CT8 Pu 17

CT8: CMP Upgrade 2016/17 Page 1
Subject CT8
CMP Upgrade 2016/17
CMP Upgrade
This CMP Upgrade lists the changes to the Syllabus objectives, Core Reading and the
ActEd material since last year that might realistically affect your chance of success in
the exam. It is produced so that you can manually amend your 2016 CMP to make it
suitable for study for the 2017 exams. It includes replacement pages and additional
pages where appropriate.
Alternatively, you can buy a full set of up-to-date Course Notes / CMP at a significantly
reduced price if you have previously bought the full-price Course Notes / CMP in this
subject. Please see our 2017 Student Brochure for more details.
This CMP Upgrade contains:
 all significant changes to the Syllabus objectives and Core Reading.
 additional changes to the ActEd Course Notes, Series X Assignments and

Question and Answer Bank that will make them suitable for study for the 2017
exams.
The Actuarial Education Company © IFE: 2017 Examinations

Page 2 CT8: CMP Upgrade 2016/17
1 Changes to the Syllabus Objectives

This section contains all the non-trivial changes to the Syllabus objectives.
Chapter 2
Page 1
Syllabus objective (i)6. has been removed.
Chapter 3
Page 1
Syllabus objective (i)8. has been changed to:
“State conditions for absolute dominance and for first- and second-order dominance.”
Chapter 7
Page 1
Syllabus objectives (v)1. and (v)3. have been changed to include the “uses” of the
CAPM and APT model:
1. Describe the assumptions, principal results and uses of the Sharpe-Lintner-

Mossin Capital Asset Pricing Model (CAPM).
3. Discuss the assumptions, principal results, uses and limitations of the Ross
Arbitrage Pricing Theory model (APT).
Chapter 10
Page 1
Syllabus objective (vii)2. has changed to:
“Outline the nature of autoregressive models of security prices and other economic
variables, including the economic justification for such models.”
The bullet point list in Syllabus objective (vii)5. has been removed, although the
preceding sentence remains unchanged.
© IFE: 2017 Examinations The Actuarial Education Company

2 Changes to the Core Reading

This section contains all the non-trivial changes to the Core Reading.
Chapter 2
Page 3-6
Consumer choice theory has been completely removed from this chapter, and so these
pages are no longer required.
Chapter 4
Page 6
The final sentence in the definition of Value at Risk has been clarified and updated to:
VaR represents the maximum potential loss on a portfolio over a given future
time period with a given degree of confidence, where the latter is normally
expressed as 1  p . So, for example, a 99% one-day VaR is the maximum loss on
a portfolio over a one-day period with 99% confidence, ie there is a 1%
probability of a greater loss.
Chapter 10
Pages 7-8
The annual rolling volatility example is no longer required, leading to the removal of
Figure 10.1 on page 8, and the paragraph of Core Reading immediately before it (which
appears at the bottom of page 7).

Pages 10-13
The Core Reading in the normality assumption section has been reduced to the
following text (with Figures 10.2 and 10.3 being deleted):
Normality assumption
A further strand of empirical research questions the use of the normality

assumptions in market returns. Actual returns tend to have many more extreme
events, both on the upside and downside, than is consistent with such a model.
In particular, market crashes appear more often than one would expect from a
normal (or lognormal) distribution. While the random walk produces continuous
price paths, jumps or discontinuities seem to be an important feature of real
markets. Furthermore, days with no change, or very small change, also happen
more often than the normal distribution suggests.
This would seem to justify the consideration of Levy processes.
However, whilst a non-normal distribution can provide an improved description

of the actual returns observed (in particular the greater frequency of more
extreme events than would be the case under the lognormal model), the
improved fit to empirical data comes at the cost of losing the tractability of
working with normal (and lognormal) distributions.
Pages 21-24
The section on the Wilkie model has been removed from the Core Reading.
Chapter 11
The following comparison of European and American options has been added on
page 4:
A European option is an option that can only be exercised at expiry. An

American option is one that can be exercised on any date before its expiry.

Chapter 13
Page 11
The following clarification regarding replicating and hedging portfolios has been added
at the top of the page:
A replicating portfolio will always precisely reproduce the relevant payoff or

cashflow. A hedging portfolio aims to reduce the amount of risk relating to a
derivative strategy, but is not guaranteed to reproduce the payoff or cashflow
precisely. Furthermore, a replicating portfolio is only a hedging portfolio if the
position taken in it is opposite to that of the payoff or cashflow which it aims to
reproduce.
Chapter 18
Page 7
The following definition of credit spread has been added immediately after the first
paragraph of Core Reading:
Credit spread is a measure of the excess of the yield on a risky security over a
risk-free yield. It largely relates to the expected cost of default, as referred to
here. However, in practice it will also typically reflect other factors, such as a
risk premium relating to the risk of default and a liquidity premium.

3 Changes to the ActEd Course Notes

This section contains additional significant changes to the ActEd Course Notes.
However, if you wish to have all the changes to the ActEd Course Notes, you will need
to buy a full set of the up-to-date version (which you can do at a significantly reduced
price if you have previously bought the full-price Course Notes / CMP in this subject).
Chapter 0
Page 3
The list of relevant past questions from Subject 103 and Subject 109 is no longer being
maintained, and so page 3 has been removed.
Chapter 2
Consumer choice theory has been completely removed from this chapter, and so any
references to “consumers and investors” in this chapter have been replaced with simply
“investors”.
Pages 3-6
With the removal of consumer choice theory, these pages are no longer required (along
with the corresponding section of the Chapter Summary).
Chapter 3
Page 26
The second sentence of Solution 3.4 has been corrected to:
“In addition, U offers a wider spread of returns about 7 % – ie a greater chance of

an 8 % return, but at the risk of a greater chance of obtaining only 6 %.”

Chapter 4
Page 14
Part (d) of Question 2 has been modified in line with the Core Reading changes around
VaR to:
(d) the 95% Value at Risk.
The solution remains the same on page 16.
Chapter 9
Page 12
The example at the start of page 12 has been removed, along with the sentence
immediately before it and the one immediately after it (which appear on pages 11 and
12 respectively).
Chapter 10
Pages 7-13
The annual rolling volatility example is no longer required and the normality
assumption section has been significantly reduced. Replacement pages are provided at
the end of this document.
Pages 21-24, 28
The Wilkie model is no longer included in the course, and so pages 21 to 24 have been
removed (along with the corresponding section of the Chapter Summary).
Question 10.13 on page 28 is therefore not required.
Chapter 11
Page 35
The intrinsic value in Solution 11.7 has been corrected to:
 Intrinsic value = max  K  St , 0  max 110  112, 0  0

Chapter 14
Page 19
The expression at the bottom of the page for dV (t , St ) has been corrected to contain a
qSt dt term instead of a qSt dZt term in the penultimate bracket thus:
f
dV (t , St )  df (t  St )  (dSt  qSt dt )
s
 f  f f 1  2f 2 2  
    St dZt    St   St  dt 
s  t  s 2 s 2 
   
f

s
  St dt   St dZt   qSt dt 

f f 1  2f 2 2 
    qSt   St  dt
 t

s 2 s 2 


4 Changes to the Q&A Bank

The most significant changes to the Q&A Bank are given below.
Q&A Part 1
Question 1.7
This question is no longer required.
Question 1.17
Parts (d) and (e) have been updated in line with the changes to Core Reading regarding
VaR to the following:
(d) Value at Risk at the 95% confidence level

(e) Tail Value at Risk at the 95% confidence level, conditional on the VaR being
exceeded.
The solutions remain the same.
Q&A Part 2
Question 2.22
Parts (i) and (iii) of this question are no longer relevant.
Q&A Part 3
Solution 3.21(ii)
The first equation for ct should equal 229.18 not 228.18, that is:
ct  5, 000   0.0975   5, 250e 0.05½   0.2389   229.18

     
0.4612 0.4056
The implied volatility approximation of 17% remains unchanged, although the final
equation becomes:
187.06  90.77   0.1

    17%
229.18  90.77 0.2  0.1

5 Changes to the X assignments

There have been no significant changes to the X Assignments.

6 Other tuition services

In addition to this CMP Upgrade you might find the following helpful with your study.
6.1 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 ActEd’s study materials, please refer to the 2017 Student
Brochure, which is available from the ActEd website at www.ActEd.co.uk.
6.2 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 ActEd’s tutorials, please refer to our latest Tuition Bulletin, which
is available from the ActEd website at www.ActEd.co.uk.

6.3 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 ActEd’s marking services, please refer to the 2017 Student
Brochure, which is available from the ActEd website at www.ActEd.co.uk.
6.4 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.

CT8-10: Stochastic models of security prices Page 7
1.3 Empirical tests of the log random walk model of security prices
Empirical results for testing the log random walk model are mixed.
As the model incorporates independent returns over disjoint intervals, it is

impossible to use past history to deduce that prices are cheap or dear at any
time. This implies weak form market efficiency, and is consistent with empirical
observations that technical analysis does not lead to excess performance.
Question 10.4 (Revision)
Can you remember what “technical analysis” is?
It should be pointed out that the lognormal model is widely used. For example, it is the
assumed underlying process for share prices that we will use to price share options later
on in the course. This is largely due to the (relative) mathematical simplicity of the
model.
However, more detailed analysis reveals several weaknesses in the log random
walk model.
Volatility, σ
The most obvious is that estimates of σ vary widely according to what time
period is considered, and how frequently the samples are taken.
For example, the volatility has been found to be greater in recessions and periods of
financial crisis. Also σ can be estimated based on daily, monthly or annual share price
records. Even if the data used covers the same time period, this usually leads to
different numerical estimates of σ .
We can also take some evidence from option prices. The Black-Scholes formula
(which will be introduced in Chapter 14) describes option prices in terms of
anticipated values of volatility over the term of the option. Given observed
option prices in the market, it is possible to work backwards to the implied
volatility; that is, the value of σ which is consistent with observed option prices.
Later on in this course, we will discuss the Black-Scholes formula. This formula
expresses the price of an option as a function of several variables, one of which is σ .
Hence, given the actual price of the option in the marketplace, together with values for
all the other variables in the model (which we can actually observe), we can work
backwards to derive the implied value for σ that is consistent with that observed price.
In other words, the price of an option tells us implicitly what the market believes the
volatility of the security price to be.

Page 8 CT8-10: Stochastic models of security prices
Examination of historical option prices suggests that volatility expectations

fluctuate markedly over time.
The evidence therefore suggests that the assumption of a constant volatility

(homoscedasticity) may be inappropriate. Instead, log stock price returns appear to be
heteroscedastic, ie the volatility of the process varies.
One way of modelling this behaviour is to take volatility as a process in its own
right. This can explain why we have periods of high volatility and periods of low
volatility. One class of models with this feature is known as ARCH:
autoregressive conditional heteroscedasticity. These models are covered briefly in
Subject CT6.
Question 10.5
Explain what is meant by an ARCH model.
Drift parameter, μ
A more contentious area relates to whether the drift parameter μ is constant

over time. There are good theoretical reasons to suppose that μ should vary
over time. It is reasonable to suppose that investors will require a risk premium
on equities relative to bonds.
The risk premium compensates the investor for the extra risk taken – both default risk
(if compared to bonds) and volatility of the share price.
As a result, if interest rates are high, we might expect the equity drift, μ , to be
high as well.
So, if the expected return on bonds is currently high say, then investors will require a
correspondingly higher expected return on equities in order to make it worthwhile to
hold them, instead of bonds. If this is not the case, then investors will sell equities and
buy bonds until the expected returns are again brought back into line.
Mean reversion
One unsettled empirical question is whether markets are mean-reverting, or not.

A mean-reverting market is one where rises are more likely following a market
fall, and falls are more likely following a rise.
Hence, if returns have recently been above the long-run average level, then we might
expect them to be lower than average over the next few periods, so that average returns
revert back towards their long-run trend level.

CT8-10: Stochastic models of security prices Page 9
There appears to be some evidence for this, but the evidence rests heavily on
the aftermath of a small number of dramatic crashes. After a major crash, we
might well expect the market to revert to its former level after sufficient time.
Momentum effects
Furthermore, there also appears to be some evidence of momentum effects,

which imply that a rise one day is more likely to be followed by another rise the
next day. For example, if returns increase, then everyone may jump on the bandwagon
and drive prices even higher.
Normality assumption
A further strand of empirical research questions the use of the normality

assumptions in market returns. Actual returns tend to have many more extreme
events, both on the upside and downside, than is consistent with such a model.
In particular, market crashes appear more often than one would expect from a
normal (or lognormal) distribution. While the random walk produces continuous
price paths, jumps or discontinuities seem to be an important feature of real
markets. Furthermore, days with no change, or very small change, also happen
more often than the normal distribution suggests.
This would seem to justify the consideration of Levy processes. Levy processes
no longer appear in the actuarial syllabus. One of the features of a Levy process is that
the sample paths are not necessarily continuous, but can have jump discontinuities.
So, the distribution of actual market returns appears to be more peaked and with fatter
tails than is consistent with strict normality.
However, whilst a non-normal distribution can provide an improved description

of the actual returns observed (in particular the greater frequency of more
extreme events than would be the case under the lognormal model), the
improved fit to empirical data comes at the cost of losing the tractability of
working with normal (and lognormal) distributions.
Question 10.6
The shares of Abingdon Life can be modelled using a lognormal model in which
μ = 0.104 pa and σ = 0.40 pa. If the current share price is 2.00, derive a 95%
confidence interval for the share price in one week’s time, assuming that there are
exactly 52 weeks in a year.

Page 10 CT8-10: Stochastic models of security prices
Summary
So, to summarise Section 1.3, the continuous-time lognormal model may be

inappropriate for modelling investment returns because:
ł The volatility parameter σ may not be constant over time. Estimates of

volatility from past data are critically dependent on the time period chosen for
the data and how often the estimate is re-parameterised.
ł The drift parameter μ may not be constant over time. In particular, bond yields
will influence the drift.
ł There is evidence in real markets of mean-reverting behaviour, which is

inconsistent with the independent increments assumption.
ł There is evidence in real markets of momentum effects, which is inconsistent

with the independent increments assumption.
ł ( )
The distribution of security returns log Su S t has a taller peak in reality than
that implied by the normal distribution. This is because there are more days of
little or no movement in financial markets.
ł (
The distribution of security returns log Su S t ) has fatter tails in reality than
that implied by the normal distribution. This is because there are more extreme
movements in security prices.
ł The sample paths of security prices are not continuous, but instead appear to
jump occasionally.

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CT8: CMP Upgrade 2016/17 Page 1

This CMP Upgrade contains:

 all significant changes to the Syllabus objectives and Core Reading.

 additional changes to the ActEd Course Notes, Series X Assignments and

The Actuarial Education Company © IFE: 2017 Examinations

1 Changes to the Syllabus Objectives

Syllabus objective (i)6. has been removed.

Syllabus objective (i)8. has been changed to:

1. Describe the assumptions, principal results and uses of the Sharpe-Lintner-

Syllabus objective (vii)2. has changed to:

© IFE: 2017 Examinations The Actuarial Education Company

2 Changes to the Core Reading

The Actuarial Education Company © IFE: 2017 Examinations

A further strand of empirical research questions the use of the normality

This would seem to justify the consideration of Levy processes.

However, whilst a non-normal distribution can provide an improved description

A European option is an option that can only be exercised at expiry. An

© IFE: 2017 Examinations The Actuarial Education Company

A replicating portfolio will always precisely reproduce the relevant payoff or

The Actuarial Education Company © IFE: 2017 Examinations

3 Changes to the ActEd Course Notes

The second sentence of Solution 3.4 has been corrected to:

“In addition, U offers a wider spread of returns about 7 % – ie a greater chance of

© IFE: 2017 Examinations The Actuarial Education Company

(d) the 95% Value at Risk.

The solution remains the same on page 16.

Question 10.13 on page 28 is therefore not required.

The intrinsic value in Solution 11.7 has been corrected to:

 Intrinsic value = max  K  St , 0  max 110  112, 0  0

The Actuarial Education Company © IFE: 2017 Examinations

© IFE: 2017 Examinations The Actuarial Education Company

4 Changes to the Q&A Bank

This question is no longer required.

(d) Value at Risk at the 95% confidence level

The solutions remain the same.

Parts (i) and (iii) of this question are no longer relevant.

ct  5, 000   0.0975   5, 250e 0.05½   0.2389   229.18

187.06  90.77   0.1

The Actuarial Education Company © IFE: 2017 Examinations

5 Changes to the X assignments

© IFE: 2017 Examinations The Actuarial Education Company

6 Other tuition services

6.1 Study material

We offer the following study material in Subject CT8:

We offer the following tutorials in Subject CT8:

The Actuarial Education Company © IFE: 2017 Examinations

6.4 Feedback on the study material

© IFE: 2017 Examinations The Actuarial Education Company

As the model incorporates independent returns over disjoint intervals, it is

Question 10.4 (Revision)

Can you remember what “technical analysis” is?

The Actuarial Education Company © IFE: 2017 Examinations

Examination of historical option prices suggests that volatility expectations

The evidence therefore suggests that the assumption of a constant volatility

Explain what is meant by an ARCH model.

A more contentious area relates to whether the drift parameter μ is constant

One unsettled empirical question is whether markets are mean-reverting, or not.

© IFE: 2017 Examinations The Actuarial Education Company

Furthermore, there also appears to be some evidence of momentum effects,

A further strand of empirical research questions the use of the normality

However, whilst a non-normal distribution can provide an improved description

The Actuarial Education Company © IFE: 2017 Examinations

So, to summarise Section 1.3, the continuous-time lognormal model may be