George Akerlof examined how the presence of asymmetric information can

lead to bad outcomes in otherwise fair markets. What good was Akerlof

exploring in a paper titled "Market for LemonsLower wages mean lower prices, meaning a dollar in one region can buy

more than a dollar in another region. To compare living standards, what

metric do economists use to adjust the national income for cost of living?

11. (7 points) You are a consultant hired by insurance company XYZ to evaluate their ALM process. During your review, you find the following: . Company XYZ's assets include treasuries, corporate bonds, commercial mortgages and MBS . XYZ's goal is to match the duration of assets and liabilities . They calculate and report effective duration of liability and assets quarterly. Below are the results from the ALM model. Interest Rate Move Assets Liability Shock Up 50 bps 180 M 160 M No shocks 200 M 180 M Shock Down 50 bps 210 M 220 M (a) (/ point) Compare Macaulay duration, empirical duration, effective duration and key rate duration. (b) (/ point) Explain the possible reasons that the value of assets could move differently from the duration predicted value. (c) (1 point) Identify risks that XYZ faces in a falling interest rate environment. (d) (2.5 points) Estimate the value of assets and liabilities following a 70bps drop in interest rates using duration and convexity. (e) (1.5 points) Evaluate suitability of adding the following assets to improve the company's asset liability risk management. (i) 30 year high yield bond (ii) 15 year callable investment grade bond18. (5 points) You are the Chief Investment Officer of Rookie Life Insurance Company (RLIC). The company is only 2 years old, but has had enormous success in writing new annuity business. The company has sold $1 billion in deferred payout annuities. A deferred payout annuity is a single premium contract sold to 30 year old individuals and begins making monthly payments at age 65. The company is risk adverse, wishes to maximize surplus, and wants to duration match when the contracts are in their payout period. The liability duration will initially be 25, but will be 8 in the payout stage. You have decided on the following initial investment mix: Expected Asset Class Weight Return Duration Common Stock 20% 7.5% Private Preferred Stock 30% 5.0% 15.0 Municipal Bonds 30% 5.0% 20.0 Short Term Bonds 20% 2.5% 2.0 Total 100% 5.3% 10.9 (a) (1.5 points) Explain what aspects of the portfolio should be monitored for changes in RLIC's circumstances and constraints, and how each will likely change over time. (b) (1.5 points) If the stock market decreases by 30%, explain the benefits and costs of rebalancing the portfolio. (c) (2 points) You are considering the following rebalancing disciplines . Calendar rebalancing Percentage of portfolio rebalancing (i) Explain why the calendar rebalancing might be more appropriate during the deferral period. (ii) Explain why the percentage of portfolio rebalancing might be more appropriate during the payout period.13. (7 points) You are the portfolio manager of an asset management firm. Due to a series of quantitative easing policies implemented by the Federal Reserve in the past, you are now evaluating the decision of investing in commodities in a balanced fund portfolio using crude oil futures. (a) (/ point) Describe the advantages of investing in commodities in the portfolio. (b) (/ point) Explain why purchasing oil futures is more effective in getting commodity exposure than purchasing stocks of an oil company. (c) (/ point) Propose a formula to determine the relationship between futures price and spot price. Define all terms. (d) (/ point) Define the law of one price and describe how it relates to oil ETT's. (e) (3 points) The available crude oil futures contracts are shown in the below table: Futures Price as of November 2013 Futures Prices as of Change in Spot Contract Maturity (USS) October 2013 (US$) Price (US$) December 2013 92.20 91.20 0.55 January 2014 91.55 90.65 0.55 February 2014 89.50 88.60 0.55 (i) Describe the three components of returns on a futures contract. (ii) Explain the sloping structure of the futures prices listed in the table. (iii) Recommend a futures strategy that is expected to provide a positive return with the above oil futures contracts.12. (7 points) Tom is the portfolio manager for ABC Life's investments in agency MBS, agency CMOs and mortgage bonds. (a) (/ point) Describe each of the assets: agency MBS, agency CMOs and mortgage bonds. (b) (/ point) Compare the credit risks of each instrument. (c) (/ point) Compare the prepayment risks of each instrument. (d) (2 points) As part of the company's ALM interest rate risk policy, Tom is required to manage his portfolio to match a target duration and cash-flow profile to fund a specific set of liabilities. ABC Life is looking to better measure Tom's performance by implementing a benchmark for his agency MBS investments. (i) Describe the considerations in selecting a benchmark. (i) Recommend a benchmark for the agency MBS portfolio. (e) (/ point) ABC Life is also looking to setup an index for Tom's mortgage bond portfolio to mitigate risk. Identify the key risk associated with a fixed income credit portfolio and explain ways to mitigate this risk. (f) (/ point) Tom plans to use a stratified sampling approach to replicate the credit index. Explain whether this is an appropriate approach