CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank 07 fixed income questions

Rob Watson, CFA, manages numerous bond portfolios.. 5 minutes The following information prepared by one of Watson’s quantitative analysts, pertains to another portfolio, Bond Portfolio

FIXED INCOME QUESTION 1 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 21 MINUTES

Rob Watson, CFA, manages numerous bond portfolios Selected information for one of his

portfolios and the benchmark index used to evaluate the portfolio are provided below

Average % weighting in industrial sector 31% 27%

Average % weighting in investment grade 73% 78%

A. Determine whether Portfolio A’s total return mandate is enhanced indexing or active

management Support your decision with two reasons

(5 minutes)

The following information prepared by one of Watson’s quantitative analysts, pertains to another

portfolio, Bond Portfolio B The projected bond prices included in the table assume the yield

curve remains unchanged Watson wants to use the data to calculate projected return

Average annual coupon rate 4.5%

Percentage of portfolio invested in foreign bonds 30%

Percentage of portfolio bond value projected to default 0.12%

Projected average yield and spread change of portfolio –0.37%

Projected average depreciation of foreign currencies 2.55%

Current average bond price of portfolio 100.97

Projected average bond price in 6 months 100.90

Projected average bond price in one year 100.81

Average bond convexity of portfolio 2.74

Average bond duration (modified duration) of portfolio 7.5

Average bond effective duration of portfolio 6.9

B. Calculate the projected return for Portfolio B for a six month holding period Show your

calculations

(6 minutes)

Watson is reviewing the following two statements made by his assistant:

1 The correlation of returns between government bonds and riskier assets tends to increase during periods of market stress

2 With floating-coupon bonds, both the interest and principal are directly protected from inflation

For each statement above, determine whether the statement is correct or incorrect If incorrect,

justify your determination with one reason Answer the question in the template provided

(6 minutes)

Template for Part C

Statement

Determine whether the statement is correct or incorrect

(circle one)

If incorrect, justify your determination

with one reason

1 The correlation of

returns between

government bonds and

riskier assets tends to

increase during

periods of market

stress

Correct

Incorrect

2 With floating-coupon

bonds, both the

interest and principal

are directly protected

from inflation

Correct

Incorrect

Watson has recently hired a new assistant The assistant is familiar with stock trading and surprised how much more difficult it is to trade corporate bonds Watson explains that dealer markets and over-the-counter (OTC) trading in the corporate bond market are a contributing factor to this lack of liquidity

C. Explain two reasons why dealer markets and OTC trading of bonds contributes to lower

liquidity in the corporate bond market

(4 minutes)

QUESTION 2 HAS FIVE PARTS (A, B, C, D, E) FOR A TOTAL OF 17 MINUTES

Eva Toth, CFA, manages bond portfolios with a wide range of underlying bond maturities; using

a combination of investment-grade (IG) and high-yield (HY) bonds She is working with her firm’s marketing group and has been asked to provide background information for clients on three issues:

 Relative price sensitivity of HY and IG bonds to changes in spread and risk-free rates

 Relative liquidity of IG and HY bonds and the effect on portfolio turnover

 The relative merits of I-spread and G-spread

A State whether HY bond prices have greater sensitivity to spread change or changes in

risk-free rates Justify your response with one reason

(3 minutes)

B State whether turnover in HY portfolios is likely to be higher or lower compared to IG

portfolios Justify your response with one reason

(3 minutes)

C Discuss two reasons why the I-spread cannot be used as a direct substitute for the G-spread

(4 minutes)

Next, Toth reviews the following information on two bonds, one of which she will short sell for

a period of six months

Bond Yield Z-spread Spread duration Default rate*

* Annualized default rate with loss given default of 65%

D Select the best bond for Toth to short sell for a six month period, assuming all spreads widen

by 50bp Justify your selection Show your calculations

(4 minutes)

Lastly, Toth reviews information on three additional bonds, all of which are similar to each other with the exception of optionality One of the bonds is option free, one is callable and one is putable Toth believes that interest rate volatility will increase significantly in the near term and that this is not reflected in market consensus views

Bond G-spread I-spread Z-spread OAS

E Select the bond Toth will purchase to profit from her expectation that interest rate volatility will increase significantly in the near term and justify your selection

(3 minutes)