2019 Exam commentary

Examiners’ commentaries 2019
Examiners’ commentaries 2019
FN3023 Investment management
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2018–19. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).
Information about the subject guide and the Essential reading
references
Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2016).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.
General remarks
Learning outcomes
At the end of this course, and having completed the Essential reading and activities, you should be
able to:
•list given types of financial instruments and explain how they work in detail
•contrast key characteristics of given financial instruments
•briefly recall important historical trends in the innovation of markets, trading and financial
instruments
•name key facts related to the historical return and risk of bond and equity markets
•relate key facts of the managed fund industry
•define market microstructure and evaluate its importance to investors
•explain the fundamental drivers of diversification as an investment strategy for investors
•aptly define immunisation strategies and highlight their main applications in detail
•discuss measures of portfolio risk-adjusted performance in detail and critically analyse the
key challenges in employing them
•competently identify established risk management techniques used by individual investors
and corporations.
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FN3023 Investment management
Format of the examination paper
The examination paper consists of eight questions of which you have to answer any four. The
questions are a mixture of three types. The first type is a question that asks for a numerical problem
to be solved. The second type of question asks for institutional knowledge, for instance candidates
are asked to explain what instruments are traded in the money market or how a limit order market
works. The third type of question asks for an essay-style answer about a conceptual issue in finance,
for instance what implications the efficient market hypothesis have on investment returns and
factors that may explain why the efficient market hypothesis may not hold in practice.
What are the examiners looking for?
With numerical questions, it is important that answers and steps are carefully and clearly explained.
A very good answer would specify what knowledge is used. For instance, when the CAPM model is
used as a basis for a cost of capital calculation, it is important that this is outlined in the answer.
When the question asks for an outline of institutional details, an ideal answer is brief and concise,
with a clear emphasis on relevant facts. For instance, if you explain what instruments are traded in
the money market, you need to focus on the distinguishing features of these instruments – that they
are fixed income instruments of short maturity, often of large denominations, and issued by the
government, banks or corporations. When the question asks for a critical evaluation of a conceptual
issue, it is important that you address all aspects of the question and structure your argument
carefully so that it is clear to the examiners what level of understanding you have.
Key steps to improvement
The key test of how much you understand about this subject is whether you can transfer knowledge
about one type of problem in finance to other problems.
The typical pattern that the examiners find when marking the papers for this course is that
questions that may appear difficult (in the sense they are technically demanding, for instance)
achieve higher scores than questions that may appear to be easy, if the difficult question is closer to
material that candidates have studied beforehand.
In other words, the examiners find that candidates tend to find it difficult to transfer their
knowledge into new areas. Therefore, problem-solving practice is probably the most valuable
preparation for the examination, and it is important that you attempt to solve problems that go
outside what you encounter in the subject guide.
Examination revision strategy
Many candidates are disappointed to find that their examination performance is poorer than they
expected. This may be due to a number of reasons. The Examiners’ commentaries suggest ways of
addressing common problems and improving your performance. One particular failing is ‘question
spotting’, that is, confining your examination preparation to a few questions and/or topics which
have come up in past papers for the course. This can have serious consequences.
We recognise that candidates may not cover all topics in the syllabus in the same depth, but you
need to be aware that the examiners are free to set questions on any aspect of the syllabus. This
means that you need to study enough of the syllabus to enable you to answer the required number of
examination questions.
The syllabus can be found in the Course information sheet in the section of the VLE dedicated to
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Examiners’ commentaries 2019
each course. You should read the syllabus carefully and ensure that you cover sufficient material in
preparation for the examination. Examiners will vary the topics and questions from year to year and
may well set questions that have not appeared in past papers. Examination papers may legitimately
include questions on any topic in the syllabus. So, although past papers can be helpful during your
revision, you cannot assume that topics or specific questions that have come up in past examinations
will occur again.
If you rely on a question-spotting strategy, it is likely you will find yourself in difficulties
when you sit the examination. We strongly advise you not to adopt this strategy.
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FN3023 Investment management
Examiners’ commentaries 2019
FN3023 Investment management
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2018–19. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).
Information about the subject guide and the Essential reading
references
Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2016).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.
Comments on specific questions – Zone A
Candidates should answer FOUR of the following EIGHT questions. All questions carry equal
marks.
Question 1
(a) What are stop-loss orders and stop-buy orders? What benefits do such orders
offer to investors?
(7 marks)
(b) A 5-year bond with annual coupons 4% of the face value is trading at
yield-to-maturity 5%. What is the duration of the bond?
(9 marks)
(c) Consider the Kyle framework for market microstructure. A market for a stock
where a competitive risk-neutral market maker clears incoming buy and sell
orders in a sequence. Each order is for one share, and the incoming orders are
drawn randomly from a pool consisting of uninformed traders, making up 90%
of the pool, and informed traders, making up 10% of the pool. The uninformed
traders buy or sell with equal probability, whereas the informed traders buy for
sure when the value is high and sell for sure when the value is low. The high
value is $25 per share and the low value is $15 per share. The market maker
believes initially that the probability of a high value is 40% and the probability
of a low value is 60%. What bid and ask prices does the market maker quote in
anticipation of the first order?
(9 marks)
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Examiners’ commentaries 2019
Reading for this question
For (a), you should read Chapter 2 in the subject guide. For (b), you should read Chapter 7. For
(c), you should read Chapter 5.
Approaching the question
(a) A good answer should contain the following. Stop-loss are orders to sell a given quantity as
long as the price remains below a given limit; stop-buy are orders to buy a given quantity as
long as the price remains above a given limit. They provide quick exits from loss-making
long and short positions, respectively, limiting the investor’s loss.
(b) A good answer should contain the following. You can assume an arbitrary face value, say
$1, since the duration depends on yields, coupon rates and maturity and not the face value
of the bond. Then we find that the bond price is:
0.04
0.05 ×(1 −1.05−5)+1.05−5= $0.9567.
Duration is then:
1
0.9567 ×(1 ×0.04 ×1.05−1+ 2 ×0.04 ×1.05−2+· · · + 5 ×1.04 ×1.05−5)=4.62.
(c) A good answer should contain the following. The market maker revises their beliefs about
the likelihood of high (H) and low (L) values depending on the order flow. Using Bayes’
theorem, we find that the conditional probability of Hgiven a buy order is:
P(H|buy) = P(buy |H)P(H)
P(buy) =(0.9×0.5+0.1) ×0.4 (0.9×0.5+0.1) ×0.4 + (0.9×0.5) ×0.6= 0.4490.
Simlarly, the conditional probability of Lgiven a sell order is:
P(L|sell) = P(sell |L)P(L)
P(sell) =(0.9×0.5+0.1) ×0.6 (0.9×0.5+0.1) ×0.6 + (0.9×0.5) ×0.4= 0.6471.
Therefore, the ask price is designed to meet the buy order, which is:
0.4490 ×$25 + (1 −0.4490) ×$15 = $19.50
and the bid price is designed to meet the sell order, which is:
(1 −0.6471) ×$25 + 0.6471 ×$15 = $18.53.
Question 2
(a) What are zero-coupon bonds? What benefits do such bonds offer to investors?
(7 marks)
(b) The following table shows data on a portfolio, the market index, and the risk
free interest rate.
Average return of the portfolio 10%
Correlation coefficient of the portfolio with 0.6
the market index
Standard deviation of the portfolio 50%
Average return of the market index 8%
Standard deviation of the market index 30%
Observed risk free interest rate 3%
Work out the M2-measure and Jensen’s alpha for the portfolio.
(9 marks)
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