SA5 FAQs (updated March 2018) This thread contains the Subject SA5 questions asked most frequently by students, with answers written by ActEd's tutors. Each year, we'll incorporate these questions and solutions into the study material. This thread was last updated in March 2018. General questions Question What material from other subjects will I need to know for the Subject SA5 exam? Answer The two most important sources of information, in addition to the Subject SA5 course itself, are the Course Notes for Subject ST5 and CA1. There are, however, some areas contained in Subject CT2 that may be relevant. I have tried to list the potentially important topics below. I do not expect Subject ST6 to constitute a part of future SA5 exams. Any material in Subject SA5 and ST5 is examinable and should be understood. The areas of particular importance (although it is almost impossible to second guess the examinable material) from subjects other than SA5 and ST5 are as follows: Debt finance Many questions in SA5 are about financing a project, an expansion, some equipment, or a takeover using debt. There are many types of debt, and their features are mentioned throughout the actuarial syllabus, including CT2 and ST5. The rating of such debt is also very common in SA5. Capital project appraisal methods Most of the capital project material is contained in the Subject SA5 course itself, however there is material in Subject CA1 and CT2 on the details of risk identification, analysis and mitigation that might be important. This material also covers considerations in choosing a risk discount rate. Option diagrams Students have in the past, been requested to illustrate a particular option strategy by drawing a position diagram. There are a number of option positions mentioned in Subject SA5 although the techniques for creating position diagrams is covered in Subject CT8 and in ST5. Share issues The process of issuing shares, either through a rights issue for an existing company or as an offer for sale launching a new company on the exchange, are important. These are covered in CT2 on a high level, where the role of underwriting is discussed. This is potentially useful material. Infrastructure investment and private debt There is some useful core reading in Subject ST5 on this topic. In addition, there was a monster question in Subject SA6 September 2014 Q1 [42 marks], which contains a lot of useful ideas not contained in the ST5 material. Infrastructure is becoming a more important subject as the government tries to find alternative ways of financing hospitals, roads, etc, without having to borrow. A good knowledge of this, and keeping up to date on real world events in this space is important for SA5. Private equity This has always been an important topic in SA5 and is covered in the core reading for ST5. It links with the concept of fundamental analysis of a company, which is covered in ST5. Which past paper questions are relevant? SA5 has not changed much since 2005, and most of the papers dating back to then are relevant, although sometimes the "topical issues" become dated. In theory, many of the questions that have been set for Subject ST5 are relevant for this subject, and these papers should be viewed as a useful resource. However, some of the questions on indices, performance measurement/attribution, risk-adjusted returns, fund management techniques (such as technical, quantitative and fundamental analysis, active and passive methods, and styles) and derivative usage in fund management are of less relevance. The questions that are on asset management are in general less important than those on corporate finance. Question The further reading list is very large for Subject SA5. Which ones are most important? Answer This is a very difficult question to answer. In the past, the more topical Subject SA5 questions have often focused on topics that had been discussed in the financial press and occasionally in Actuarial circles (Finance Conferences) or in the British Actuarial Journal in the 3 of 4 years prior to the exam. In SA5 past papers to date, there have been questions that asked about: the procedure and steps required to set up a company the procedure and the approximate timetable of an acquisition/merger catastrophe bonds liquidity risk management lender of last resort infrastructure financing Quantitative Easing Solvency II, and other European regulation (Solvency II has been more heavily examined in recent papers) regulation for the banking industry including Basel II and III The continuing debate over the Eurozone (BREXIT, and other countries that possibly want to exit the EU) and the levels of government debt are important, as is the credit rating of government debt. Quantitative easing and the powers of a central bank (including the fact that the ECB and the BofE are undertaking QE, while the US is reversing its QE) are also topical. The LIBOR scandal and the FX rate scandal and financial services regulation are important. The move to central clearing may be topical. The changes in world politics, and the possibility of trade wars and tariffs has been a hot topic in 2017. Most of the information required could have been acquired through reading of the UK financial press over the previous 24 months. The further reading is list is a good method of broadening your knowledge of the material required for SA5 and it does no harm to read a selection of the papers and books. But it is not generally the source of a great deal of marks. Finally, operational risk & liquidity risk/Basel II and III, Solvency II are thing that are being discussed widely in actuarial circles as well as elsewhere in the financial world. I expect these to be important topics. Liquidity risk is important at the present time. Question Do I need to sit the Practice Module at the same time as Subject SA5? Are the marks averaged between the SA5 and the Practice Module exams to determine whether I pass or not? Answer Both papers are entirely separate and one can be passed without passing the other. The Profession do recommend that students sit the practice module at the same sitting as they sit the Subject SA5 exam, but this is not essential. The Practice Module exam consists of 25 multi-choice questions that will be based on a generic bit of Core Reading (that can be purchased from ActEd) and 25 multi-choice questions based on the SA5 Core Reading. A specimen exam is on the Institute?s website. Future exams will be added to a data bank so that exams can be generated electronically at some point in the future. ActEd provide Practice Module Multi-choice Booklets that contain 240 questions on the generic Core Reading and 240 questions on the SA5 Core Reading. These might prove useful for those wishing additional practice material. These are also available on an online basis for those who prefer electronic methods of study. Questions on the Course Notes Question Are there any Actuarial Guidance Notes that are relevant? Answer There are no Guidance Notes that are directly relevant to Subject SA5 and none are mentioned in the Core Reading. Question What exactly is the arbitrage position that is described in April 2008 Q2 part (v)? Answer The slightly confusing part of the description is the term “buy and swap” as this indicates that the bond is purchased and then the return on the bond is swapped (presumably through a total return swap). In fact this is not the case. The reference to “swap” is with regards to the Repo transaction described lower down. So in fact the owner of the bond uses the physical bond to finance a Repo in order to get cash, and then hedges the credit risk through a CDS. Essentially this means that the trade earns LIBOR + 70bp through the corporate bond (including the spread), less the 55bp required for the CDS, less the LIBOR cost of the Repo, plus the LIBOR that could be earned on the cash received under the Repo agreement. This equals LIBOR + 0.15%. If the Repo counterparty applies a haircut of 4%, this means that the trader will have to put 4% of the value of the trade forward as extra collateral under the Repo. In addition, he will require to place a further 1% of the value of the trade aside in his own balance sheet as “risk capital” (presumably to assure a certain level of maximum gearing in his own business). He can therefore only do the trade 20 times before he runs out of capital. Therefore the total return he can achieve from the trade is LIBOR plus 20 times the 0.15% margin on each trade. This is LIBOR + 3%. Q. How does the examiner get the numbers in the cashflow analysis in April 2012, Q2(viii) and the maturity gap in part (ix)? A. The cashflow has a few components to it that we need to work out in advance. Firstly the £500,000 loan will give a positive cashflow for the company at t=0, but will give monthly outflows of £500,000*(0.1/12) (assuming that the 10% is a monthly convertible rate, which seems likely). This equates to £4,167 each month. The second calculation is the repayment amount on each loan. It repays over 36 months, and the monthly convertible rate is 0.15/12 = 0.0125 per month. Using our annuity formula a=(1-v^n)/i for annuities that pay in arrears, we get (1-(1.0125)^-36)/(0.0125) = 28.8473. So the first loans made at t=0 result in an outflow of cash of £200,000, and a monthly inflow of £200,000/28.8473 = £6,933 each month. The second batch of loans results in an outflow of £200,000 at t=2 (start of month three) and a monthly inflow of £6,933. So at t=0 we have an inflow of £500k and an outflow of £200k, resulting in a £300k balance. At t=1 we have an interest outflow of 4,167 and a repayment inflow of 6,933 resulting in a balance of £302,766. At t=2 we have another loan interest, £6,933 of loan repayments, and a capital outflow of £200k, resulting in a balance of £105,533. And thereafter we have interest of £4,167 and home loan repayments of 2*£6,933 each month. At t=6 we have cash balances of £144,331. The maturity gap at t=6 requires us to assume a subjective “gap”, but the core reading suggests that gaps of a few months is typical in practice. If we select 6 months for example, as being a typical number. Rate sensitive assets (RSA) are assets that mature into cash, or have their interest rate reset to the market within the gap. Since the only assets the company has are home loan repayments, which are 2 or more years in term (at t=6 months), and have a fixed interest rate, none of these will qualify as RSA. The only RSA the company has is the cash balance of £144,331. We need to value the “rate insensitive assets” or fixed-rate assets, and for this we need two more annuity functions. One for the first batch of loans that have 30 months remaining, and one for the second batch which have 32 months remaining. The two factors are 24.8889 and 26.2413 respectively. So the value of the loans outstanding are £172,556 and £181,932 totalling £345,489. The rate sensitive liabilities are zero and the nominal value of the £500k loan that matures in over 4 years, would qualify as a rate insensitive (or fixed rate) liability. The examiner then compares the RSA and the RSL to show that there are more RSA than RSL. And then compares the insensitive assets and liabilities (345,489 to 500k) to show that there is an imbalance here too. Q. In April 2013 Q2 (x) the examiner uses a strange formula to evaluate the effect of gearing of the return on capital employed. What is the formula doing here? A. The formula looks complex, but if it is broken down into steps it seems easier. If a company earns 15% unleveraged after tax then the P&L looks like this: Profit before tax 20 Tax at 25% (5) Profit after tax 15 If the company is 50 / 50 debt and equity and the 100% of assets earns the same gross return of 20% before tax, then the p&L would look like this: Operating profits 20 Interest on 50 of debt at 6% (3) Profit before tax 17 Tax at 25% (4.25) Profit after tax 12.75 If this profit is distributed over 50 of equity that is a 25.5% return on equity. This is the same 25.5% that emerges from the examiners equation. Q: How did the examiner get the numbers for the personal tax calculation in September 2013? A: Salary and benefits in kind would be taxable in the income tax system, even though the benefits in kind were not received by Mr X as cash in hand. The personal allowance was £8,105 at the time of the question, and above this the first £34,370 was taxable at the basic rate of 23%. This meant that the tax due was (£34,370*0.23) + ((£118,000-£8,105-£34,370)*0.4) which equals £37,084. The Share portfolio generated a gain of £11,000 and was jointly owned. As it was jointly owned the gain could be shared between husband and wife, making £5,500 each. But the capital gains allowance is around £11,000 each, which means that neither pays tax on this gain. Net dividends of £2,500 were received, which were again jointly owned, making income of £1,250 for each of them. The additional tax that a higher rate tax payer would pay is 22.5% of the “gross dividend” (namely 22.5% * (£1,250/0.9) ). This comes to £312.5 for Mr X. But basic rate taxpayers are not subject to further tax under the imputation system, so Mrs X is exempt. The offshore account generated 1,200 francs which is equivalent to £800 and is jointly owned. So £400 of this income is allocated to Mr X and is subject to the higher rate of 40% (ie potentially £160 in UK tax). However the withholding tax may be reclaimable or offsetable against this liability. The 400 francs of withholding tax is divided between Mr X and Mrs X to give them £133 of reduction in the income (400/1.5/2). So Mr X pays £160-£133) = £26.67. This seems reasonable as 400 francs is 33% of the gross overseas income of 1,200 francs, so most of the tax has already been paid on this income. In Mrs X accounts, the offshore income would be taxable, but as she has not received total income in excess of her personal income tax allowance of £8,105, no tax is paid. In theory she can reclaim the withholding taxes that have been deducted from the net dividends, but in practice that might be harder than it looks. The examiners solution appears to indicate that no UK tax would be paid, but does not indicate a negative “reclaim” of the withholding taxes abroad. Venture capital and betting are exempt from tax.
