Institute and Faculty of Actuaries (IFoA) Exams Economics, Business and Financial Engineering (CB2, CM2) Syllabus

Economics, Business and Financial Engineering (CB2, CM2) syllabus — full chapter and topic list

Expand any chapter to see its topics and sub-topics. This is the whole examinable outline for Economics, Business and Financial Engineering (CB2, CM2) in Institute and Faculty of Actuaries (IFoA) Exams, not a summary of it.

1. 1

   Microeconomics

   3 topics

   • Demand, supply and market equilibrium
     • Elasticity of demand and supply
     • Consumer theory and utility maximisation
   • Firm behaviour and market structures
     • Costs of production in the short and long run
     • Perfect competition, monopoly and oligopoly
     • Game theory and strategic interaction
   • Market failure and welfare
     • Externalities and public goods
     • Asymmetric information, adverse selection and moral hazard
2. 2

   Macroeconomics

   3 topics

   • National income and output
     • GDP measurement and the circular flow of income
     • Aggregate demand and aggregate supply
   • Money, inflation and monetary policy
     • Role of central banks and interest rate setting
     • Inflation, unemployment and the Phillips curve
   • Fiscal policy and international trade
     • Government spending, taxation and budget deficits
     • Exchange rates and the balance of payments
3. 3

   Financial Economics and Asset Pricing

   3 topics

   • Utility theory and stochastic dominance
     • Expected utility and risk aversion measures
     • First and second order stochastic dominance
   • Portfolio theory and asset pricing models
     • Mean-variance portfolio selection
     • Capital Asset Pricing Model (CAPM)
     • Arbitrage Pricing Theory and multifactor models
   • Market efficiency and behavioural finance
     • Efficient markets hypothesis forms
     • Behavioural biases and anomalies
4. 4

   Stochastic Modelling of Financial Markets (CM2)

   4 topics

   • Models of asset prices
     • Random walk and lognormal models
     • Geometric Brownian motion and Ito's lemma
   • Option pricing
     • Binomial lattice pricing
     • Black-Scholes-Merton formula and the Greeks
     • Risk-neutral valuation and martingale measures
   • Interest rate and credit risk models
     • One-factor short rate models (Vasicek, Cox-Ingersoll-Ross)
     • Structural and reduced-form credit risk models
   • Measures of investment risk
     • Value at Risk and Tail Value at Risk
     • Coherent risk measures

Economics, Business and Financial Engineering (CB2, CM2) flashcards for Institute and Faculty of Actuaries (IFoA) Exams

21 of 51 cards from the Economics, Business and Financial Engineering (CB2, CM2) deck — real questions with worked answers.

1. State the law of demand and the law of supply.

   Law of demand: ceteris paribus, as the price of a good rises, the quantity demanded falls (demand curve slopes downward). Law of supply: ceteris paribus, as price rises, quantity supplied rises (supply curve slopes upward).

2. Define market equilibrium and state the condition that holds at the equilibrium price.

   Market equilibrium is the price-quantity combination where the market clears. At the equilibrium price $P^{*}$, quantity demanded equals quantity supplied: $Q_{d}(P^{*}) = Q_{s}(P^{*})$, so there is no excess demand or excess supply.

3. Define the own-price elasticity of demand and state how it classifies demand as elastic, inelastic or unit elastic.

   $E_{d} = \dfrac{\% \Delta Q_{d}}{\% \Delta P} = \dfrac{dQ}{dP}\cdot\dfrac{P}{Q}$. Demand is elastic if $|E_{d}| > 1$, inelastic if $|E_{d}| < 1$, and unit elastic if $|E_{d}| = 1$.

4. How does the income elasticity of demand distinguish normal, inferior and luxury goods?

   Income elasticity $E_{Y} = \dfrac{\% \Delta Q_{d}}{\% \Delta Y}$. Normal good: $E_{Y} > 0$; inferior good: $E_{Y} < 0$; luxury (superior) good: $E_{Y} > 1$; necessity: $0 < E_{Y} < 1$.

5. What does the cross-price elasticity of demand reveal about the relationship between two goods?

   $E_{xy} = \dfrac{\% \Delta Q_{x}}{\% \Delta P_{y}}$. If $E_{xy} > 0$ the goods are substitutes; if $E_{xy} < 0$ they are complements; if $E_{xy} = 0$ they are unrelated.

6. Define consumer surplus and producer surplus.

   Consumer surplus is the area between the demand curve and the price paid, i.e. the difference between what consumers are willing to pay and what they actually pay. Producer surplus is the area between the price received and the supply curve, i.e. revenue above the minimum suppliers would accept.

7. State the profit-maximising output condition that applies to a firm in any market structure.

   A firm maximises profit by producing the output at which marginal revenue equals marginal cost: $MR = MC$ (with $MC$ rising through $MR$). It produces in the short run only if price covers average variable cost.

8. List the four main market structures and one key distinguishing feature of each.

   Perfect competition: many firms, homogeneous product, price takers. Monopolistic competition: many firms, differentiated products, free entry. Oligopoly: few firms, interdependent decisions. Monopoly: single seller, high barriers to entry, price maker.

9. For a perfectly competitive firm, what is the relationship between price, marginal revenue and the long-run equilibrium profit?

   The firm is a price taker, so $P = MR = AR$. In long-run equilibrium free entry/exit drives price to minimum average cost, $P = MC = \min(AC)$, and firms earn zero economic (normal) profit.

10. How does a profit-maximising monopolist set output and price, and why is it allocatively inefficient?

    It sets $MR = MC$ then charges the price from the demand curve at that quantity, giving $P > MR = MC$. Because price exceeds marginal cost, output is below the socially optimal level, creating a deadweight loss.

11. Define market failure and list its main sources.

    Market failure is a situation where the free market fails to allocate resources efficiently. Main sources: externalities, public goods, market power (monopoly), information asymmetries, and missing markets.

12. Distinguish between a negative and a positive externality, and state the efficient outcome condition.

    A negative externality imposes uncompensated costs on third parties (e.g. pollution); a positive externality confers uncompensated benefits (e.g. vaccination). The socially efficient output equates marginal social benefit with marginal social cost: $MSB = MSC$.

13. Define the two defining characteristics of a pure public good.

    Non-rivalry: one person's consumption does not reduce the amount available to others. Non-excludability: it is impossible (or very costly) to prevent non-payers from consuming it. These lead to the free-rider problem and under-provision by markets.

14. What is deadweight loss and when does it arise?

    Deadweight loss is the loss of total economic surplus (consumer + producer) caused by an inefficient allocation where output differs from the competitive equilibrium. It arises from monopoly, taxes, subsidies, price controls, and externalities.

15. Define GDP and distinguish nominal from real GDP.

    GDP is the total market value of all final goods and services produced within a country in a period. Nominal GDP is measured at current prices; real GDP is measured at constant (base-year) prices, removing the effect of inflation.

16. State the expenditure (income-output) identity for national income in an open economy.

    $Y = C + I + G + (X - M)$, where $C$ is consumption, $I$ investment, $G$ government spending, $X$ exports and $M$ imports. $(X-M)$ is net exports.

17. Define the marginal propensity to consume and the simple Keynesian multiplier.

    $MPC = \dfrac{\Delta C}{\Delta Y}$, the fraction of an extra unit of income spent on consumption. The simple multiplier is $k = \dfrac{1}{1 - MPC} = \dfrac{1}{MPS}$, where $MPS$ is the marginal propensity to save.

18. List the three traditional functions of money.

    Money serves as: (1) a medium of exchange, (2) a unit of account (a common measure of value), and (3) a store of value. Some texts add a fourth function: a standard of deferred payment.

19. State the equation of exchange (quantity theory of money) and identify its terms.

    $MV = PT$ (or $MV = PY$), where $M$ is the money supply, $V$ the velocity of circulation, $P$ the price level and $T$ (or $Y$) the volume of transactions (real output). With $V$ and $T$ fixed, changes in $M$ feed directly into $P$.

20. Define inflation and distinguish demand-pull from cost-push inflation.

    Inflation is a sustained rise in the general price level. Demand-pull inflation arises from excess aggregate demand ("too much money chasing too few goods"); cost-push inflation arises from rising production costs (e.g. wages, raw materials) shifting aggregate supply leftward.

21. What does the short-run Phillips curve describe?

    The short-run Phillips curve shows an inverse relationship between the unemployment rate and the rate of inflation. In the long run it is vertical at the natural rate of unemployment, so there is no permanent inflation-unemployment trade-off.

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