Reading 22 Liability-Driven and Index-Based Strategies FinQuiz.com FinQuiz.com CFA Level III Item-set - Question Study Session 10 June 2018 Copyright © 2010-2018 FinQuiz.com All rights reserved Copying, reproduction or redistribution of this material is strictly prohibited info@finquiz.com FinQuiz.com © 2018 - All rights reserved Reading 22 Liability-Driven and Index-Based Strategies FinQuiz.com FinQuiz Item-set ID: 134576 Questions 1(134577) through 6(134582) relate to Reading 22 Time Associates Case Scenario Ada Strong is a risk management specialist at Time Associates, an asset management firm Strong’s current task is to identify the most appropriate means for managing the liabilities exposure for two of her clients: Rachel Lake, a self-practicing nutritionist and Wholesome Foods, an endowment which funds research projects on growing staple foods organically Rachel Lake: Lake has acquired a £3 million mortgage loan at a loan-to-value ratio of 65% to finance the purchase of her residential home The loan calls for quarterly payments at a periodic rate of 2.60% The loan will fully amortize at maturity, twenty-five years from today, and contains a prepayment option Strong is seeking to identify a suitable interest-rate sensitive asset portfolio for immunizing Lake’s obligation using a duration matching strategy Stone instructs her subordinate, Carl Mendes, to compose an asset portfolio by stating, “As long as the 1) effective duration and 2) initial market values of the asset and liability portfolios are matched, Lake’s liability will be immunized against interest rate risk and her asset portfolio will not require rebalancing.” Wholesome Foods: Wholesome Foods has issued A-rated fixed-rate corporate bonds to finance a research initiative conducted by Landlock, a facility conducting research on farming practices The bonds range from a maturity of 3.5 to 8.2 years, have a total market value of £120 million, BPV of £0.7 million, Macaulay duration of 6.2 years, and convexity of 58.1 After considerable discussion, Strong and Mendes identify three potential portfolios comprising AAA-rated investment-grade bonds for employment in a duration-matching approach (Exhibit 1) Exhibit Portfolio Current market value (millions) BPV Macaulay duration Convexity Term, Coupon A B C £130 £0.9 6.7 53.2 £120 £0.8 6.9 61.9 6.7 years, 7.3% 3.8 years, 3.5% 4.9 years, 6.5% £125 £0.7 6.2 58.1 1.5 years, 1.8% 4.1 years, 6.2% 7.5 years, 8.0% FinQuiz.com © 2018 - All rights reserved Reading 22 Liability-Driven and Index-Based Strategies FinQuiz.com During this process Mendes asks Strong whether the mismatch in credit ratings between the bonds constituting the asset and liability portfolios poses any risk to duration matching Strong anticipates that the recent decline in economic growth will result in a decline in corporate bond yields and will result in a negative duration gap between Wholesome Foods’ asset and liability portfolios She decides to negotiate three interest rate derivatives with a commercial bank (Exhibit 2) for the purposes of rebalancing the portfolio in the event of a duration mismatch Derivative Strike rate Premium paid Exhibit Purchased Receive-Fixed Receiver Swap Swaption 4.20% basis points 4.10% 120 basis points Swaption Collar Purchased receiver swaption: 5.00% Sold payer swaption: 5.50% basis points FinQuiz Question ID: 134577 From the perspective of her lender, Lake’s liability is most likely characterized as: A Type II B Type III C Type IV FinQuiz Question ID: 134578 Strong’s instructions to Mendes regarding Lake’s liability are inappropriate because she: A has not assumed that yield curve shifts are parallel B should use money duration to measure interest rate risk C has failed to consider that duration is not a static risk measure FinQuiz Question ID: 134579 Using the data in Exhibit and information on Whole Foods’ liabilities portfolio, the most suitable asset portfolio to achieve immunization using duration matching is: A Portfolio A B Portfolio B C Portfolio C FinQuiz.com © 2018 - All rights reserved Reading 22 Liability-Driven and Index-Based Strategies FinQuiz.com FinQuiz Question ID: 134580 Based on the data in Exhibit 1, which of the following statements is most likely correct? A Portfolio A has the greatest structural risk B Portfolio C is optimal for liquidity management C Portfolio B has the least cash flow reinvestment risk FinQuiz Question ID: 134581 The most appropriate response to Mendes’ query concerning the credit quality mismatch is a: A yes, exposure to spread risk increases B yes, exposure to model risk increases C no, because both bonds are of high credit quality FinQuiz Question ID: 134582 Using the data in Exhibit 2, Strong will select a purchased receiver swaption if the swap rate will: A exceed 5.00% B exceed 5.50% C be less than 4.20% FinQuiz.com © 2018 - All rights reserved .. .Reading 22 Liability-Driven and Index-Based Strategies FinQuiz. com FinQuiz Item- set ID: 134 576 Questions 1( 134 577) through 6( 134 582) relate to Reading 22 Time Associates Case... effective duration and 2) initial market values of the asset and liability portfolios are matched, Lake’s liability will be immunized against interest rate risk and her asset portfolio will not... Portfolio C FinQuiz. com © 2018 - All rights reserved Reading 22 Liability-Driven and Index-Based Strategies FinQuiz. com FinQuiz Question ID: 134 580 Based on the data in Exhibit 1, which of the following