2019 CFA level 3 qbank reading 22 introduction to fixed income portfolio management answers

Question #1 of 13 Credit risk is a major source of concern for repo agreements Protection against borrower default can be mitigated by the safety of the underlying security that is used as collateral and the "haircut" that requires additional capital over the principal borrowed amount Which of the following statements regarding the hair cut is most accurate? A) The size of the haircut increases as the volatility of the underlying asset increases B) The size of the haircut is not related to the underlying asset’s volatility .in C) Average credit spreads determine the haircut, not volatility Explanation (Study Session 11, Module 22.3, LOS 22.e) bo ok c Related Material w w w o m SchweserNotes - Book Question #2 of 13 en tre Haircuts for highly rated government securities are typically around 1% to 2% and will be higher for more risky securities As the underlying security increases in volatility, the haircut percentage generally increases to provide further credit protection against the possibility of default by the borrower Tara Harris is the lead portfolio manager for the Quantas Bond Fund and needs to raise $8,000,000 to meet expected withdrawals this quarter Quantas Bond Fund's investors primarily consist of medical professionals that are taxed at the top tax bracket in the U.S Harris is considering selling two bonds this quarter to meet the expected redemptions Selected data for the two bonds: Bank Bond Current Market Value $8,000,000 $8,000,000 Capital gain/loss $200,000 -$400,000 Coupon Rate 3.50% 4.00% Maturity 12 years 12 years Investment committee analysis Undervalued Overvalued 39% Capital Gains tax rate 15% en tre Top U.S Income tax rate in Telecomm Bond bo ok c Based on the above information, the optimal tax loss harvesting strategy is: A) Sell $6,000,000 of the Telecomm Bond and $2,000,000 of the Bank Bond B) Sell $8,000,000 of the Telecomm Bond C) Sell $8,000,000 of the Bank Bond m Explanation o The optimal strategy is to sell $8,000,000 of the Bank Bond and realize a $400,000 loss for tax considerations The loss can be used to o set current or future capital gains for tax purposes w w (Study Session 11, Module 22.3, LOS 22.f) Related Material w SchweserNotes - Book Question #3 of 13 Jake Tyler is new to investing and has learned that correlation among assets is important in determining diversi cation bene ts However, Jake also begins to wonder if asset class volatility is also important in understanding portfolio risk The most correct statement regarding bond volatility by Tyler is: A) Bonds are generally less volatile than equities B) Bonds are generally more volatile than equities C) Bonds have the same volatility as equities Explanation Volatility of the asset class is also important in determining portfolio risk and bonds generally have less volatility than equities (Study Session 11, Module 22.1, LOS 22.a) Related Material SchweserNotes - Book in Question #4 of 13 The bond type that provides the best in ation hedge and protects against in ation for both the en tre coupon payments and the principal received at maturity are: A) xed – coupon bonds B) in ation linked bonds bo ok c C) oating-coupon bonds Explanation In ation Linked Bonds (see chart below) Coupon Protected o In ation linked bonds not protected not protected m Fixed-coupon bonds Par Floating-coupon bonds Protected Protected not protected w w (Study Session 11, Module 22.1, LOS 22.a) Related Material w SchweserNotes - Book Question #5 of 13 Which of the following are common xed-income derivatives that are traded on exchanges? A) Bond futures and options on futures B) Interest rate swaps and bond futures C) Interest rate swaps and credit default swaps Explanation A common alternative to investing directly in bonds is to use xed-income derivatives Bond futures and options on futures are traded on exchanges, while interest rate swaps and credit default swaps trade over the counter (OTC) Since the nancial crisis, many OTC securities are starting to have similar features compared to exchange traded products (i.e initial margin, daily cash settlement, etc.) (Study Session 11, Module 22.1, LOS 22.c) Related Material SchweserNotes - Book Question #6 of 13 in Which of the following statements listing the typical liquidity of xed income sub-sectors from en tre highest to lowest is most accurate? A) Sovereigns, corporate bonds with shorter maturity, corporate bonds with longer maturity B) Corporate bonds with shorter maturity, corporate bonds with longer maturity, bo ok c Sovereigns C) Corporate bonds with shorter maturity, Sovereigns, corporate bonds with longer maturity Explanation o m Bond market liquidity is not constant among xed income sub-sectors Sovereign government bonds are generally more liquid than corporate bonds and bonds with longer maturities are generally less liquid than shorter-maturity bonds since many purchasers of long-term bonds intend to hold them until maturity, i.e they stop trading after a while w w (Study Session 11, Module 22.1, LOS 22.c) Related Material w SchweserNotes - Book Question #7 of 13 Which of the following liability-based strategies provides the lowest expected return and requires the lowest risk and complexity in its design? A) Horizon matching B) Contingent immunization C) Cash ow matching Explanation Cash ow matching Comparison of Liability-Based Strategies Initial funding required (PVA) Risk and complexity Expected realized return if successful (3) Lowest (1) Lowest (1) Horizon matching (2) (2) (2) Duration matching Lowest (1) (3) (3) Contingent immunization Highest (4)* Highest (4) Highest (4) (Study Session 11, Module 22.1, LOS 22.b) Related Material bo ok c SchweserNotes - Book w w o m Question #8 of 13 w en tre *This re ects the requirement to initially overfund with a surplus in Cash ow matching Tami Taylor works for a large multinational corporation based in Texas that recently purchased Euro 5,000,000 of Greek bonds from a large shipping conglomerate Taylor has been called to tomorrow's Board meeting to discuss the investment Selected Data on the Greek Bond Portfolio: Euro 5.00 Average bond coupon payment (per Euro 100 par) Euro 5.50 Coupon frequency Annual Current average bond price Euro 94.12 in Notional principal of the shipping conglomerate bonds (in millions) Euro 94.74 Average bond convexity 0.25 Average bond modi ed duration en tre Expected average bond price in one year (assuming unchanged yield curve) 5.00 0.50% Expected credit loss 0.20% bo ok c Expected average yield and yield spread change Expected currency losses (Euro depreciation versus $) 0.25% Assuming no reinvestment income the calculated expected return of the Euro bond portfolio next year is closest to: m A) 4.25% .o B) 3.75% w w C) 3.55% w Explanation Total expected return = Rolling yield + E(Change in price based on investor's yield and yield spread view) – E(Credit losses)+ E(Currency gains or losses) Rolling yield = Yield income + Rolldown return Return Component Yield income Formula Annual coupon payment/Current bond price = Rolling yield (Bond priceEnd−of−horizon period −Bond priceBeginning−of−horizon period  ) Bond priceBeginning−of−horizon period Yield income + Rolldown return Given + E(Currency gains or losses) Given o w w = Total expected return m – E(Credit losses) bo ok c en tre + E(Change in price based on investor's [–MD × ΔYield] + [ẵ ì Convexity ì (Yield)2 ] yield and yield spread view) in + Rolldown return w The portfolio's yield income (current yield) is 5.84% The portfolio has average coupon payments of Euro 5.50 on Euro 100 Notional and currently trades at Euro 94.12 The current yield (yield income) is Euro 5.50 / Euro 94.12 = 5.84% Assuming we are at the end of year one and we had an unchanged yield curve, the rolldown return is (Euro 94.74 – Euro 94.12) / Euro 94.12 = 66% The rolling yield (yield income + rolldown return) is 5.84% + 66% = 6.5% The expected change in price based on Tami's expectation of yield spreads is -0.5% The bond portfolio has a modi ed duration of 5.0 and a convexity of 25 The expected change in bond price is: (-5 × 005) + (.5 × 25 x 0052) = -.025 = -2.5% Tami expects 2% credit loss in her Euro bond portfolio Tami expects the Euro to depreciate by 25% over the next year versus the U.S dollar resulting in a 25% loss to the portfolio The total expected return, combing the components is: + 5.84% Yield Income + 0.66% Rolldown return - 2.50% Expected change in price based on Tami's view on yield spreads - 0.20% Expected credit losses in Euro bonds - 0.25% Expected depreciation of Euro versus USD = 3.55% (Study Session 11, Module 22.2, LOS 22.d) Related Material in SchweserNotes - Book Question #9 of 13 en tre Leslie currently has 40% of her overall portfolio invested in a diversi ed xed-coupon bond portfolio with an average duration of years The remainder of her portfolio is evenly spread across both large and small cap stocks that are balanced globally across many sectors and countries, primarily through diversi ed ETFs Leslie primarily wants to reduce the overall risk of bo ok c her portfolio and also keep up with in ation until she retires in 16 years Leslie is a professional photographer and has a limited understanding of the nancial markets During a recent meeting with her nancial advisor, Leslie was informed of some changes she should consider making to her portfolio Her advisor identi ed that the correlation coe cient of Leslie's current bond portfolio with her equity holdings is - 05 Also, the correlation m coe cient between her equity holdings and an ETF consisting of in ation-linked bonds is 23 .o Finally, the approximate correlation coe cient between Leslie's current xed income portfolio and the proposed in ation-linked ETF is relatively high at 55 w w Her advisor recommends that Leslie should diversify her current xed-coupon bond holdings by adding in ation- linked bonds to her portfolio w The following action Leslie would take considering her primary goal is to reduce her portfolio risk and also keep up with in ation until she retires is most likely: A) ignore the recommendation since her portfolio is already properly diversi ed B) reduce her current bond holdings by 25% and purchase small cap emerging market stocks with the proceeds C) rebalance 25% of her xed Income holdings into in ation-linked bonds Explanation Rebalancing 25% of her xed income holdings into in ation-linked bonds to an already diversi ed portfolio of bonds and stocks generally results in superior risk-adjusted real portfolio returns Leslie can also lower the overall risk of her portfolio by adding in ation linked bonds to her portfolio The correlation between nominal xed–coupon bonds and in ation-linked bonds is 55, which is less than 1.0 Adding the in ation-linked bonds helps to meet Leslie's requirement to keep up with in ation Increasing the percentage of the portfolio in emerging markets stocks will not reduce the overall portfolio risk as Leslie has requested Based on Leslie's primary goal, she should follow her advisor's advice and add in ation-linked bonds to her portfolio (Study Session 11, Module 22.1, LOS 22.a) Related Material en tre in SchweserNotes - Book Question #10 of 13 Jim is a new associate in operations at a mid-sized xed income consulting rm Jim is trying to bo ok c learn the bene ts of cash ow matching versus duration matching and reaches out to some of his friends on Wall Street for assistance in understanding the key features of liability-based mandates Jim's friend Je tells Jim that the key features of cash ow matching include: making no yield rebalancing is not required m curve assumptions, matching the bond portfolio's cash ows to existing liabilities and frequent o Jim also called his friend Ted who tells Jim the bene ts of cash ow matching include: accommodating multiple yield curve assumptions, frequent rebalancing and the ability to w w handle increased complexity, so many advanced traders like this strategy overall Which of Jim's friend's explanation of cash ow matching is most accurate? w A) Ted’s statement B) Neither Je nor Ted statements are correct C) Je ’s statement Explanation Je 's statement is the most accurate Cash ow matching makes no yield curve assumptions', rebalancing is not required, and bond portfolios are created to match cash ows with liabilities (Study Session 11, Module 22.1, LOS 22.b) Related Material SchweserNotes - Book Question #11 of 13 Amanda Smith is a new member of a large pension fund and her team is focused on xed income investing Amanda has been researching in ation-linked bond volatility and how this volatility compares to the volatility found with conventional bonds and equities After concluding her analysis, Amanda is most likely to nd: A) In ation-linked bonds generally are more volatile than conventional bonds but less volatile than equities B) In ation-linked bonds have the same volatility as conventional bonds but less volatility than equities C) In ation-linked bonds generally have lower return volatility than conventional in bonds and equities en tre Explanation In ation-linked bonds are linked to real interest rates, not nominal rates and real rates are generally not as volatile as conventional bonds or equities (Study Session 11, Module 22.1, LOS 22.a) Related Material bo ok c SchweserNotes - Book m Question #12 of 13 o The following is selected data on Omega Fixed-Income Mutual Fund $105.00 Average Modi ed duration 8.50 Average Annual Coupon $1.50 PV of assets (millions) $120.00 w w w Current average bond price Value of Portfolio's equity (millions) $62.25 Value of borrowed funds (millions) $30.26 Borrowing rate 1.75% Return on Invested Funds 4.25% The leveraged portfolio return for the Omega Fixed Income Mutual Fund is closest to: A) 9.43% B) 5.75% C) 5.47% Explanation Return on the leveraged portfolio = Return on invested funds + (value of borrowed funds / value of portfolio's equity) x (return on invested funds – borrowing rate) = 4.25% + ($30.26 million / $62.25 million) x (4.25% - 1.75%) = 5.47% (Study Session 11, Module 22.3, LOS 22.e) Related Material SchweserNotes - Book in Question #13 of 13 en tre Je Timura is currently the lead portfolio manager for an International xed income portfolio Timura has an upcoming meeting on December 20th with his largest client, Tucker Powell, to discuss the rm's outlook for the upcoming year At the meeting, Timura tells Powell that he expects the yield curve to continue to remain unchanged for the next 16 months Assuming the bo ok c forecast is correct, which of the following statements is most likely correct? A) The current yield (yield income) of an international global portfolio is an incomplete measure of the portfolio’s expected return B) Since Timura is expecting a stable yield curve, yield income is a good estimate of the bond portfolio’s expected return for next year m C) The best estimate of the bond’s return is the portfolio’s yield income plus its w w Explanation o rolldown return minus its expected credit losses Yield income (current yield) is an incomplete measure of a bond portfolio's expected return w Decomposing expected xed-income returns allows an investor to di erentiate among several important return components At the most general level, expected returns (denoted as E(R) below) can be decomposed (approximately) in the following manner: E(R) ≈ Yield income + Rolldown return + E(Change in price based on investor's views of yields and yield spreads) − E(Credit losses) + E(Currency gains or losses) (Study Session 11, Module 22.2, LOS 22.d) Related Material w w w o m bo ok c en tre in SchweserNotes - Book ... gains for tax purposes w w (Study Session 11, Module 22 .3, LOS 22. f) Related Material w SchweserNotes - Book Question #3 of 13 Jake Tyler is new to investing and has learned that correlation among... Assuming no reinvestment income the calculated expected return of the Euro bond portfolio next year is closest to: m A) 4.25% .o B) 3. 75% w w C) 3. 55% w Explanation Total expected return = Rolling... Income holdings into in ation-linked bonds Explanation Rebalancing 25% of her xed income holdings into in ation-linked bonds to an already diversi ed portfolio of bonds and stocks generally results