Schweser QBank 201703 fixed income portfolio management part II

Explanation To increase the duration of a bond portfolio through futures, the portfolio manager should buy futures contracts.. Entering this into the following formula gives us the chang

Test ID: 7428091Fixed-Income Portfolio Management-Part II

frequently use consultants and make choices using qualitative factors

never use consultants but do make choices using qualitative factors

frequently use consultants but never make choices using qualitative factors

Explanation

These are common steps in the process of choosing both equity and fixed-income managers

John Hanes serves as a portfolio manager for Stackhouse Investments One of his clients, the Red Wing Corporation, holds a $50 millionface value position in a T-bill that matures in 182 days on March 21 (today is September 21) Red Wing also owns a $100 million position

in a floating rate note (FRN) that matures in one year, pays LIBOR plus 25bp and has interest rate reset dates on December 21, March

21, and June 21 Red Wing has indicated that they need to sell the T-bill investment sooner than anticipated to fund an unexpected series

of cash outflows

Which of the following positions would effectively shorten the maturity of your client's Treasury bill investment and hedge your clientagainst adverse movements in interest rates until the sale date given that one T-bill contract controls $1,000,000 in T-bills?

Buy 50 T-bill futures contracts

Sell 500 T-bill futures contracts

Sell 50 T-bill futures contracts

Explanation

Since the client owns $50 million of face value of the T-bill, we should sell 50 December T-bill futures contracts We sell 50 contractsbecause each contract controls a $1 million T-bill with a 90-92 day maturity upon expiration of the futures

Assuming interest rates rise, which of the following CORRECTLY describes the outcome regarding the ultimate disposal of the T-bill?

The T-bill will lose value, but the short T-bill futures contracts will gain in value to

offset the loss

The T-bill futures contract will lose value, but the Treasury bill will gain in value to offset the

loss

The holdings of T-bill futures contracts will have to be reduced (rebalanced) in order to

maintain the current hedged relationship

Explanation

This position will also hedge your client against adverse movements in interest rates should he decide to sell before the expiry of the T-billfutures If interest rates rise, the T-bill will lose value, but the short T-bill futures position will gain value to offset this loss

Which of the following is a methodology that could be employed to convert your client's FRN to a one-year fixed rate structure?

Enter into an interest rate collar

Enter into a one-year, quarterly, receive-fixed interest rate swap

Purchase an interest rate cap

appropriate because the existence of the embedded derivatives would make

the distribution of returns not normal

not appropriate because the existence of the embedded derivatives would make the

distribution of returns not normal

not appropriate because the existence of the embedded derivatives would make the

distribution of returns normal

Explanation

The standard deviation is a measure for normal distributions Embedded options would make the distribution of the bondreturns not normal Therefore, the standard deviation would not be an appropriate measure

Which foreign bond has the greatest expected excess return and what is the excess return?

Bond with Greatest

Excess Return Excess Return

Which of the following statements about bond portfolio management is least accurate?

A portfolio managers sold a floor to finance the purchase of a cap in

anticipation of higher interest rates on a floating-rate liability

A portfolio manager with a $50 million face value in bonds and a futures contract with

$100,000 face value should use 500 futures contracts according to the Face Value

Naive model

To increase the duration of a bond portfolio through futures, the portfolio manager

should sell futures contracts

Explanation

To increase the duration of a bond portfolio through futures, the portfolio manager should buy futures contracts

Which of the following is NOT an advantage of using financial futures for asset allocation purposes instead of the cash market securities?Large orders have a very small market impact in the futures market

Futures are priced exactly the same as the underlying asset but are more liquid

Futures have lower brokerage fees

5.21472 bp due to an increase in the yield.

10.42945 bp due to a decline in the yield

5.21472 bp, due to a decline in the yield

Explanation

By purchasing Bond B Hopper can realize a yield gain of (6.45 - 5.60) = 85 basis points if the yield spread does not increase The yieldadvantage for the 6-month time horizon is (85/2) = 42.5 basis points to bond B This is the yield advantage that must be offset in order tobreak even, hence we use 42.5 basis points in the formula to indicate the price of bond A will increase Since we are looking at this fromthe standpoint of a change in yield on Bond A: (0.425/-8.15) x 100 = -5.21472, implying that the change in yield for bond A is -5.21472bpand the spread must increase by 5.21472 basis points This change will result in capital gains for Bond A, which will offset B's yieldadvantage

Steve Kiteman, CFA, manages a domestic bond portfolio and is evaluating two bonds Bond A has a yield of 6.42% and amodified duration of 11.45 Bond B has a yield of 8.25% and a modified duration of 9.50 Kiteman has an expected holdingperiod of three months The breakeven change in the spread due to a change in the yield on bond B is:

4.12783 bp due to a decrease in the yield for Bond B

4.81579 bp due to an increase in the yield for Bond B

3.99563 bp due to an increase in the yield for Bond B

Explanation

The Bond B has a yield advantage of 183 basis points With a three-month investment time horizon, the yield advantage is(183/4) = 45.75 basis points Since we are looking at this in terms of Bond B: (-0.4575/-9.50) x 100 = +4.81579bp, implyingthat the spread must increase by 4.81579 basis points Hence, in terms of the yield on Bond B, the breakeven change inyield is +4.81579bp, or an increase in the yield on Bond B (thus resulting in the widening of the spread between A and B bythis amount) This change will result in capital losses for Bond B, which will offset B's original yield advantage Note that theCFA curriculum specifies using the bond with the greater duration which in this case would be bond A although as we havedemonstrated in this question the bond with the shorter duration can also be used Thus, if you are not told which bond to use

to perform the calculation you should use the one with the greater duration

Which of the following statements regarding leverage is least accurate?

A leverage-based strategy decreases portfolio returns when the return on the

strategy is greater than the cost of borrowed funds

Leverage refers to using borrowed funds to purchase a portion of the securities in the

portfolio

Leverage is beneficial only when the strategy earns a return greater than the cost of

Richards asks about the different factors that could affect the repo rate specifically focusing on the scenario where the

collateral is in limited supply due to high demand for the collateral

The effective duration of Richards' portfolio is closest to:

Entering this into the following formula gives us the change in value of the portfolio:

Change in value of the portfolio = (market value) × (duration) × (expected change in yield)

Change in value of the portfolio = $153,000 × 6.8 × 0.0025 = $2,601

(Study Session 10, LOS 22.d)

Richards asks Cupp to explain the difference between duration and spread duration Which of the following statementsregarding duration and spread duration is least accurate?

Spread duration measures the sensitivity of non-Treasury issues to a change in

their spread above Treasuries of the same maturity

A parallel change in the yield curve will cause the spread duration to also change

Spread duration measures used for fixed rate bonds include the nominal spread,

zero-volatility spread, and option-adjusted spread (OAS)

Explanation

Spread duration measures the percentage change in the total value of the portfolio given a parallel change in the spread overTreasuries A parallel change in the yield curve will cause the yields on all bonds including Treasuries to change by the sameamount thus the spread duration will not change (Study Session 9, LOS 20.h)

Using the repo agreement, what is the effective duration of the equity invested?

8.05

6.22

8.28

Explanation

The repo agreement described has a duration of 0.25

Duration of bond positions = (52/193) × 8.2 + (61/193) × 6.8 + (80/193) × 5 = 6.43

The duration of the equity invested can be found as:

D = (D I - D B)/E

where:

D = duration of equity

D = duration of invested assets

D = duration of borrowed funds

E i B

E

i

Question #16 of 72 Question ID: 466099

I = amount of invested funds

B = amount of borrowed funds

E = amount of equity invested

Using the information provided in the question:

D = [(6.43)(193,000 − (0.25)(40,000)] / 153,000 = (1,230,990 − 10,000) / 153,000 = 8.05

(Study Session 10, LOS 22.a & b)

If Richards uses the zero-coupon bonds to leverage her portfolio, what is the change in value of the leveraged portfolio for a

25 basis point change in interest rates?

Change in zero-coupon bond = $40,000 × 3 × 0.0025 = $300

Total change in the portfolio = $1,066 + $1,037 + $1,000 − $300 = $2,803

(Study Session 9, LOS 20.g)

The scenario Richards mentions regarding the supply and demand for the collateral in the repurchase agreement shouldcause the repo rate to be:

lower

higher

stay the same

Explanation

No single repo rate exists for all repurchase agreements The particular repo rate depends upon a number of factors

If the availability of the collateral is limited, the repo rate will be lower The lender may be willing to accept a lowerrate in order to obtain a security they need to make delivery on another agreement

The repo rate increases as the credit risk of the borrower increases (when delivery is not required)

As the quality of the collateral increases, the repo rate declines

As the term of the repo increases, the repo rate increases It is important to note that the repo rate is a function of therepo term, not the maturity of the collateral securities

E

Question #18 of 72 Question ID: 466107

As the demand for funds at financial institutions changes due to seasonal factors, so will the repo rate

(Study Session 10, LOS 22.b)

An analyst is considering various risk measures to apply to a bond portfolio He requires a measure that will use as much data

as possible so little information will be lost Given this requirement, as he considers using the semivariance and/or value atrisk, he would reject:

the semivariance but not value at risk

both value at risk and the semivariance

value at risk but not the semivariance

Explanation

The measures to compute value at risk uses the total distribution of returns above and below the mean The semivarianceonly uses half the data, the portion of data below a given value so it is statistically less accurate VAR does not give an

indication as to the magnitude of the worst possible outcome

Which type of credit risk is defined as the risk that the issuer will not meet the obligations of the issue?

Credit spread risk

Which of the following is NOT an advantage of using financial futures for asset allocation?

Time savings

More precise hedging

Less portfolio disruption

Question #21 of 72 Question ID: 466139

A U.S investor holds a bond portfolio that includes bonds that are an obligation of a British company and denominated inBritish pounds In estimating the sensitivity of the value of that foreign position to rates in the United States, with respect to thecountry beta for Great Britain and the British bond's duration, it is most correct to say a:

lower country beta and lower bond duration will lead to higher interest rate risk

lower country beta and higher bond duration will lead to lower interest rate risk

higher country beta and higher bond duration will lead to higher interest rate risk

Explanation

The duration contribution to the domestic portfolio is the product of the country beta and the bond's duration It is most correct

to say that when both go up, the interest rate risk increases

The Reliable Insurance Company sells fixed rate annuities as part of its product mix and uses the proceeds to invest in floatingrate notes What kind of interest rate change should they hedge against and which is the most appropriate hedging strategy?They would be concerned with interest rates:

decreasing and would hedge this risk by buying a cap and selling a floor

increasing and would hedge this risk by selling a floor and buying a cap

decreasing and would hedge this risk by selling a cap and buying a floor

Explanation

An insurance company that sold a fixed rate annuity and invests the proceeds in a floating rate note would be concerned thatinterest rates would decrease thus causing the return on their floating rate note to be less than what they owe on the fixed rateannuity They can mitigate this risk by selling a cap and using the proceeds to buy a floor which would payoff in the event thatinterest rates decreased below the floor strike price

FI Investment Co (FI) has recently observed an increase in the credit risk of their fixed income portfolios Management hasnever used credit derivatives to hedge this risk, but thinks that this might be time to try them Bill Bales, one of the portfoliomanagers, is instructed to learn about the basics of credit derivatives and then use them to hedge credit risk in FI's portfolios

First, Bales looks at why investors would sell credit protection He makes some notes as to why credit protection would besold:

Question #23 of 72 Question ID: 466132

1 Sellers are hedging their fixed income positions

2 Sellers may expect a ratings upgrade for the asset/issuer as a likely outcome

3 Sellers may sell credit protection options to enhance portfolio income, assuming the options finish in-the-money

4 Sellers believe that a takeover by another firm is unlikely

Next, Bales explores the use of binary credit options He realizes there are quite a few of them To put them in perspective, hedevelops a list of binary credit options that might be appropriate for FI portfolios:

1 A call option that has its value tied to the difference between the market spread and a reference spread and the payoff is

an increasing function of the credit spread

2 A put option that allows the holder to put the bond back to the issuer at a fixed-price if the credit rating falls

3 A call option that pays the difference between a reference value and the market value of the bond after a downgrade

4 A call option that pays additional coupon income in the event of a downgrade

Bales' research indicates that not only can credit derivates be used to protect FI's fixed income portfolios from certain types ofrisks, but they can also be employed to lower the firm's borrowing costs Bales is able to convince FI's CEO Tim Brown toissue the following bond:

A 5-year, annual pay, $20 million bond offering at a rate of LIBOR plus 150 basis points

LIBOR is 6.5%

The bonds will be issued with a binary credit put, with a strike price at par

One year from today (t=1) (the day after the coupon payment is made) LIBOR moves to 7% and the yield on the bond is at9.25%

Regarding the sellers of credit protection, which statement is most accurate?

Regarding a total return credit swap which of the following statements is least accurate?

The swap can hedge many types of risk with a single contract

The total return payer owns the underlying assets

The total return payer receives an amount based on a specified reference at the

swap's settlement dates

Explanation

The total return payer may or may not own the underlying securities Entering into a credit swap as the total return payerwithout owning the underlying assets is a way to short a bond A total return credit swap does hedge many types of risk Also,the number of transactions will likely be less than trading the underlying, and the total return receiver pays an amount based

Question #25 of 72 Question ID: 466134

on a specified reference at the swap's settlement dates (Study Session 10, LOS 22.g)

Suppose the investor who buys FI's bond issue holds 1,000 bonds with a $1 million face value position Subsequently a creditdowngrade occurs and the bond declines in value to $700 If the strike price is $1,000 what is the option value per $1,000 par

(Note: if protection were purchased on the entire position, the overall payoff would be $300,000 (= $300 × 1,000), less the cost

of purchasing the options.) (Study Session 10, LOS 22.g)

Assume that instead of a binary credit put option, FI intends to issue the bond with a credit spread call option The bond's riskfactor is 2 and assume it is now one year from today The value of the credit call option is closest to:

the credit call is out-of-the-money

(0.0925 − 0.0700 − 0.0150) × $20,000,000 × 2 = $300,000

(Study Session 10, LOS 22.g)

With regard to the binary credit options, which of the statements given are least accurate?

Question #28 of 72 Question ID: 466137

does not continue to rise (or fall) based on the value of the underlying Thus, a call that has a payoff as an increasing function

of the credit spread would not be binary (Study Session 10, LOS 22.g)

FI holds a large position with a 10-year maturity Recently, Bales has observed a significant increase in the spread relative tothe 10-year Treasury Today he learns that Moody's has changed the rating on the bond from investment grade to

speculative In terms of credit risk, FI is dealing with:

credit spread, default and downgrade risk Credit spread risk can be managed

with credit options and credit forwards Downgrade risk can be managed with

either credit forwards or swaps Default risk can only be managed with swaps

credit spread and downgrade risk Credit spread risk can be managed with credit

spread options, credit spread forwards, and total return swaps Downgrade risk can

be managed with credit options, credit swaps, and total return swaps

credit spread and default risk Credit spread risk can be managed with credit options

and credit forwards Default risk can be managed with credit forwards, swaps, and

credit options

Explanation

These are examples of credit spread and downgrade risks Credit spread risk is the risk that the yield premium over therelevant risk free benchmark will increase Downgrade risk reflects the possibility that the credit rating of an asset/issuer isdowngraded by a major credit-rating organization The investor can use credit spread options, credit spread forwards, or totalreturn swaps to manage credit spread risk Credit options, credit swaps, and total return swaps can be used to managedowngrade risk (Study Session 10, LOS 22.g)

A portfolio manager is considering increasing the dollar duration of a portfolio by either buying more bonds or buying futurescontracts Having used a reliable model to determine a bond position and a futures position that have equal dollar durations,choosing to add the futures position to the existing portfolio will increase the final portfolio's dollar duration:

more than the proposed bond position

significantly, but less than the proposed bond position

by an amount equal to the proposed bond position

Explanation

Theoretically, using bonds or futures can accomplish the same goal

Which of the following is NOT an advantage of using futures instead of cash market instruments to alter portfolio risk?

Lower transaction costs

Higher margin requirements

18.08219 bp due to a decline in the yield.

13.89474 bp due to a decline in the yield

14.72190 bp due to an increase in the yield

Explanation

Bond A has a yield advantage of 132 basis points relative to Bond B An increase in Bond B's credit rating will increase its priceand lower its yield Since we are looking at this in terms of Bond B: (1.32/-7.30) x 100 = -18.08219bp, the breakeven change inyield is -18.08219bp, or a decline in the yield on Bond B resulting in the widening of the spread between A and B by thisamount The increase in price for Bond B will result in capital gains for Bond B, which will offset A's original yield advantage.Note that the CFA curriculum specifies using the bond with the greater duration which in this case would be bond A although

as we have demonstrated in this question the bond with the shorter duration can also be used Thus, if you are not told whichbond to use to perform the calculation you should use the one with the greater duration

A manager of a fixed-income portfolio sells futures contracts identical to contracts it already owns With respect to the portfoliounder management, the effect of this will be to:

increase the value

decrease dollar duration

increase modified duration

Explanation

The only one of the choices we know for sure is that dollar duration will decline The act of closing a futures contract does notnecessarily change a portfolio's value one way or another The modified duration is a weighted average of the durations of thepositions and not the dollar durations, it may go up or down

Question #33 of 72 Question ID: 466154

bond

Canadianbond

Europeanbond

Japanesebond U.S bond

Jebson and Dickens analyze the returns under several assumptions First, they estimate the breakeven change in spreadignoring the forward discount or premium They then incorporate the forward discount and premium into the analysis

Jebson says that after purchasing any one of the bonds that have a yield disadvantage to the U.S bond, one way to make upfor the yield differential would be to have a yield decrease in the foreign country Dickens says that an increase in market yield

of the U.S bond can also make up the yield differential

Jebson and Dickens explore the role duration plays in determining the yield disadvantage one bond has relative to another.Jebson says that if there is a 10 basis point decrease in all bond yields, including the risk-free rates, then the U.S bond would

be the best investment Dickens says that such a shift in yields would significantly affect the breakeven yield changes neededfor the foreign bonds to provide the same return as the U.S bond

Jebson and Dickens both cite ways a market move can make up for a yield disadvantage of each foreign bond, after

purchase, relative to the U.S bond With respect to their statements:

Jebson is correct and Dickens is wrong

Jebson and Dickens are both correct

Jebson and Dickens are both wrong

Explanation

If a foreign bond is at a yield disadvantage based upon the yield when purchased compared to the U.S bond, then either adecrease in the foreign bond yield (i.e., increase in price) or an increase in the U.S bond yield (i.e., decrease in price) willmake up for the yield disadvantage (Study Session 10, LOS 22.k)

With respect to the affect of a negative 10 basis point shift in bond yields and the risk-free rate:

Jebson is wrong and Dickens is correct

Jebson is correct and Dickens is wrong

Jebson and Dickens are both correct

Explanation

Jebson is correct because the decrease in bond yields will increase the price of the U.S bond by the largest amount This isbecause it has the highest duration Such a shift, if it includes the risk-free rates, will not significantly affect the breakeven