Request to clarify answers to April 2020&2022 exams

[Bill SD]

Hi, I celebrated the Easter weekend with some past paper practice but am left with 7 queries on the April 2020 and 2022 exams (even after reviewing the Examiners Reports and the Acted ASET). So appreciate any further explanations:

I have 6 queries on 3 question parts (Q1(viii), Q2(i) a) and Q2(vii)) quoted here from the April 2020 exam:

Q1(viii) Set out how the actuary might use a financial model to undertake this work?

My query#1: The Examiners Report presumes the actuary is using a stochastic model and there are none of the usual points in mark scheme about deciding whether stochastic or deterministic model is more appropriate. Is this stochastic model presumption because (i) it's an actuary rather than a non-technical person, (ii) due to the description as a 'financial' model or (iii) it's a situation with multiple parameters/random variables?

Q2(i) a) Propose and calculate appropriate risk-related metrics for The Bank for the year using the information provided above.

Examiners report & ASET includes these 3 ratios: Shareholder Value (SHV), Shareholder Value Added (SHA) and Economic Income Created (EIC) with limited explanation of what they represent. I found the Module 30 Acted notes (pages 26-27) similarly overly-brief and unhelpful.

My query#2: Why Is EIC calculated using (economic) Capital rather than profit/revenues given its name is 'income' and purpose is to "capture the quantity of return generated by a unit of activity"?

"SHV captures the present value of all future cashflows (ie a perpetuity)"
My query#3: Where are the cashflows in the SHV and SHA calculation -why is economic capital simply used?

My query#4: Why is it sensible to use (RAROC-g)/(hurdle-g) as the discount factor, rather than the risk-free rate or simply RAROC?

Presume it should be possible for an investor to judge if the RAROC, SHV, SHA or EIC ratios imply a relatively worthwhile investment compared to the hurdle rate (with the caveat that also need to compare with industry peers/alternative investments). So surprised why there are no marks in examiner report for commenting on the results of these ratios. While there are substantial marks for this in April 2022 for the Q1(iv) "Evaluate CACC’s business performance &key risks".

My query#5: How can I know when examiners want specific comments on ratio results (eg. April 2022: "The debt: equity ratio is Z£1,800,000/Z£700,000 which is 2.6 which is high") versus when examiners want generic comments (eg.April 2020: "SHV provides measures for the economic value of the bank")?

Q2(vii) Discuss how each of the following risks could be quantified for The Bank: · credit risk · market risk · liquidity risk · operational risk.

My query#6: Would it be an acceptable answer for each risk to explain how bank can (i) follow the Basel approaches for that risk (given the question stated that the bank will operate under the Basel Accords) and/or (ii) calculate VaR/TVaR/Expected Shortfall metrics on dummy data (Examiners report only mentions this approach for Market risk, but could equally apply for all risks, like with Solvency II)? Or is the focus in this question on simply quantifying risk rather than setting a capital requirement (which is in later question parts (ix-xi)).

April 2022 exam: Q2(ii) Describe key lessons learned based on past case studies, which the Lofty Board will need to consider when integrating the ERM frameworks. [7]

Lam's seven lessons (covered in Module 32) learned from past Case studies are: 1. know your business; 2.establish checks and balance; 3.set limits and boundaries; 4. keep your eye on the cash; 5.use the right yardstick; 6. pay for the performance you want 7. balance the yin and the yang.

My query#7: What is the fundamental difference between lesson Numbers 2 and 3 (checks, balances, limits and boundaries); and 5 and 6 (use right yardstick, pay for performance you want)?

I initially just assumed Lam separated into 7 lessons for marketing purposes (rather than identifying 7 distinct lessons) and so was surprised that exam awards separate marks for each of the 7 lessons.

Thanks very much in advance for any clarifications

 

[Alvin Kissoon]

Hi Bill,

Glad to hear you're doing plenty of question practice! To answer your queries:

1. It's (iii). Due to the multiple parameters/random variables. One of the advantages of a stochastic model is they allow naturally for the uncertainty of outcomes, which is well suited to this situation.
2. - 4. There are a number of possible ways of analysing risk, and these are the metrics suggested by Lam to optimise risk. Further details on these metrics can be found on p. 133-135 of Lam. Note that as per the syllabus objective, for the exam we only need to know, be able to calculate, and to understand how they might be used (which is what is being tested in the exam question).
5. The question wording is key in identifying this. For example, in 2020 paper the wording is 'propose and calculate' and then 'comment on how potential investors may use each metric' - so this indicates that specific commentary on the results was not needed (presumably it would have said 'comment on your results' if they wanted such). In contrast, in the 2022 paper it asks you to 'Evaluate' , which is defined the Institute's command verb terminology as 'Judge the suitability of something for a given purpose' - which indicates that specific comments would be needed. You may wish to put both in as good practice to cover both the general and the specific off anyway, since as you're calculating them you will naturally have thoughts on the results.
6. With these long questions, it is good to read through the whole question to identify which part of the course is being tested to avoid double counting of answers. As you correctly say, the fact the question then goes onto economic capital is an indication that part (vii) is about quantifying risk.
7. If such a question comes up, it is a good idea to separate out all 7 lessons. 2. and 3. and 5. and 6. are looking at the same areas but with different perspectives:
- 2. and 3. focus on preventing too much risk; however 2. is more a preventative measure, whilst 3. is more about telling a business what actions to take when too much risk has been taken.
- 5. and 6. focus on maximising performance; however 5. is more about the use of performance metrics, whilst 6. talks about the use of compensation as an incentive.

I hope this helps but as usual, feel free to follow up on any of these points.

Alvin.