Reading 23 Yield Curve Strategies FinQuiz.com FinQuiz.com CFA Level III Item-set - Question Study Session 11 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 23 Yield Curve Strategies FinQuiz.com FinQuiz Item-set ID: 134615 Questions 1(134616) through 6(134621) relate to Reading 23 Sunrise Associates Case Scenario Celine Tyson is a fixed-income portfolio manager at Sunrise Associates, an asset management firm Tyson manages a $20 million portfolio of 5% annual coupon-paying corporate bonds which carry a credit rating of ‘B’ Each bond in the issue is priced at $98.76 per 100 of par The portfolio is benchmarked to an index constituting corporate and Treasury bonds For the next 12 months, Tyson has forecasted a decline of 150 basis points across the yield curve To take advantage of this opportunity, she would like to extend her portfolio’s duration and is exploring the following two strategies for doing so: Strategy A: Use leverage to purchase bonds each of which has a duration equal to that of the original portfolio’s This strategy illustrated in Exhibit Strategy B: Use interest rate swaps The only reservation Tyson has with Strategy A is the “additional liquidity, credit and interest rate risk associated with the strategy” Exhibit 1: Details Concerning Strategy A Required duration 8.50 Current effective duration 6.00 Effective convexity 1.15 Portfolio equity $20 million Required additional PVBP $5,000 Expected bond price in 12 99.34 months (per 100 of par) Next, Tyson discusses her forecast with Liam Knight, a senior economic analyst at the firm, who is of the view that Tyson’s forecast is inaccurate Knight predicts a different Treasury yield curve outlook (Exhibit 2) and incorporates a higher interest rate volatility assumption over the same forecast horizon FinQuiz.com © 2018 - All rights reserved Reading 23 Yield Curve Strategies FinQuiz.com Exhibit 2: Knight’s 12-Month Projected Yield Curve Outlook Yield Curve Shift Maturity Current Yield (%) (%) Yield Forecast (%) 2-Year 1.75 + 1.50 3.25 5-Year 1.99 + 0.35 2.34 10-Year 2.89 0.00 2.89 30-Year 3.10 - 1.80 1.30 Butterfly spread 0.93 1.23 (2-10-30) In light of the new information, Tyson decides to modify her original positioning strategy and is now considering how best to increase convexity for enhancing return Tyson lists down two alternative strategies which she will consider for implementation: Strategy C: Construct a bullet/barbell/laddered portfolio using 2-, 5-, 10-, and/or 30-Year Treasuries Strategy D: The derivatives approach – purchase call options on long-term Treasury bonds Tyson presents the results of her strategy to the firm’s investment committee She concludes the presentation with the following statements: Statement 1: “For parallel yield curve shifts, a barbell portfolio will outperform a bullet portfolio because of the embedded convexity.” Statement 2: “For nonparallel yield curve shifts, the bullet portfolio always outperforms the laddered and barbell portfolios.” FinQuiz Question ID: 134616 The amount of leverage required under Strategy A is closest to: A $5.88 million B $8.33 million C $23.48 million FinQuiz Question ID: 134617 Is Tyson correct regarding the additional risks associated with Strategy A? A Yes B Only with respect to interest rate risk C Only with respect to interest rate and credit risk FinQuiz.com © 2018 - All rights reserved Reading 23 Yield Curve Strategies FinQuiz.com FinQuiz Question ID: 134618 The swap position required for implementing Strategy B will be a: A fixed-rate payer B fixed-rate receiver C floating-rate receiver FinQuiz Question ID: 134619 Using the data in Exhibit 2, which of the following portfolio structures will generate the highest profits if Strategy C is executed? A Bullet: Purchase 10-year Treasuries B Barbell: Purchase 2- and 30-Year Treasuries in equal amounts C Laddered: Purchase 2-, 5-, 10- and 30-Year Treasuries in equal amounts FinQuiz Question ID: 134620 A shortcoming of purchasing options to modify portfolio convexity is that the: A strategy will work poorly when interest rates move significantly B opportunity to accumulate yield premium is reduced if the time horizon is short C cost of the strategy can be high if the direction of interest rate movements is uncertain FinQuiz Question ID: 134621 Considering Tyson’s concluding remarks in her presentation, she is least accurate regarding: A Statement B Statement C both of the statements FinQuiz.com © 2018 - All rights reserved .. .Reading 23 Yield Curve Strategies FinQuiz. com FinQuiz Item- set ID: 134 615 Questions 1( 134 616) through 6( 134 621) relate to Reading 23 Sunrise Associates Case Scenario... Yield Forecast (%) 2-Year 1.75 + 1.50 3. 25 5-Year 1.99 + 0 .35 2 .34 10-Year 2.89 0.00 2.89 30 -Year 3. 10 - 1.80 1 .30 Butterfly spread 0. 93 1. 23 (2-10 -30 ) In light of the new information, Tyson decides... Only with respect to interest rate and credit risk FinQuiz. com © 2018 - All rights reserved Reading 23 Yield Curve Strategies FinQuiz. com FinQuiz Question ID: 134 618 The swap position required