Institute and Faculty of Actuaries (IFoA) Exams Financial Mathematics and Actuarial Valuation (CM1, CB1) Flashcards

24 sample cards from the Financial Mathematics and Actuarial Valuation (CM1, CB1) deck

Sampled from the end of the deck, so these are different cards from the ones shown on the syllabus page.

1. In a multiple-state model, write the Kolmogorov forward equation form for the transition probability and define a transition intensity $\mu^{ij}_{x}$.

   $\mu^{ij}_{x}$ is the instantaneous rate of transition from state $i$ to state $j$ at age $x$ ($j\neq i$). For an occupancy probability $_{t}p^{ii}_{x}=\exp\left(-\int_{0}^{t}\sum_{j\neq i}\mu^{ij}_{x+s}\,ds\right)$ (probability of remaining in state $i$).

2. In the alive–dead two-state model, relate the transition intensity to ordinary mortality.

   The single intensity $\mu^{AD}_{x}=\mu_{x}$ (force of mortality). Then $_{t}p^{AA}_{x}={}_{t}p_{x}=\exp(-\int_{0}^{t}\mu_{x+s}ds)$ and $_{t}p^{AD}_{x}={}_{t}q_{x}$.

3. Define $_{t}p_{xy}$ (joint-life survival) and $_{t}p_{\overline{xy}}$ (last-survivor survival) assuming independence.

   Joint life (both survive): $_{t}p_{xy}={}_{t}p_{x}\cdot{}_{t}p_{y}$. Last survivor (at least one survives): $_{t}p_{\overline{xy}}={}_{t}p_{x}+{}_{t}p_{y}-{}_{t}p_{x}\,{}_{t}p_{y}$.

4. State the identity linking joint-life and last-survivor annuities/assurances for two lives $x$ and $y$.

   $a_{x}+a_{y}=a_{xy}+a_{\overline{xy}}$ and $A_{x}+A_{y}=A_{xy}+A_{\overline{xy}}$. (The values for the two individuals split into joint-life and last-survivor components.)

5. For a bond redeemable at $R$ in $n$ years paying coupons of $D$ per year (annually), write the price $P$ at yield $i$.

   $$P=D\,a_{\overline{n}|}+R\,v^{n},$$ the present value of the coupon annuity plus the redemption payment, all at the required yield $i$.

6. State the relationship between a bond's coupon rate and its yield to maturity that determines whether it trades at a premium or discount.

   If coupon rate $>$ yield, the bond trades at a premium (price $>$ redemption value). If coupon rate $<$ yield, it trades at a discount. If equal, it trades at par.

7. Define the running (income) yield and the gross redemption yield of a fixed-interest security.

   Running yield $=\frac{\text{annual coupon}}{\text{price}}$, measuring income only. Gross redemption yield is the IRR equating price to the present value of all gross coupons and the redemption proceeds (allows for capital gain/loss).

8. Define the Macaulay duration of a series of cash flows and state its interpretation.

   $$\text{Macaulay duration}=\frac{\sum_{t}t\,C_{t}v^{t}}{\sum_{t}C_{t}v^{t}}.$$ It is the present-value-weighted mean term of the cash flows and measures sensitivity of price to interest-rate changes.

9. Define the volatility (modified duration) and convexity of a cash-flow series.

   Effective/modified duration (volatility) $\nu=-\frac{1}{P}\frac{dP}{di}=\frac{\sum t\,C_{t}v^{t+1}}{P}=\frac{\text{Macaulay duration}}{1+i}$. Convexity $c=\frac{1}{P}\frac{d^{2}P}{di^{2}}=\frac{\sum t(t+1)C_{t}v^{t+2}}{P}$, measuring curvature of price w.r.t. yield.

10. State Redington's three conditions for immunisation of a portfolio of assets against small interest-rate changes.

    (1) PV of assets $=$ PV of liabilities; (2) the durations (volatilities) are equal, $\frac{dV_A}{di}=\frac{dV_L}{di}$; (3) the convexity of assets exceeds that of liabilities, $\frac{d^{2}V_A}{di^{2}}>\frac{d^{2}V_L}{di^{2}}$.

11. Define the spot rate $y_{t}$ and the forward rate $f_{t,r}$ in the term structure of interest rates.

    The spot rate $y_{t}$ is the annual effective yield on a zero-coupon bond maturing at time $t$: price $=(1+y_{t})^{-t}$. The forward rate $f_{t,r}$ is the rate agreed now for borrowing/lending over $[t,t+r]$, satisfying $(1+y_{t+r})^{t+r}=(1+y_{t})^{t}(1+f_{t,r})^{r}$.

12. Name and briefly describe three theories explaining the shape of the yield curve.

    Expectations theory: long rates reflect expected future short rates. Liquidity preference: investors demand a premium for longer terms, raising long yields. Market segmentation (preferred habitat): supply/demand in distinct maturity segments set rates, allowing non-smooth curves.

13. State the dividend discount (Gordon growth) model for the value of an equity with dividends growing at constant rate $g$.

    $$P_{0}=\frac{D_{1}}{i-g}=\frac{D_{0}(1+g)}{i-g},\quad i>g,$$ where $D_{1}$ is next year's dividend and $i$ the required return; valid only when the discount rate exceeds the growth rate.

14. List the three primary financial statements and what each shows.

    Balance sheet (statement of financial position): assets, liabilities and equity at a point in time. Income statement (profit and loss): revenues and expenses over a period, giving profit. Cash flow statement: cash inflows/outflows over a period (operating, investing, financing).

15. State the fundamental accounting equation and the distinction between accruals (profit) accounting and cash accounting.

    Accounting equation: Assets $=$ Liabilities $+$ Shareholders' equity. Accruals accounting recognises revenue/expense when earned/incurred (matching), so profit differs from cash; cash accounting records transactions only when cash moves.

16. Distinguish depreciation methods: straight-line vs reducing-balance.

    Straight-line: equal annual charge $\frac{\text{cost}-\text{residual}}{\text{useful life}}$. Reducing (declining) balance: a fixed percentage of the asset's written-down value each year, giving higher charges early and lower later. Both spread an asset's cost over its useful life.

17. Define gearing (leverage) and explain its effect on a company's risk and returns.

    Gearing measures debt relative to equity (e.g. $\frac{\text{debt}}{\text{debt}+\text{equity}}$). Higher gearing magnifies returns to equity when profits are good but increases financial risk and the volatility of shareholder returns, since interest must be paid before dividends.

18. Compare debt finance and equity finance from a company's perspective.

    Debt: fixed interest (tax-deductible), ranks ahead of equity, no ownership dilution, but obligatory payments raise insolvency risk. Equity: no obligation to pay dividends, permanent capital, but dividends are not tax-deductible, ownership/control is diluted, and equity holders demand a higher return for greater risk.

19. Distinguish a company's systematic (market) risk from its specific (diversifiable) risk.

    Systematic risk affects the whole market and cannot be removed by diversification (compensated by higher expected return). Specific (unsystematic) risk is unique to a firm/asset and can be diversified away in a well-spread portfolio, so it earns no risk premium.

20. Explain how corporation tax and capital allowances affect the appraisal of a capital project's cash flows.

    Project profits are reduced by corporation tax, lowering after-tax cash flows used in NPV. Capital allowances (tax depreciation) reduce taxable profit, generating tax savings (a positive cash flow), so appraisal uses after-tax cash flows discounted at an after-tax required return.

21. Explain the difference between an investor's real rate of return and nominal rate of return, and the link via inflation.

    Nominal return includes inflation; real return is adjusted for it. With inflation rate $e$: $1+i_{\text{real}}=\frac{1+i_{\text{nominal}}}{1+e}$, so $i_{\text{real}}\approx i_{\text{nominal}}-e$ for small rates.

22. Describe the purpose and basic mechanism of a discounted cash flow approach to comparing two investment projects with different cash-flow timings.

    Discount each project's net cash flows at a common risk discount rate to obtain NPVs on a comparable present-value basis. Choose the higher NPV. This properly accounts for the timing and magnitude of cash flows, unlike undiscounted comparisons.

23. State how to value an annuity whose payments increase geometrically at rate $g$ per year (first payment $1$ at end of year 1, $n$ payments).

    $$PV=\sum_{t=1}^{n}(1+g)^{t-1}v^{t}=\frac{1-\left(\frac{1+g}{1+i}\right)^{n}}{i-g}\quad(i\neq g).$$ This is a level annuity evaluated at the modified rate $i'=\frac{1+i}{1+g}-1$.

24. Define working capital and explain its significance for a business.

    Working capital $=$ current assets $-$ current liabilities; it funds day-to-day operations (inventory, receivables less payables). Adequate working capital ensures short-term liquidity to meet obligations; too little risks insolvency, too much ties up capital inefficiently.

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Financial Mathematics and Actuarial Valuation (CM1, CB1) flashcards FAQ