illiquid assets raises the probability of a worse outcome that the covenant cannot backstop.

Question 33Asset-liability modelling and investment strategy for insurers and pension schemes

Which statement best describes the purpose of a stochastic asset-liability model for an insurer setting its investment strategy?

  1. It generates a distribution of outcomes so that strategy can be assessed against risk appetite and capital Correct answer.
  2. It produces a single deterministic projection of the central balance sheet path
  3. It guarantees that the chosen strategy will meet all policyholder guarantees
  4. It replaces the need for an actuarial valuation of liabilities

Explanation

A stochastic ALM projects many correlated asset and liability scenarios, producing a distribution of surplus, capital and solvency outcomes. This lets decision-makers compare strategies against risk appetite and regulatory capital rather than a single path.

Question 34Asset-liability modelling and investment strategy for insurers and pension schemes

An insurer writes annuity business with liabilities of long duration. Which asset class most directly hedges the interest rate risk of these liabilities?

  1. Short-dated government bills
  2. Long-dated fixed-interest bonds and interest rate swaps Correct answer.
  3. Corporate floating-rate notes
  4. Equities with high dividend yield

Explanation

Long-duration fixed liabilities are hedged with long-dated fixed-interest instruments whose cash flows and duration match the liability profile. Swaps allow duration to be extended where physical bonds are scarce.

Question 35Asset-liability modelling and investment strategy for insurers and pension schemes

A with-profits fund is considering increasing its equity backing ratio. Which consequence is most relevant to the ALM analysis?

  1. Policyholder reasonable expectations are unaffected by the change
  2. The fund's regulatory capital requirement falls because equities are risk assets
  3. Guaranteed benefits become cheaper to provide because expected returns rise
  4. The cost of options and guarantees embedded in the policy rises as asset volatility increases Correct answer.

Explanation

Higher equity backing raises the volatility of the fund and increases the value of the guarantees and smoothing options promised to policyholders. The ALM analysis must recognise this higher cost of guarantees and any associated capital.

Question 36Asset-liability modelling and investment strategy for insurers and pension schemes

Which measure is most appropriate for quantifying the sensitivity of an insurer's surplus to a small parallel shift in interest rates?

  1. The liquidity ratio of the asset portfolio
  2. The credit spread of the bond portfolio
  3. The expense ratio of the insurer
  4. The duration gap between assets and liabilities Correct answer.

Explanation

The duration gap measures the difference in interest rate sensitivity between assets and liabilities and so captures exposure of surplus to parallel shifts. A larger gap implies a larger change in surplus for a given rate move.

Question 37Asset-liability modelling and investment strategy for insurers and pension schemes

A pension scheme's liabilities are indexed to price inflation. Which instrument most directly hedges this exposure?

  1. Index-linked gilts of matching duration Correct answer.
  2. Money market instruments
  3. Sterling corporate bonds with fixed coupons
  4. Nominal gilts of matching duration

Explanation

Index-linked bonds have cash flows that rise with the inflation index, matching inflation-linked liabilities in both timing and indexation. This directly hedges the real interest rate and inflation exposure.

Question 38Asset-liability modelling and investment strategy for insurers and pension schemes

An insurer is choosing between holding a portfolio of corporate bonds and a portfolio of government bonds to back its non-profit annuity liabilities. Which consideration most favours corporate bonds?

  1. Corporate bonds are more liquid and easier to trade in stress
  2. Corporate bonds typically offer a spread over government bonds that improves expected return for a given duration Correct answer.
  3. Corporate bonds have no default risk because they are regulated
  4. Corporate bonds carry lower credit risk than government bonds

Explanation

Corporate bonds usually yield more than government bonds of similar duration, so they can enhance return on the asset portfolio backing fixed liabilities. The ALM trade-off is the additional credit and liquidity risk that this spread compensates.

Question 39Asset-liability modelling and investment strategy for insurers and pension schemes

A life insurer uses a matching adjustment to discount eligible liabilities. Which condition is essential for the assets to qualify?

  1. The assets must be actively traded to demonstrate market liquidity
  2. The assets must be equities with predictable dividends
  3. The assets must have fixed cash flows that are highly predictable and held to maturity Correct answer.
  4. The assets must be denominated in a foreign currency to diversify risk

Explanation

The matching adjustment requires assets with fixed, highly predictable cash flows that are held to match the liabilities to maturity, so the illiquidity premium can be recognised. Equities and actively traded assets do not satisfy this.

Question 40Asset-liability modelling and investment strategy for insurers and pension schemes

An insurer's ALM committee is reviewing a strategy that increases the allocation to long-dated bonds to better match liabilities. Which risk is most likely to increase as a result?

  1. Reinvestment risk on the bond portfolio
  2. Equity risk on the bond portfolio
  3. Currency risk on the bond portfolio
  4. Liquidity risk if the bonds must be sold before maturity Correct answer.

Explanation

Buying long-dated bonds to match liabilities reduces reinvestment and interest rate risk but ties up capital in less liquid instruments. If the insurer needs to sell before maturity, it may face significant transaction costs or price impact.

Question 41Asset-liability modelling and investment strategy for insurers and pension schemes

Which statement best explains why insurers hold growth assets such as equities in with-profits funds?

  1. Equities offer higher expected returns over the long term, supporting bonuses and smoothing Correct answer.
  2. Equities are required by regulation for all with-profits funds
  3. Equities have lower volatility than bonds and so reduce risk
  4. Equities provide a guaranteed return that matches policyholder guarantees

Explanation

With-profits funds hold growth assets to earn higher expected long-term returns that fund discretionary bonuses and smoothing, at the cost of higher volatility. The ALM challenge is balancing this return against the cost of guarantees.

Question 42Asset-liability modelling and investment strategy for insurers and pension schemes

A pension scheme is considering a buy-in with an insurer. Which factor most directly affects the attractiveness of the transaction from an ALM perspective?

  1. The price relative to the scheme's own valuation of the liabilities and the risk transferred Correct answer.
  2. The number of trustees on the scheme board
  3. The insurer's marketing budget
  4. The scheme's historical investment return

Explanation

A buy-in transfers investment and longevity risk to the insurer, so the decision hinges on whether the premium is attractive relative to the scheme's own liability valuation and the risk removed. This is a core ALM and de-risking consideration.

Question 43Asset-liability modelling and investment strategy for insurers and pension schemes

An insurer's liabilities include options that allow policyholders to surrender at a guaranteed value. Which asset strategy best manages the resulting liquidity risk?

  1. Hold a buffer of liquid, high-quality assets sufficient to meet plausible surrender spikes Correct answer.
  2. Invest in equities to maximise returns
  3. Hold only assets with maturities longer than the liabilities
  4. Invest entirely in long-dated illiquid infrastructure assets

Explanation

Guaranteed surrender options create the risk of sudden cash outflows, so the insurer should hold a liquid buffer of high-quality assets that can be sold without material loss. Illiquid or long-only strategies would leave the insurer unable to meet spikes.

Question 44Asset-liability modelling and investment strategy for insurers and pension schemes

Which statement best describes the role of the risk-free curve in market-consistent ALM for insurers?

  1. It is used to discount all liability cash flows regardless of their risk characteristics
  2. It provides the base discount rate to which illiquidity and other permitted adjustments may be added for eligible liabilities Correct answer.
  3. It is irrelevant to the valuation of guarantees
  4. It determines the expected return on equities

Explanation

The risk-free curve is the foundation for market-consistent liability discounting. Where regulation permits, adjustments such as the matching adjustment or volatility adjustment may be added for eligible liabilities to reflect illiquidity.

Question 45Asset-liability modelling and investment strategy for insurers and pension schemes

A defined benefit scheme has a high proportion of deferred members with long durations. Which change in the yield curve would most increase the scheme's liabilities?

  1. A parallel upward shift in nominal yields
  2. A rise in short-dated nominal yields only
  3. A widening of corporate credit spreads
  4. A fall in long-dated real yields Correct answer.

Explanation

Deferred members with long durations make the liabilities highly sensitive to long-dated real yields, especially where benefits are inflation-linked. A fall in long-dated real yields increases the present value of those liabilities.

Question 46Asset-liability modelling and investment strategy for insurers and pension schemes

Which of the following best describes a key limitation of using historical data to calibrate a stochastic asset model for ALM?

  1. Historical data is only available for equities
  2. Past relationships between asset classes may not hold in the future, particularly in stress Correct answer.
  3. Historical data cannot be used in any actuarial model
  4. Historical data always overstates future volatility

Explanation

Stochastic models calibrated to history assume that past correlations, volatilities and mean reversion persist. Regime changes, structural shifts and unprecedented events mean these relationships may break down, understating tail risk.

Question 47Asset-liability modelling and investment strategy for insurers and pension schemes

An insurer's surplus is highly sensitive to equity market falls. Which ALM action most directly reduces this sensitivity?

  1. Extend the duration of the bond portfolio
  2. Purchase equity put options or enter an equity total return swap to hedge the exposure Correct answer.
  3. Increase the allocation to property
  4. Increase the equity backing ratio of the with-profits fund

Explanation

Equity derivatives such as put options or total return swaps can directly offset losses on the equity portfolio when markets fall. This is a targeted hedge of the surplus sensitivity identified by the ALM analysis.

Question 48Asset-liability modelling and investment strategy for insurers and pension schemes

Which statement best explains why insurers and pension schemes use liability-driven investment (LDI) techniques?

  1. To eliminate all investment risk from the balance sheet
  2. To maximise the expected return of the asset portfolio
  3. To avoid the need for actuarial assumptions
  4. To reduce the volatility of the funding level by matching assets to liability cash flows and sensitivities Correct answer.

Explanation

LDI uses instruments such as swaps and long-dated bonds to align asset cash flows and interest rate sensitivities with liabilities, reducing funding level volatility. It does not eliminate all risk, and it is not primarily a return-maximisation strategy.

Question 49Asset-liability modelling and investment strategy for insurers and pension schemes

A pension scheme is considering increasing its allocation to private credit to enhance yield. Which ALM consideration is most important?

  1. Private credit has lower credit risk than government bonds
  2. Illiquidity and valuation uncertainty may reduce flexibility and complicate collateral calls Correct answer.
  3. Private credit returns are guaranteed by the issuer
  4. Private credit is fully liquid and can be sold at short notice

Explanation

Private credit is illiquid and its valuation is less observable, which can reduce flexibility and complicate meeting collateral calls or benefit payments. The ALM analysis must weigh the yield enhancement against these risks.

Question 50Asset-liability modelling and investment strategy for insurers and pension schemes

Which of the following best describes the concept of a 'funding level' in a defined benefit pension scheme?

  1. The expected return on the scheme's assets
  2. The annual contribution rate paid by the sponsor
  3. The duration of the scheme's liabilities
  4. The ratio of the scheme's assets to the value of its liabilities on a chosen basis Correct answer.

Explanation

The funding level compares the scheme's assets with its liabilities on a specified basis, often expressed as a percentage. It is a key ALM metric because it captures the scheme's ability to meet its promises.