Schweser QBank 2017 portfolio management and wealth planning 09 asset allocation and relat portfolio management (2)

Tail risk and contagion both refer to relatively infrequent events that increase the difficulty of hedging emerging market currencies Hedging costs for managers who buy emerging market c

Asset Allocation and Related Decisions in Portfolio Management (2)

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Test ID: 7427763

Which of the following statements regarding benchmarks and indexes is most accurate?

Indexes are used in performance evaluation

Benchmarks and indexes are used in performance evaluation

Benchmarks are used in performance evaluation

Explanation

Benchmarks are the reference point used in performance evaluation and indexes are often used as that benchmark for performance evaluation

Which of the following investors would benefit most from the use of a custom benchmark?

A foundation that wants to beat the overall market return

A pension plan that has liabilities that include future wage growth and inflation

indexing

An investor who wants to earn the market return of a balanced asset allocation

between equities and bonds

Explanation

The pension plan would most likely need to create a custom benchmark that would mimic the liabilities using a combination of nominal and inflation indexed bonds and equity for wage growth The foundation could use a market index as its benchmark and the individual investor would most likely use a target date fund or a balanced fund as their investment vehicle both of which would use a benchmark that could be constructed from equity and bond indices

A U.S investor who holds a £2,000,000 investment wishes to hedge the portfolio against currency risk The investor should:

sell $2,000,000 worth of futures for British pounds

sell £2,000,000 worth of futures for U.S dollars

buy £2,000,000 worth of futures for U.S dollars

Explanation

The investor should sell £2,000,000 worth of futures contracts for U.S dollars This will offset the existing long position in pound-denominated assets In so doing, the investor has effectively fixed the exchange rate for pounds into dollars for the duration of the futures contract

Question #4 of 38 Question ID: 475727

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Portfolio managers tracking international equity indices have a tradeoff between completeness and investability because:

higher completeness results in higher investability and lower transaction

costs

higher completeness results in lower investability and higher transaction costs

lower completeness results in higher investability and higher transaction costs

Explanation

Completeness refers to the number of companies covered by an index Higher completeness means that a larger number of companies are covered, however, that results in lower investability (liquidity issues for smaller companies in the index) and higher transaction costs

A portfolio has a target asset allocation of 40% large cap domestic stocks, 20% international stocks, 30% in 9.5 year duration global bonds, and 10% real estate The overall benchmark for the portfolio is most likely a:

liability-based benchmark

broad market index

custom security-based benchmark

Explanation

A broad market index is unlikely to match this asset allocation and there is no information regarding the portfolio liabilities A custom blend of indexes would normally be used

Jane Simms manages a German portfolio denominated in the EUR and decides to use an option collar to reduce her

downside risk exposure to the Mexican peso (MXP) while retaining some potential upside Which of the following strategies will accomplish her objective?

Buy an OTM put on the MXP and sell an OTM put on the MXP with a lower strike

price

Buy an OTM put on the MXP and sell an in-the-money call on the MXP

Buy an OTM call on the EUR and sell an OTM put on the EUR

Explanation

The collar Simms describes requires buying OTM puts and selling OTM calls on the MXP However, this is directly equivalent

to buying OTM calls on the EUR and selling OTM puts on the EUR Note that selling an in-the-money call on the MXP removes all portfolio upside and will not meet her objectives

Question #7 of 38 Question ID: 472654

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Currency trading based on economic fundamentals would be most likely to sell a currency forward if the country issuing the currency is experiencing:

increasing real rates of return

rising relative inflation

declining levels of relative risk in the economy

Explanation

Higher relative inflation is associated with declining value of the currency and would tend to encourage sale of the currency by the manager The other two factors are associated with currency appreciation

By clearly specifying and agreeing to a benchmark the client and manger:

specify the desired risk and return characteristics of the portfolio

allow the client to perform a strategic asset allocation

eliminate the possibility of disappointing performance results

Explanation

Agreeing on the benchmark should reduce future arguments by setting return expectations in advance This does not in any way guarantee the manager will meet expectations Strategic asset allocation should be done in advance of manager selection and is the basis for then determining which managers may be suitable to meet client needs

The index construction method that is most biased towards the performance of the smallest companies is:

market capitalization-weighted

equal-weighted

fundamental-weighted

Explanation

With equal weighting, small-cap stocks have more weight than they would otherwise Without more information it is not clear what the fundamental approach is using though this method often weights by impact on economic output

The cost to hedge a long position in the EUR is reduced by:

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lower relative interest rates in the euro zone

forward euro exchange rates are below the spot exchange rates

negative roll yield

Explanation

A long position in the euro is hedged by selling the euro forward Positive roll yield is a reduction in hedging cost Positive roll yield for the seller of the euro occurs if the forward exchange rate for the euro is above the spot exchange rate This will occur

if euro zone interest rates are relatively low

Which of the following statements regarding hedging of emerging market currencies is least accurate?

Hedging cost varies with normally large bid/asked spreads followed by

infrequent periods of even higher spreads

Tail risk and contagion both refer to relatively infrequent events that increase the

difficulty of hedging emerging market currencies

Hedging costs for managers who buy emerging market currencies are increased by

the relatively high interest rates in emerging markets

Explanation

The relatively high interest rates of emerging market economies leads to an inverted pricing curve with forward prices of the emerging market currencies below their spot prices This raises hedging cost for sellers of the currency, not buyers; sellers receive negative roll yield while buyers receive positive roll yield EM currencies do have relatively high bid/asked spreads which increase in periods of crisis Contagion and tail risk refer to infrequent events Contagion refers to all EM currencies tending to decline together in periods of crisis, and tail risk to the downside in those periods of crisis being large in relation to typical upside movement in the currencies

The basis risk in a currency hedge is most likely highest in a:

minimum-variance hedge ratio

direct hedge

cross hedge

Explanation

A Basis risk exists when movement in the hedge currency is not matched by movement in the hedging vehicle A direct hedge will short forwards on the currency to be hedged and basis risk will therefore be low A cross hedge can range from lower to higher basis risk depending on what is used as the hedging vehicle The MVHR depends on regressing past asset returns and currency movement to calculate a hedge ratio that would had minimized past volatility of returns to the domestic investor in a foreign asset It is exposed to changing correlation and likely to have the highest basis risk

Questions #13-18 of 38

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Jane Archer manages a Swiss (CHF) based hedge fund A portion of the fund is currently allocated 60% and 40% respectively

to EUR and ASD risk-free investments, pending other investment opportunities She has collected the following information:

Estimates: Euro Zone Australia

Asset return in foreign

Change in spot exchange rate

versus the CHF −1.0% 3.0%

Asset risk measured in foreign

Currency risk (σ) 7.0% 9.0%

Correlation of currency returns

(CHF/EUR, CHF/ASD) +0.70

The following questions are from the portfolio perspective, measured in CHF

The expected return of the risk-free portion of the portfolio is closest to:

2.82%

3.74

6.56%

Explanation

The expected returns measured in the investor's domestic currency (CHF) are:

EUR asset: (1.02)(0.99) − 1 = +0.98%

ASD asset: (1.025)(1.03) − 1 = +5.58%

The weighted average return is: 0.6(0.98%) + 0.4(5.58%) = 2.82%

The standard deviation of the risk-free portion of the portfolio is closest to:

7.36%

54.13%

7.98%

Explanation

The standard deviations of the risk-free assets measured in the investor's domestic currency are:

Question #15 of 38 Question ID: 472647

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EUR asset: 7.0%(1.02) = 7.14%

ASD asset: 9.0%(1.025) = 9.23%

The variance of returns of the risk-free portion of the portfolio is:

0.6 (7.14 ) + 0.4 (9.23 ) + 2(0.6)(0.4)(0.70)(7.14)(9.23) = 54.13

The standard deviation of returns of the risk-free portion of the portfolio is:

54.13 = 7.36%

What is the expected return of the risk-free portion of the portfolio if Archer takes a leveraged position with a 150% positive weight in Australia and a 150% negative weight in the euro zone?

6.75%

9.72%

6.90%

Explanation

The expected returns measured in the investor's domestic currency (CHF) are:

EUR asset: (1.02)(0.99) − 1 = +0.98%

ASD asset: (1.025)(1.03) − 1 = +5.58%

The weighted average return is: −1.5(0.98%) + 1.5(5.58%) = 6.90%

What is the expected standard deviation of returns of the risk-free portion of the portfolio if Archer takes a leveraged position with a 150% positive weight in Australia and a 150% negative weight in the euro zone

9.94%

98.80%

3.00%

Explanation

The standard deviations of the risk-free assets measured in the investor's domestic currency are:

EUR asset: 7.0%(1.02) = 7.14%

ASD asset: 9.0%(1.025) = 9.23%

The variance of returns of the risk-free portion of the portfolio is:

(-1.5) (7.14 ) + (1.5) (9.23 ) + 2(-1.5)(1.5)(0.70)(7.14)(9.23) = 98.796

The standard deviation of returns of the risk-free portion of the portfolio is:

98.796 = 9.94%

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Question #17 of 38 Question ID: 472649

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If Archer takes a short position in a forward contract in the euro and assuming the forward exchange rate for the euro vs the CHF is downward sloping which of the follow is most accurate?

Her position will result in a loss if the euro depreciates more than predicted by

interest rate parity

She will earn a negative roll return increasing hedging costs

She will earn a negative return by shorting the currency

Explanation

Since forward curve is downward sloping for the euro exchange rate vs the CHF by taking a short position in the forward contract she will earn a negative roll return A positive roll return is earned by taking a long position in a currency with a downward sloping forward exchange rate and Archer is taking the opposite position Conversely with an upward sloping forward exchange rate curve a long position in the forward contract would result in a negative roll return and a short position would result in a positive roll return By entering into the forward contract Archer locks in the forward discount of the euro predicted by interest rate parity If the euro depreciates more than predicted by interest rate parity she would lose less by locking in a smaller depreciation of the euro using the forward contract than if she did not hedge with the forward contract Archer is shorting the forward contract not the currency itself If she had shorted the euro currency and it depreciates as expected then she would earn a profit on the decrease in value of the short position

Assuming the correlation between the ASD currency and underlying asset is highly positive which hedge ratio is most

appropriate for hedging the ASD?

A hedge ratio >1

Cannot be determined with the information given

A hedge ratio <1

Explanation

Since the ASD currency and underlying Australian asset are highly positively correlated a hedging ratio of >1, shorting more than 100% of Australian investment, would result in reduced volatility when measuring the ASD investment in the domestic CHF currency

A valid benchmark would have all the following characteristics except:

measurable

homogeneity

investable

Explanation

Investable is the most important characteristic because if it is not investable it cannot be an alternative to active management

Question #20 of 38 Question ID: 472653

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Measurable is also necessary if it is going to be used in performance evaluation Homogeneity would mean having all the same type of securities and is not directly relevant For a U.S only manager you would want homogeneous (U.S only stocks) but for a balanced equity and bond portfolio you would not

Which of the following portfolios would most likely follow a passive currency hedging strategy?

One with more confidence in the portfolio manager and high income needs

One very concerned with minimizing regret and higher allocation to equity

investments

One with a shorter time horizon and higher liquidity needs

Explanation

The following will shift the portfolio towards more passive currency management:

A short time horizon for portfolio objectives

High risk aversion

Lack of concern with regret at missing opportunities to add value through discretionary currency management

High short-term income and liquidity needs

Significant foreign currency bond exposure

Low hedging costs

Clients who doubt the benefits of discretionary management

Which of the following comments is most accurate?

A cost/benefit analysis of whether to hedge currency should include all of the

following: bid/asked transaction costs, option premiums, back office and

compliance expenses

Currency volatility becomes a more significant issue in global portfolios over a longer

time horizon as returns compound

Discretionary currency hedging allows wider deviations from the strategic hedging

than active currency management

Explanation

All of the expenses listed should be included in cost/benefit analysis of when and how to hedge currency risk including items such as back office and other overhead expenses; ultimately these direct and indirect expenses and costs will affect the client's net return

The other two answer choices are false Active management allows the wider deviations In the long run currency has less impact on risk as currency tends to mean revert in the long run A short run perspective supports currency hedging

Question #22 of 38 Question ID: 472666

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A defined benefit pension plan would most likely use a:

liability-based benchmark

returns-based benchmark

custom security-based benchmark

Explanation

Portfolios with definable liabilities should normally use the liabilities as their benchmark in order to manage the surplus

Transaction costs in general are higher for:

float adjustment bands and less popular indices

precise float adjustment and less popular indices

precise float adjustment and more popular indices

Explanation

Precise float adjustment results in frequent rebalancing and higher transaction costs More popular indices have higher liquidity and lower transaction costs

A U.S.-based investor has purchased a 15,000,000 peso office building in Mexico He has hedged his investment by selling forward futures at $0.1098/peso Two months later, the futures exchange rate has fallen to $0.0921/peso The investor's net change in the futures position is:

-$265,500

$265,500

$1,647,000

Explanation

The realized gain on the futures position is:

V0 (-Ft + F0) = 15,000,000 pesos × (-$0.0921/peso + $0.1098/peso) = $265,500

A strategist constructs a fundamental-weighted index which assigns positive weights to low price/book and price/dividend ratios A negative weight is assigned to sales If used as a benchmark, this index would most likely be used by a:

global small-cap manager

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Questions #26-29 of 38

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small-cap value manager

momentum style growth manager

Explanation

A negative weight to sales will tilt the index towards smaller companies with smaller cap Positive weights for low P/B and P/D will favor value stocks

A small, developing country has just developed an organized stock exchange where several dozen firms of all sizes trade Craig Aversa has gathered data for the companies on the exchange and plans to construct an index using a sample of the firms that he feels are representative of the stocks that trade on the exchange and the country's economy He meets with Jamie Weir who has experience in creating country indexes As they begin, Aversa says that he will develop a strict set of guidelines for determining which firms to include in the index Weir says that the guidelines should be published so that the index may be used more effectively and efficiently as a trading tool

As Aversa does his research, he uncovers some issues that may lead to potential problems Many of the firms that are traded

on the exchange and would be good candidates for inclusion in the index have large positions that are owned by a controlling family and will probably not be actively traded for the foreseeable future Several of the firms own positions, ranging from 5 to 20%, of another company on the exchange When Weir proposes the creation of a value-weighted index based upon

capitalization, Aversa says that such an index may have weights that are not representative of the actual value of the shares in the companies that are available for trading Weir acknowledges Aversa's concerns and computes a float adjustment that will increase the value of shares trading for each company to better reflect their tradable value

Aversa decides to construct the index using 10 firms For the index, Aversa decides to use the firm with the largest

capitalization from each of the four major industries in the country He will then rank the remaining firms by size and choose the six firms with the largest capitalization from that list In so doing, he feels that he is striking an appropriate balance One advantage of this method is that it turns out the gap, in terms of capitalization, between the sixth firm on the second list and the seventh firm, is fairly large Thus, Aversa feels the criteria for selection will minimize the likelihood that the component firms

in the index will have to change in the near future

Weir says that Aversa may still need to monitor the amount of the float adjustment Aversa says he plans to employ a precise float adjustment Weir says it may be more practical to create acceptable ranges for the stocks that approximate the true free float As long as the free float is within the band, they will not adjust the index

With respect to their approach to creating the guidelines:

Aversa is proposing objectivity and Weir is proposing transparency

Weir is proposing objectivity and Aversa is proposing transparency

Weir is proposing judgment and Aversa is proposing transparency

Explanation

Aversa's plan to set up strict guidelines imposes objectivity It removes subjective judgment from the process of maintaining the index Weir is proposing transparency in that she wants those who use the index to be informed as to the criteria for the index and under what conditions it might change