Questions and Answers Flashcards
Capital Market Expectations
What is consistent with a likely weak economy in the future?
When both fiscal and monetary polices are restrictive, the yield curve is downward-sloping (i.e. it is inverted as short-term rates are higher than long-term rates), and the economy is likely to contract in the future
Capital Market Expectations
During an economic recession, what will increase?
Bond prices increase during a recession as inflationary decreases and interest rates decline causing bond prices to increase since they are inversely related to the change in interest rates
Capital Market Expectations
What is not an input to the Taylor Rule?
The Taylor rule determines the target interest rate using the neutral rate, expected GDP relative to its long-term trend, and expected inflation relative to its targeted amount
Capital Market Expectations
Describe the effects of the use of Monetary Policy to stimulate growth or rein in inflation in an economy.
Both direction of a change in interest rates and the level of interest rates are important. If, for example, rates are increased to say 4% to combat inflation but this is still low compared to the neutral rate of 6% in a country, then this rate may still be low enough to allow growth and inflation to continue
Capital Market Expectations
Suppose that the consumer price index (CPI) is expected to change from 124 to 118. what asset class is most likely to perform the best during such a period?
The inflation index forecast suggests that deflation is expected. Nominal rate bonds should perform the best under that scenario because the purchasing power of the coupon payments would increase. Given the high-quality nature of the bonds, concerns about default are unlikely to dominate this greater purchasing power benefit
Capital Market Expectations
Suppose the economy is expected to grow at its long-term trend rate, target inflation is 2%, the inflation index is expected to increase to 3%, and the central bank’s real neutral short-term interest rate is 1%. The target nominal short-term interest rate should be closest to?
Since the real neutral inflation is 3%, the adjustment will be made to the nominal 4% short-term rate. Given that GDP is growing at its long-term trend, this will not impact the adjustment using the Taylor Rule. With inflation at 3% and target inflation at 2%, the central bank will increase interest rates by one-half the difference, resulting in a nominal target rate of 4.5%
Capital Market Expectations
What is not a characteristic of the economic indicators as used in economic forecasting?
A. Are difficult to understand and interpret
B. Have an effectiveness that has been verified by academic research
C. Can be adapted for specific purposes
Economic indicators are actually easy to understand and interpret
Capital Market Expectations
An analyst has accurately estimated a real growth rate of 3% in his discounted cash flow model by examining the growth of the economy. Population growth is expected to be 1%, labor force participation is expected to grow by 0.5% and capital expenditures are expected to grow by 1%. What best describes the analyst’s estimate of growth?
The analyst:
A. Has not accounted for ** in the forecast
B. Is anticipating technological progress
C. Is forecasting unrealistic growth
B. Total factor productivity, such as technological progress, can reasonably explain the differential between the inputs to economic growth and the analysts growth rate in the discounted cash model. (inflation is no a concern since the analyst is working with real numbers)
Capital Market Expectations
Which of the following is least likely to be considered an exogenous shock?
A. Political tensions arising between two neighboring countries
B. Strong economic recovery following a slow recession
C. Discovery of a new natural resource to be used in production
B Normal business cycle activity is not considered exogenous since the activity is built into the asset price. The other items are considered exogenous in that they arise out side the normal economic cycle.
Capital Market Expectations
Suppose that currently, monetary policy is stimulative and fiscal policy is restrictive. Which of the following most likely describes the shape of the yield curve?
A. Very Steep
B. Inverted
C. Moderately Steep
Stimulative monetary policy will result in lower short-term rates. Restrictive fiscal policy will slow economic activity thus likely reducing rates in the future. The net result is a moderately steep yield curve. If both were stimulative, the yield curve would rise sharply and ve very steep. An inverted yield curve is normally the results of restrictive monetary and fiscal policy
Capital Market Expectations LM2
What is not indicative of low risk in an emerging market economy?
The debt-to-GDP ratio of 70% to 80% has been troublesome for emerging countries. A current account deficit exceeding 4% of GDP has been a warning sign of potential difficulty. Foreign exchange reserves less than 100% of short-term debt is a sign of trouble ( greater than 200% is considered strong)
Capital Market Expectations LM2
Suppose that an equity market has a dividend yield of 3%, real earnings growth of 2%, inflation of 1%, and a 0.5% reduction in shares outstanding anticipated. Furthermore, the P/E ratio is expected to rise from 16 to 16.32. The return on the market that would be forecast by the Grinold-Kroner model would be closest to:
The forecasted return includes all the elements of Grinold-Kroner. The reduction in shares outstanding represents a repurchase yield and adds to the forecasted return. The increase in the P/E ratio would result in an addition return. Numerically, the return is computed as:
dividend yield + real earnings growth+inflation - (-reduction in shares)+((expected P/E/ current PE) -1)
3% + 2% +1% -(-0.5%)+((16.32/16)-1) = 0.085
Capital Market Expectations LM2
ABC is a bond fund engaging in active management. ABC has expertise in identifying and improving credit conditions and, therefore, is willing to accept significant credit risk. If ABC seeks to increase the premiums earned by accepting credit risk, which of the following strategies is most likely to be pursued by ABC?
A. Increasing the maturities of credit-risky bonds
B. Shifting from AA to AAA bonds
C. Decreasing the maturities of credit-risky bonds
Shortening maturity is the correct strategy since credit premiums have been shown to be especially generous at the short end of the curve. Increasing the maturities of credit risky bonds would go against the empirical evidence about term and premiums. Moving from AA to AAA bonds would be an effective way to take on increasing credit risk because that would be a move toward safer investments and away from the expertise of the fund.
Capital Market Expectations LM2
Joshua Petersen is a real estate analyst that want to make appropriate adjustments to a capitalization rate. He predicts that vacancy rate will increase and that the availability of credit will decrease. Based on these views, it is most likely that Petersen:
A. Should increase the capitalization rate
B. May need to either increase or decrease the capitalization rate because the two predictions have?????
C. Should decrease the capitalization rate
Capitalization rate are positively related to vacancy rates and inversely related to the availability of credit, Therefore, the appropriate adjustment to the capitalization rate would be to increase it. This is logical since both factors should negatively impact the value of real estate, which would also be the result of higher capitalization rates.
Capital Market Expectations LM2
What factors would most likely be considered a sign that an emerging market is more susceptible to risk?
Less developed and smaller financial markets, and wealth concentration are both signs that an emerging market is more susceptible to risk. A greater dominance of cyclical industries, including commodities, is also a sign of increased risk.
Capital Market Expectations LM2
What best describes an advantage and disadvantages of using factor-based variance/covariance matrices versus sample variance/covariance matrices in estimating volatility?
The use of a few common factors greatly reduces the number of observations needed to produce a variance-covariance matrix and is a strength of the factor-based approach. The disadvantages of the factor-based approach are that the matrix is not unbiased and is not consistent.
Capital Market Expectations LM2
An analyst estimates the following statistics for properties in the commercial real estate sector: Current capitalization (cap) rate: 4.3%, next year’s expected cap rate: 3.8%, net operating income (NOI) real growth rate: 1.2%, expected inflation: 0.9%. Based on the information provided, the expected return on the commercial real estate sector property is closest to:
To find the change in the expected cap rate from 4.3% to 3.8% you will need to subtract the current cap rate from the expected cap and then divide it by the current cap rate:
(3.8% - 4.3%) / 4.3% = -11.6%
The expected return on the commercial real estate properties can be written as:
E(RRE) = Cap Rate + Nominal NOI Growth Rate - %▲Cap rate =
4.3% + (1.2% + 0.9%) - (-11.6%) = 18.0%
Capital Market Expectations LM2
Christopher Lawe is an analyst examining data from a country he believes is experiencing significant economic changes over both the short and long term. In the short term, the economy is at the trough of a cycle, and in the long term he believes the country will experience increased integration with the world market. Based on Lawe’s analysis, the country’s equity market is most likely to experience what?
Equities tend to do well from a point when the economy is at a trough because future economic expansion positively impacts returns. An increase in integration will reduce the risk of the equity market, thus reducing required returns. The reduction in required returns will increase equity prices and result in higher returns through increased integration
Capital Market Expectations LM2
What statement regarding risk in emerging market economies is least accurate?
A. Their undiversified nature makes them susceptible to volatile capital cows and economic crisis
B. Inadequate fiscal and monetary policies
C. The economies are often heavily dependent on consumer durables
C. Small economies are often heavily dependent on the sale of commodities and their undiversified nature make them susceptible to volatile capital flow and economic crises
Capital Market Expectations LM2
Suppose that an equity market has a dividend yield of 3%, real earning growth of 2%, inflation of 1%, and is experiencing a reduction in shares outstanding of 0.5%. The P/E ratio is expected to rise from 16 to 16.32. The repricing return is expected to be closest to:
The repricing component is the percentage change in the P/E ratio.
(16.32 / 16) - 1 = 2%
Overview of Asset Allocation
Asset classes may share different sources of risk. An alternative to asset allocation is the use of risk factors. Describe this approach
Risk factors describe the sources of risk for an asset class, not the other way around. The objective of risk factors is to determine the systematic source of risk of all asset classes and then construct an asset allocation around desirable exposures to these risk factors. Risk factors are often not investable (i.e. inflation). Asset classes often have overlapping risk factors. For example, credit and equities will have overlapping risk factors.
Examples of risk factors include volatility, liquidity, inflation, interest rates, duration, foreign exchange, and default risk.
Overview of Asset Allocation
Regarding the use of risk factors when making asset allocation decisions, what is most correct?
A. Multifactor models can be used to isolate systematic risk exposures
B. Risk factors cannot be used at units of analysis in asset allocation
C. Risk factors are as easy to invest in as an asset class
A. - Multifactor models can be used for asset allocation by creating factor portfolios, which isolate systematic risk exposures (i.e., non-diversifiable risks). Risk factors can be used as units of analysis in asset allocation. But one problem is that it is not always easy to determine how to invest in those identified risk factors. Some may be investable and others may not. Asset classes are by definition assets that are owned and investable, though the cost and ease of investing varies
Overview of Asset Allocation
Concerning asset allocation risk measures, what statistical risk measures are most likely associated with a defined benefit plan utilizing an asset-only approach?
For the asset-only approach, the relevant risk measure is the standard deviation of portfolio returns, which incorporates asset-class volatilities and asset-class return correlations. This case specifically says an asset only approach is being used and that is not uncommon for DB plans. Arguably a liability relative style is more appropriate, but the asset only approach can implicitly deal with the liabilities by targeting a rate of return sufficient to meet the liability payouts.
Overview of Asset Allocation
Explain key characteristics of asset classes.
A desirable characteristic of asset classes is they should not be highly correlated with each other. Furthermore, asset classes should be mutually exclusive and collectively mutually exhaustive.
Overview of Asset Allocation
What strategic rebalancing considerations encourage the use of a wider rebalancing range?
Higher transaction costs for an asset class imply wider rebalancing ranges. If investors believe that current trends will continue, an argument can be made for using wider rebalancing corridors. More risk-averse investors and beliefs in mean reversion both encourage tighter rebalancing corridors.
Overview of Asset Allocation
Bruce Calloway is interested in utilizing an appropriate asset allocation strategy for his portfolio. His long-term view of the capital market conditions is that there will always be change and opportunities to capture excess returns in the market. A risk neutral investor, his is a consistent risk taker and his risk tolerance on his portfolio can be expected to be constant based on such market expectations. What asset allocation strategy is the best strategy for his portfolio?
The most appropriate asset allocation strategy is the tactical strategy. This strategy assumes that the investor’s risk tolerance is constant and his capital market expectations are subject to frequent change. The tactical tolerances do change with changes in wealth levels. For example, when the market conditions are bearish, the investor’s view of risk does not change concerning capital commitments to stocks. It will allocate a consistent portfolio level to cash or bonds. In a bull market or when the markets rally, the investor’s risk tolerance will not change and will continue to allocate consistent amounts of stocks and cash or bonds.
Overview of Asset Allocation
What strategic asset allocation analysis means?
This is often expressed as a percentage of total value invested in each asset class. Strategic asset allocation analysis is usually done whenever the investor’s circumstances change significantly and is often done as frequently as annually. It is based on long-run capital market conditions, and requires transactions to rebalance the mix periodically
Overview of Asset Allocation
An Organizatioin has positive net worth. This implies that the…..
A positive economic net worth implies that the value of the organization’s economic assets exceeds the value of economic liabilities. Economic assets and liabilities include the traditional account balance sheet assets and liabilities as well as extended portfolio assets and liabilities that are not included on traditional balance sheets. Therefore, extended portfolio assets and liabilities alone do not cover off the economic net worth. Although it would be unusual in practice, the economic net worth could be positive in theory even if the accounting owner’s equity is negative.
Overview of Asset Allocation
According to modern portfolio theory, which risk is rewarded?
According to modern portfolio theory, only systematic risk is rewarded. Total risk (may be measured by standard deviation) is comprised on systematic and unsystematic risk
Overview of Asset Allocation
What is a less than desirable characteristic of an asset class used for describing the returns on a portfolio?
A less than desirable characteristic of an asset class when describing portfolio returns is high volatility; meaning large price fluctuations, which indicates a high risk of potential losses and can negatively impact the overall stability of a portfolio, even if it also has the potential for high returns
Overview of Asset Allocation
Which of the following would indicate that an asset class is useful for describing the returns of a portfolio? (explain)
A. The intercept term is significantly different from zero
B. The error term is high
C. The R-Squared of the model is high
C - A high R-squared would indicate that the model explains a good proportion of portfolio returns.
Overview of Asset Allocation
What statements regarding the strategic asset allocation process is least accurate?
A. The strategy asset allocation review is typically performed once per year
B. Strategic asset allocation, similar to tactical asset allocation, employs a short-run capital market projection
C. The strategic asset allocation must be rebalanced periodically for changes in the valuation of the various asset classes in the portfolio
B - Strategic asset allocation employs a long-term capital market projection
Overview of Asset Allocation
Deviation from the policy portfolio due to short-term capital market expectation is called _____________?
Tactical asset allocation is the deviation from the policy portfolio (Strategic Asset Allocation) based on short-term capital market expectations
Overview of Asset Allocation
Decision-reversal risk is likely to:
Decision-reversal risk is thoughtlessly reversing a previous instrument decision, at the worst time; it is much more than merely changing investment strategy as the key words are “worst time”. It commonly occurs when less knowledgeable investors get into complex positions they do not understand, panic when things don’t go well, and sell. Thoughtless selling when an asset is down would likely reduce upside recovery and create a negative (cut of the upside) skew in the returns. It refers primarily to the investor panicking and is presumably less common in more knowledgeable institutional investors who have more access to investment information.
Overview of Asset Allocation
What is an unlikely characteristic of strategic asset allocation?
Strategic asset allocation takes into account long-term capital market expectations and the investor’s investment policy statement (risk/return objectives and constraints).
Principles of Asset Allocation
A portfolio manager expects that transaction costs will rise next year and that the correlation of equities with the rest of the portfolio will rise. What is the net impact of those changes on the portfolio’s optimal rebalancing corridor width?
The rise in transaction costs and the rise in asset class correlation with the rest of the portfolio will result in an overall wider optimal portfolio width. Higher transaction costs allow for a wider corridor width because the asset mix would have to change more to justify the higher cost of rebalancing. Higher correlation of equities with the rest of the portfolio will lead to a wider corridor because the portfolio will move more with the asset class and the allocations will tend to stray more slowly from the target.
Principles of Asset Allocation
What statement about an investor’s goal-based asset allocation approach is the least correct?
A. The asset opportunity sets will consist of both taxable and tax-exempt investments
B. The goals-based asset allocation approach typically uses pre-established sub-portfolios to meet client goals
C. The investor’s different goals with specified probabilities of success will be averaged, and a single module with the highest expected return will be used
C, - The advantage of the goals-based asset allocation approach is that it can incorporate different goals by an investor that could differ by amount, timing, and urgency. Each goal is evaluated separately by looking at modules (pre-established sub-portfolios) that provide the minimum expected return needed to satisfy that goal. Goals are not average and multiple modules are used since each module will result in different minimum returns depending on the level of specified probabilities of success. The ass opportunity set for each module consists of both taxable and tax-exempt investments.
Principles of Asset Allocation
In the context of portfolio rebalancing, if the correlation of the asset class with the rest of the portfolio is lower, then the optimal corridor of the class will?
The lower the correlation of the asset class with the rest of the portfolio, the narrower the corridor, because the portfolio will not “move” as closely with the asset class so the allocations are more likely to diverge from the target allocation. Therefore, the corridor needs to be narrowed to control the risk.
Principles of Asset Allocation
What is true regarding the two-portfolio (or the hedging/return-seeking) approach to liability-relative asset allocation?
The hedging portfolio could be constructed using various techniques such as cash flow matching, and immunization. If the funding ratio is less than 1, it becomes difficult to create a hedging portfolio that completely hedges the liabilities. The two-portfolio approach has the distinctive feature that the composition of the liabilities is already in place when the asset allocation decisions are made, so the two decisions are made independently
Principles of Asset Allocation
A bank is most likely to use which approach for liabillity-relative asset allocation?
Banks (along with insurance companies and hedge funds with short positions) make decisions about the composition of their liabilities jointly with their asset allocation decisions, which makes the integrated approach most appropriate. Surplus optimization and the two-portfolio approach have the distinctive feature that the composition of the liabilities is already in place when the asset allocations decisions are made, so the two decisions are made independently
Principles of Asset Allocation
Explain the two-portfolio approach
A two-portfolio approach is an approach to liability-relative asset allocation that separates the asset portfolio into two sub-portfolios: a hedging portfolio and a return-seeking portfolio. It is one of three commonly used approaches, the other two being surplus optimization and integrated asset-liability approach. The two-portfolio approach is used to analyze a firm’s entire collection of businesses relative to one another
Principles of Asset Allocation
What heuristic and other approaches to asset allocation are most closely associated with the assumption of a lack of informationally efficient markets?
The endowment model has a large allocation to alternative assets as well as support for active management. The endowment model also seeks to earn illiquidity premiums. Those three factors suggest that there is an assumption of a lack of informational efficient markets. The Norway model’s asset allocation emphasizes publicly traded securities, which reflect a belief in the market’s informational efficiency.
Principles of Asset Allocation
A 30-year-old wealthy investor wants to maximize her allocation to commodity investments. What approaches to asset allocation would best achieve her objective?
The Endowment model (or Yale model) allows for higher allocation to alternative investments, including commodities, real estate, and private equity, than recommended under mean-variance optimization (MVO). The investor should select managers with significant exposure to these alternative asset classes. The model does not cap the allocation to alternative investments. The “120 minus age rule” considers only two asset classes: equities and fixed-income, with the equity allocation percentage determined as 120 minus age, but it does consider alternative investments. The “1/N rule” considers an equally weighted portfolio for each selected asset class. If commodities is one of the 10 asset classes selected, then this approach caps the commodities allocation at 1/10 = 0.10 or 10%, which may be insufficient for the investor
What is the “60/40” Stock-Bond Heuristic?
This approach goes directly for a static split of 60% stocks and 40% bonds for a truly one-size-fits-all approach. There is some evidence that the global market portfolio is close to the exact makeup of 60-40. However, this varies over time.
Principles of Asset Allocation
Explain the “120-minus age rule”
It is a guideline for investing. The concept behind the rule is to invest in high-risk, high-reward assets while you are young. The rule calculates a percentage dedicated to equity holding in any investor’s portfolio by the equation:
120 - Investors Age.
For example, a 30-year old investor would allocate 120-30 = 90, or 90% of their portfolio to stocks.
This rule is a one-size-fits-all approach and considers no facets of an investor’s life other than age. There is, also, no theoretical basis for this rule. However, it ends up approximating the relationship between human and financial capital over time.
Explain the Endowment Model
The endowment model, named after the endowment of Yale University in the 1990’s, pulls back on the typical public equity and passive management approach of many institutions, and instead has focused on large allocations to private equity and real estate. The endowment model also favors active management.
This model well for some large institutional investors, such as Yale, as these institutions are in an excellent position to earn the illiquidity premiums in these investments due to to their ability to meet the minimum investment amounts and lockup periods.
Explain the Risk Parity Approach and formula
The risk parity approach seeks to rectify a criticism of MVO in that while it diversifies risk across asset classes, it does not necessarily diversify across the sources of risk. The risk parity approach states that each asset class should contribute equal risk to the overall portfolio. A significant criticism of this approach is that it does not consider return.
The risk parity approach, which is somewhat contentious, has several variations. However, the most widely used version can be mathematically expressed as follows:
Ɯi X Cov (ri, rp) = 1/n δ^2p
Where:
Ɯi = Weight of asset i
Cov(ri, rp) = Covariance of asset i with the portfolio
n = Number of assets
δ^p = Variance of the portfolio
Typically, the problem has no closed-form solution and must be solved using optimization techniques such as mathematical programming. Before Markowitz introduced mean-variance optimization, which considers risk and return, most asset allocation methods only focused on return.
The main criticism of risk parity is that it ignores expected returns, a shortcoming shared by most rules-based risk approaches such as other forms of volatility weighting, minimum volatility, and target volatility.
The composition of the opportunity mainly influences the risk contribution in risk parity. For instance, if the opportunity set comprises seven equity asset classes and three fixed-income asset classes, 70% of the risk is expected to come from equities and 30% from fixed income. On the other hand, if the opportunity set comprises three equity asset classes and seven fixed-income asset classes, 70% of the risk will come from fixed-income and 30% from equities. Therefore, risk parity practitioners must know how their opportunity set is formed.
Principles of Asset Allocation
Mean-variance optimization (MVO) outputs using factor exposures differ from using asset class exposures that reflect the same underlying assets in that they:
A choice of whether to use factor exposures or asset class exposure depends on the way investors form capital market expectations. When factor exposures and asset class exposures reflect the same exposures (ie, underlying assets), the MVO results indicate that neither approach is superior to the other. As a result, their efficient frontiers will not be significantly different
Principles of Asset Allocation
Which of the following does not accurately reflect a statement describing the resampled efficient frontier?
A. At each level of return the most efficient of the simulated efficient portfolio is at the center of a distribution
B. A single portfolio with specific asset class weights at each level of return.
C. A portfolio may be considered statistically equivalent if the managers’ portfolio is within a 90% confidence interval of the most efficient portfolio
A single portfolio with specific asset class weights at each level of return describes traditional mean-variance optimization. The other answer choices describe the resampled efficient frontier where Monte Carlo simulation is used to create an efficient frontier at each return level and run thousands of times resulting in an efficient frontier that is the result of an averaging process. The efficient frontier becomes a blur rather than a single sharp curve. At each level of return, the most efficient of the simulated portfolios is at the center of the distribution.
Principles of Asset Allocation
A risk manager at HIJ Bank is worried that an increase in interest rates will negatively impact the bank’s surplus, while an increase in risk volatility may negatively impact some of its liabilities. What liability-relative asset allocation approach would be most appropriate for the bank?
Because the bank wants to look at both sides of the balance sheet through stress testing against future changes in multiple factors (interest rates and risk volatility), an integrated asset-liability approach is most appropriate. That approach will allow the bank to determine the optimal asset and liability mix to meet its objectives. Surplus optimization is an extension of mean-variance optimization (MVO) that manages the portfolio surplus against the surplus volatility. The two-portfolio approach segments the portfolio assets to hedge liabilities, and separately manages the remaining portfolio using MVO
Principles of Asset Allocation
The investment committee of a life insurance company recommends a strategic asset allocation for the company based on the projected policy premium inflows and payouts along with long-term capital market expectations. What is this approach to strategic asset allocation known as?
Asset-Liability Approach
Because the committee takes into account the company’s inflows and outflows, which are liabilities, the approach called asset-liability approach to strategic asset allocation
Principles of Asset Allocation
Andrew Tyson, age 31, has an existing investment portfolio consisting of investment-grade bonds and large-cap stocks. He also owns an apartment unit in the city and has a stable and promising career as an engineer. By including his apartment and his human capital in his investment portfolio, his capacity to bear risk would likely_____________?
Because human capital and residential real estate are two large, but often overlooked components of an investor’s total investment portfolio, including them in the analysis along with traditional investments would increase the investors capacity to bear risk
Principles of Asset Allocation
A pension fund has pension assets that significantly exceed the value of pension liabilities. The fund wants to minimize the risk that the pension plan will become unfunded. What liability-relative approaches is most appropriate for the fund?
The two-portfolio approach is most appropriate for the pension fund because it allows the fund to create an asset portfolio that hedges it liabilities, while separately creating a portfolio that manages the remaining assets using mean-variance optimization (MVO) under a return-seeking approach. Should the funded status of the plan deteriorate in the future, the manager could reduce allocation to the return-seeking portfolio and increase allocation to the hedging portfolio. Surplus optimization is an extension of MVO that manages the portfolio surplus against the surplus volatility. Integrated asset-liability approach jointly optimizes assets and liabilities, typically against future changes in multiple factors.
Principles of Asset Allocation
Which of the following statements regarding mean variance optimization (MVO) is least accurate?
A, All asset weights add up to 100%
B. Short positions are permitted
C. An individual with average risk aversion will have a lamda of about 4
A common constraint in MVO is the non-negativity constraint, which means all weights in the portfolio are positive and between 0 and 100% (there are no short positions). The most common constraint in MVO is known as the budget or utility constraint, which means the asset weights must add up to 100%.. Lamda is based on an investor’s willingness and capacity to take on risk. In practice, investors are assumed to have a lamda between 1 and 10, with an average level of 4
Principles of Asset Allocation
An institutional investor has a significant allocation to private equity in its portfolio. What approaches are least appropriate for addressing the liquidity risk of private equity in a mean-variance optimization (MVO) context?
A. Only exclude private equity as an asset class when running MVO
B. Include private equity as an asset class when running MVO using highly diversified asset class inputs
C. Include private equity as an asset class when running MVO but us the risk characteristics of private equity instead of private equity as an asset class
A
Illiquid asset classes, including private equity, can be included in or exclude from MVO. If they are excluded, they should be used to meet separately set target asset allocations. B & C are correct statements
Asset Allocation with Real-World Constraints
The Howarth School Foundation (HSF) has historically provided 30% of the annual operating costs of running the Howarth Law school. Recent changes in government funding mean that previously fully funded scholarships will now only be 40% funded and that HSF must provide more support to the school. Based on this information, HSF will most likely:
The school is becoming more dependent on the foundation, decreasing the ability to take risk and increasing liquidity demands for payouts to the school. Shifting to more liquid investments makes sense. Higher duration is not relevant and is probably riskier plus zero-coupons provide no regular cash flow. Higher return may seem logical but taking more risk to get it is not appropriate when ability to take risk has declined. Plus land is an illiquid asset.
2 Asset Allocation with Real-World Constraints
Julia Adamson is 77 years old, with a life expectancy of nine years. Adamson has told her portfolio manager that her portfolio needs to fund three buckets that each allow her to maintain her current standard of living: (1) from now until age 80, (2) age 80 to 90, and (3) age 90 to 100. Which of the three buckets should allow for the highest allocation to risky investments?
Given Adamson’s life expectancy of nine years, buckets 1 and 2 have the greatest priority. Investments allocated to those two buckets should be more conservative with greater emphasis on liquidity. Bucket 3 is at least four years outside of her life expectancy range and therefore, can be invested in higher risk investments to ensure asset growth for the longer-term should she exceed her nine-year life expectancy.
3 Asset Allocation with Real-World Constraints
Ruby Pascal is an institutional money manager managing a $200 million portfolio. The cost basis of each of five selected assets from the portfolio is above market value and Pascal decides to sell those assets. The least likely reason for the sale is:
Prior to a sale, when the cost basis of an asset exceeds its market value, the asset has an unrealized loss. The primary reason for selling assets with unrealized losses is to engage in tax loss harvesting. Tax loss harvesting involves realizing capital losses against current or future realized capital gains to reduce the portfolio’s overall tax liability.
4 Asset Allocation with Real-World Constraints
If an investment is held in an account that is taxed annually, the government bears:
If the investment returns are taxed solely as income at the tax rate t and the pre-tax standard deviation of returns is S, then the investor’s after-tax risk is S × (1 − t), and the government bears a portion of the risk.
5 Asset Allocation with Real-World Constraints
A pension fund is searching for an optimal portfolio by comparing the present value of contributions and contribution risk as measured by a 95% confidence interval that contributions will not exceed a given threshold. Which of the following portfolios would be the most efficient under these criteria?
The best choice will: minimize contribution risk which is the chance of having to increase contributions, and also minimize the expected present value of future contributions.
6 On a graph where the risk is on the horizontal axis and the returns are on the vertical axis, the existence of taxes on investment returns would probably shift the mvo portfolio
6 C Taxes lower returns, but they also shift some of the investment risk to the government.
9 Asset Allocation with Real-World Constraints
If an investment is held in a tax-exempt account, then the investor bears:
In a taxable account, losses realized result in a reduction in taxes that serve to offset the magnitude of the loss. Thus, some of the downside risk is transferred to the government. In a tax-exempt account, the variability of returns is not affected by the taxes.
11 Asset Allocation with Real-World Constraints
Carry in currencies is an example of which of the following forms of asset allocation?
Carry in currencies (as well as commodities and fixed income) is an example of systematic TAA; systematic TAA uses strategies that have historically been predicable and persistent. In the specific case of currencies, TAA determines which currencies should be overweighted or underweighted based on short-term interest rate expectations.
13 Asset Allocation with Real-World Constraints
Gil Tabor, CFA, and Jan Sills, CFA, are discussing how the choice of account type affects investment risk and the amount of that risk borne by the government via taxes. Tabor says that the government bears some of the tax risk in a tax-exempt account. Sills says the government bears some of the risk in a tax-deferred account before withdrawals occur. Concerning these assertions:
If the investment is held in a tax-exempt account, then the investor bears all the investment risk. This is also true for tax-deferred accounts before withdrawals occur because even though the government taxes the future accumulation, the variability of returns during the deferral period is not reduced by taxes levied at the time of withdrawal.
14 Asset Allocation with Real-World Constraints
Goals-based investing is most directly useful to counter
The answer is loss aversion based specifically on what the reading says. You have taken at least 2 CFA exams and know such picky questions are unusual. Exhibit good judgment, give your best guess, and move on.
15 Asset Allocation with Real-World Constraints
Peter and Cornelia Hargrave, both age 60, have a $2.5 million investment portfolio. The Hargraves want to retire in five years and as a result, use a strategic asset allocation of 55% equities, 40% bonds, and 5% cash. The portfolio is expected to provide income for 20 years after retirement and is invested among two equity portfolio managers and a fixed-income manager. Last week, the Hargraves learned that one of the equity portfolio managers has taken on extremely risky derivatives positions generating substantial losses that wiped out $500,000 of the $2.5 million portfolio. Given the change in portfolio value, Hargraves should reduce the exposure under the strategic asset allocation to which asset class?
Given the significant reduction in the portfolio value (20%) and only a modest amount of time prior to retirement, the Hargraves should reduce exposure (in terms of the percentage of the remaining portfolio assets) to riskier assets such as equities and increase exposure to less risky assets such as fixed income. The fixed income assets should be duration matched to meet the time to retirement, income needs at retirement, and life expectancy.
Option Strategies
Melinda has a long position on 50,000 of DWD Inc. (DWD). DWD is currently trading at $42 per share and it is widely believed that DWD’s price will not rise in the next year. She is concerned that the price could fall below $35. Assuming Melinda is seeking protection from her long position for the next year and wants to minimize her total costs, what is her least likely course of action?
Purchasing a put with a strike price of $41 will provide her with downside protection if the stock price falls from the current price of $42. However, selling a put with a strike price of $35 exposes her to losses if the stock price falls below $35 just like she is concerned about. Therefore, purchasing a 41 put and selling a 35 put is not an appropriate course of action. Purchasing a put with a strike price of $39 will provide her with downside protection if the stock price falls from the current price of $42. Selling a call with a strike price of $45 will provide her with some additional income since the stock price is not expected to rise. Therefore, this is a reasonable course of action. Purchasing a put with a strike price of $40 will provide her with downside protection if the stock price falls from the current price of $42. Therefore, this is a reasonable course of action.
Option Strategies
An investor is interested in buying KPQ shares but finds the current trading price of $128 too high. The investor is willing to pay $115 per share. Which of the following strategies is most appropriate for the investor?
The investor would receive premiums from selling the $115 strike price puts. If the share price declines below $115, the investor would be obligated to buy the shares at $115, although this price would be reduced by the option premium received from selling the puts. The investor would keep all future upside potential once the shares are purchased. The $115 strike price calls would be in-the-money by $13 each. This is equivalent to buying the shares at $128 (in fact it is more expensive given that the options would also have time value) and is therefore not appropriate. A collar would involve buying the shares at $128 and would also limit the investor’s upside potential and is not appropriate.
Option Strategies
Richard Macpherson recently entered into a six-month forward contract to buy 400 shares of Mobilia shares at $85 per share. Mobilia does not pay dividends. Which of the following strategies would be most effective as a synthetic hedge of Macpherson’s position?
A long forward contract can be hedged using a synthetic short forward contract. A synthetic short forward can be created by buying a put option and selling a call option with the same maturity and price as the forward contract.
Option Strategies
An investor is short 10 contracts of July $40 calls and short 10 contracts of July $40 puts on Alphastar shares. The investor does not own the underlying shares. Which of the following statements about the investor’s position is most accurate?
The investor has limited risk should the share price fall: the maximum loss is the $40 exercise price. However, the investor is exposed to unlimited risk if the share price were to rise since the price increase is not capped. (Note that this short position in an equal number of calls and puts on the same underlying with the same expiry is called a short straddle position.) The investor is not hedged against price changes in Alphastar shares. In fact, the investor will suffer losses if the share price declined or increased by more than the premiums received for the options. A rise in volatility will result in both rising call and put option prices (negative to the investor).
Option Strategies
An investor who is long a put and short a call on the same underlying (with the same strike price and same expiration) has an identical payoff position to someone who is:
The put-call parity relationship describes two positions that have identical payoff values. Under the put-call parity, a long call and a short put (on the same underlying stock, and with the same exercise price and expiry) have an identical payoff to taking a long position in the stock and borrowing the present value (PV) of the strike price: call premium − put premium = underlying stock − PV(X) received We can rearrange this formula to reflect the situation in this question: put premium − call premium = PV(X) received − underlying stock In other words, a long put and short call position can be replicated through lending the PV of the strike price plus a short position in the underlying stock.
Option Strategies
An investor has constructed a zero-cost collar on a share with a price P0. For any movement in the share price above P0, the investor will most likely have:
A zero-cost collar is constructed on a share by selling a (typically out-of-the-money, or OTM) call and buying a put (typically also OTM) with the same premium as the call. Because the option premiums are the same there is zero net premium, and any increase in the share price above the initial price of P0 will result in a gain, with the gain capped at the call strike price. (Similarly, any decline in value below P0 will result in a loss, with the loss capped at the put strike price.)
Option Strategies
An option trader establishes a protective put position by buying a stock at $85 and buying an $86 put option for $2. The breakeven stock price for this position is:
The breakeven stock price is $87, which is $2 (= the option premium) above the initial stock price. At $87, the trader has a $2 gain on the stock, offset by the $2 premium paid for the put option. (Note that at $87, the put option is still out of the money).
Option Strategies
What are covered call options on an underlying stock
The maximum loss is the cost of the stock, offset by the premium earned by selling the call. The maximum loss is denoted as S0 – C0. The breakeven price is equal to the cost of the stock less the call premium, denoted as S0 – C0.
Option Strategies
An analyst noticed that following a period of low volatility, implied volatility has picked up for out-of-the-money (OTM) put options, while the price of the OTM call options declined. Which of the following terms least describes this scenario?
A volatility skew describes a scenario where implied volatility increases for OTM puts and decreases for OTM calls. OTM puts are more desirable as insurance against market declines, and the increased desirability increases the price, and therefore volatility, of OTM put options. A risk reversal strategy combines long (short) calls and short (long) puts on the same underlying. A volatility smile describes a scenario where further-from-atthe-money options have higher implied volatilities.
Swaps, Forwards & Future Strategies
A manager of a $20,000,000 portfolio wants to decrease beta from the current value of 0.9 to 0.5. The beta on the futures contract is 1.1 and the futures price is $105,000. Using futures contracts, what strategy would be appropriate?
Number of contracts = -69.26 = (0.5 − 0.9) × ($20,000,000)/ (1.1 × $105,000), and this rounds down to 69 (absolute value). Since the goal is to decrease beta, the manager should go short which is also indicated by the negative sign
Swaps, Forwards & Future Strategies
Jeanne Leon is the portfolio manager for a US fixed-income fund. Leon is concerned the central bank policy will lead to rising interest rates over the next two years. In anticipation of this, Leopn wishes to reduce the duration of his portfolio. What derivative is most likely to achieve his goals?
Receiver swaps (receive fixed, pay floating) can be synthetically replicated by issuing FRNs and using the proceeds to buy fixed coupon bonds. FRNs have lower durations than fixed coupon bonds, resulting in receiver swaps increasing duration and payer swaps reducing duration. Leon should therefore enter payer interest rate swaps if she wishes to reduce the portfolio’s duration. A short FRA (Forward Rate Agreements) is an obligation to pay floating and receive fixed. A series of short FRAs replicates a receiver swap. This strategy will increase the portfolios duration. Leon should consider a series of long FRA contracts to replicate a payer swap if the goal is to reduce portfolio duration. Taking positions such as US Treasury bond futures can be used to modify a portfolio’s duration. Long futures positions increase the exposure to fixed rate returns and short futures positions will decrease the exposure.
Swaps, Forwards & Future Strategies
CorePro Inc., based in the United States, wishes to borrow €30m to finance a subsidiary in Italy. CorePro has decided to borrow domestically in dollars and then enter into a cross-currency basis swap to exchange the USD for euros. The basis on the euro-dollar swap is quoted as - 20 basis points. The current $/€ exchange rate is $1.2. The swap has a 10 year tenor with quarterly settlement date. At the last settlement date, 90-day USD LIBOR was 2%, and 90-day Euribor was 2.5%. The interest paid and received by CorePro at the next settlement date will be closest to:
A. Pays $180,000 and receives €172,500
B. Pays €187,500 and receives $198,000
C. Pays €172,500 and receives $180,000
A cross-currency swap pays variable interest on both legs, typically based on LIBOR or Euribor. When the dollar is s been trading at +ve basis against most currencies. This means the floating $interest rate in a cross-currency swap will be higher than the $LIBOR rate. Arbitrage should prevent this from happening but due to the additional regulatory cost (in particular implications for capital adequacy) fewer banks are undertaking these activities. In this example the dollar has +20BP against the Euro. This means that dollar lenders will generate an additional 20 BP above $LIBOR when lending the dollar. Rather than adding the 20BP to the $interest received each period, typically the 20 BP is deducted from the Euro interest payments. An extra 20 BP on dollar lending will be quoted as a basis of −20BP against the Euro. Next settlement date: USD 90-day LIBOR at last settlement date = 2% 90-day Euribor at last settlem Receives $36m × 0.02 × 90/360 = $180,000ent date = 2.5% Basis quoted at initiation of the swap −20 BP (typically quoted from the non- dollar perspective) CorePro (dollar lender, euro receiver): Pays €30m × (0.025 − 0.002) × 90/360 = €172,500 Note that the dollar lender benefits from the 20 BP basis, not by receiving 20 BP more $interest, but by paying 20 BP less € interest. Note that because the principal amounts are equivalent ($36m = €30m) at inception whether the basis is added to the $interest payments or deducted from the € interest payments makes no difference. (However, market convention is to deduct it from the non-dollar interest payments.) You would have arrived at an incorrect answer if you added the basis to the $interest.
Swaps, Forwards & Future Strategies
A company has substantial bank loans and pays interest at LIBOR +80 BP. The central bank has signaled its intention to increase target interest rates over the next 12-month period. What type of interest derivatives would the company most appropriately enter into to mitigate its floating rate exposure?
A, Long short-term interest rate futures
B. A payer swap
C. Short FRA contracts
B
Short FRA positions will lose value when interest rates rise. As interest rates rise the fixed rate that the short party receives looks less attractive as the fixed rate in new FRAs, covering the same notional borrowing and lending period, increases. A payer swap is an agreement to pay fixed and receive floating. As interest rates rise, the floating payments received increase in size relative to the constant fixed payments. With a properly constructed interest rate swap, the net receipt on the payer swap will offset the increased interest payments on the company’s bank debt. Long short-term interest rate futures will decrease in value as interest rates rise. The pricing convention (IMM index convention) used for the future is 100 − 30 day annualized forward interest rate at maturity. As interest rates rise and the forward rate increases the futures price will decline.
Swaps, Forwards & Future Strategie
A US firm borrows dollars and uses a plain-vanilla currency swap to obtain euros for investment in Europe is most likely to:
A. Lower borrowing costs
B. Increase the duration of the position
C. Create a synthetic pay-fixed dollar loan
Swaps can lower overall borrowing costs by allowing firms to borrow at a lower rate within their own country rather than paying a higher rate by borrowing directly in the foreign currency. For example, a U.S. borrower needing euros would have to pay a higher rate than a counterparty in Europe. The European counterparty can borrow at a lower rate and pass the savings on to the U.S. borrower who passes similar savings back via borrowing dollars in the U.S. and exchanging them for the euros. None of the other answers make sense.
Swaps, Forwards, and Futures Strategies
Swaps, Forwards & Future Strategies
Sheila manages a $100 million fixed-income portfolio. The portfolio duration is currently 4.9 and she would like to increase it to 5.7. She selects a swap with a net duration of 6.1. Based only on the information provided, which of the following statements is least likely correct?
A. Sheila should have a receive-floating/pay-fixed position in the swap
B. Sheila should have a pay-floating/receive-fixed position in the swap
C. Sheila should select a swap with a notional principal of approximately 1.3 million to achieve the desired duration
A
Because Sheila wants to increase the duration of the portfolio, she should have a pay- floating/receive-fixed position in the swap with a notional principal of $13,114,754 as computed below: Notional principal = $100,000,000 × [(5.7 – 4.9)/ 6.1] = $13,114,754
Swaps, Forwards & Future Strategies
A portfolio manager has a net long position in both stocks and bonds and no cash. When pre-investing a future cash inflow, to replicate the existing portfolio, using bond and stock futures, the manager will need to do what?
Since the original portfolio is long in both stocks and bonds, the manager will go long both stock and bond futures contracts
Swaps, Forwards & Future Strategies
To create a synthetic cash position one must…
Security – Futures = Cash, therefore, buy the common equity and sell short the corresponding futures contract.
Swaps, Forwards & Future Strategies
A firm has outstanding floating rate debt on which they pay LIBOR + 200 basis points and management expects interest rates to increase very shortly. To create synthetic fixed-rate debt, the best strategy for the firm is to enter into a swap in which way?
To create synthetic fixed-rate debt, the firm should pay fixed and receive floating in a swap. The floating rate payment they receive in the swap will partially offset the floating rate they pay on their debt. Any portion of the floating rate on the debt that remains (assume 100bps) will add to the fixed rate they pay on the swap. Their net position on the debt and the swap will be pay fixed + 100 bps = fixed rate.
Swaps, Forwards & Future Strategies
If a manager shorts a forward currency contract to hedge the expected value of a foreign-equity portfolio in one year, what is the worst-case scenario for the portfolio returns?
This should be obvious because a decline in the equity position is bad and the short position in a forward currency contract hurts when the foreign currency appreciates. If the equity position falls short of the contracted amount, in addition to the loss from the decline in asset prices, then the manager will suffer a loss equal to the difference in the hedged amount and the actual equity value times the difference in the spot and contracted forward rate.
Currency Management
Jane Simms manages a German portfolio denominated in the EUR and decides to use an option collar to reduce her downside risk exposure to the Mexican peso (MXP) while retaining some potential upside. What strategies will accomplish her objective?
The collar Simms describes requires buying OTM puts and selling OTM calls on the MXP. However, this is directly equivalent to buying OTM calls on the EUR and selling OTM puts on the EUR. Note that selling an in-themoney call on the MXP removes all portfolio upside and will not meet her objectives.
Currency Management
A Swiss-based investor (home currency is CHF) has a short exposure to the pound (GBP). The one-year CHF interest rate is 1.5% and the GBP interest rate is 2.5%. Using a one-year forward contract, the investor will most likely……
To hedge the short GBP exposure, the investor will buy the forward contract. Using the GBP as the base currency, based on interest rate parity, the GBP will trade at a forward discount because of the higher interest rate. Forward = Spot × [(1 + iCHF)/ (1 + iGBP)] = Spot × [(1.015)/ (1.025)] = Spot × 0.99 Therefore, the GBP forward discount is 0.99 – 1 = -0.01 or -1%. Since the forward is “cheaper” than the spot, the long exposure will earn a positive roll yield (think sell high, buy low).
Currency Management
A trader has a EUR 5,000,000 short asset exposure and wishes to hedge it using a six-month long forward contract. Relative to choosing a one month long forward contract that is rolled over each month, the six month forward contract would most likely….
The six-month forward contract requires no rebalancing, while the one-month rolled forward requires monthly rebalancing. Less frequent rebalancing indicates lower risk aversion. Because the value of the hedged asset could change over the six months, the six-month hedge is not perfect and could result in a significantly over- or underhedged position (for example, if the asset value increases to EUR 5,500,000 in two months, the manager would be underhedged by EUR 500,000). Because there are no contracts to roll over prior to the six-month maturity, there are no realized gains or losses generated before the maturity of the six-month contract.
Currency Management
Luis manages a Canadian based investment fund in CAD, which has some US-based investments. Assuming there is a negative correlation between CAD and corporate profits of the US companies in which it invests, what is the appropriate minimum variance hedge ratio required to reduce the volatility of the returns in CAD?
If there is negative correlation between the CAD currency and US corporate profits, then it must mean that the correlation between USD currency and US corporate profits is positive (Note: when we compare USD and CAD currencies to each other, the strengthening of one currency means the weakening of the other currency and vice versa). Therefore, RDC volatility will increase because RFX (USD currency) and RFC (USD corporate profits) are positively correlated. That means there is a greater need to hedge (i.e. hedge ratio must be greater than one) in order to reduce the volatility of RDC.
Currency Management
What would most likely lead a portfolio manager to buy a foreign currency in the forward market?
No manager views were indicated in the question; lacking views, an active manager should take a neutral exposure to the currency. Being underweighted in the assets would produce an underweighting in the currency which is corrected by buying the currency forward. The other two answers are incorrect. Being overweighted would lead to selling the currency forward. A carry trade would buy the higher yield currency in the spot, not forward, market.
Currency Management
Gill is a US-based investor and would like to hedge her long position to the Canadian dollar (CAD) using options. Her objective is to minimize the initial option cost by giving up some upside potential but does not want to lose any downside protection. What option strategies is Gill least likely to select?
A. Collar
B. Put Spread
C. Seagull Spread
A put spread would involve buying out-of-the-money (OTM) puts on the CAD and then selling puts that are even further OTM. Therefore, the strategy does reduce initial cost but it also reduces downside protection (compared to buying OTM puts only). There is also no impact on upside potential. A collar could involve buying an OTM put on the CAD and selling an OTM call on the CAD. The OTM put provides some downside protection while costing less than an at-the-money (ATM) put. The sale of the OTM call removes some upside potential. A seagull spread is a put spread combined with selling a call. Compared to the put spread, the seagull spread has an even lower initial cost and the same downside protection, but reduces some upside potential due to the sale of the call.
Currency Management
A call option with a strike price of $60 will be available as soon as the stock price of DAG inc (DAG) reaches $55. What items best describe the option on DAG?
A, Knock-in option
B. Knock-out option
C. Binary Option
A
The call option on DAG is a knock-in option because it only comes into existence if the underlying first reaches some prespecified level (i.e. DAG stock reaches $55). A knock-out option ceases to exist if the underlying reaches some prespecified level. A binary (or digital) option pays a fixed amount that does not vary with the difference in price between the strike and underlying price.
Currency Management
Which of the following portfolios would most likely follow a passive currency hedging strategy?
A. One with a shorter time horizon and higher liquidity needs
B. One with more confidence in the portfolio manager and higher income needs
C. One very concerned with minimizing regret and higher allocation to equity investments
A
The following will shift the portfolio toward more passive currency management: A short time horizon for portfolio objectives, High risk aversion, Lack of concern with regret at missing opportunities to add value through discretionary currency management, High short-term income and liquidity needs, Significant foreign currency bond exposure, Low hedging costs, Clients who doubt the benefits of discretionary management.
Currency Management
A US investor has some of her wealth invested in a 300,000 Euro portfolio managed by a European fund manager. The investor wants to terminate her Euro portfolio in nine months but is worried about currency fluctuation and therefore wants to hedge the full 300,000 Euro value today. The investor should:
The investor wants to sell her Euro portfolio in nine months. A 9-month sell Euros/buy US dollars forward contract would achieve this objective. A currency forward contract with an underlying notional value of 300,000 Euros would hedge the portfolio value today but ignores any potential gains or losses over the next nine months. As a result, the hedge is imperfect, and the investor may have either over- or under-hedged her portfolio. At the same time, the contract will fix in advance the amount of US dollars to be received in the future.
Currency Management
The one-year interest rate is 3% in Country A and 6% in Country B. Assuming covered interest rate parity holds:
Assuming covered interest rate parity holds, the currency of the country with the higher interest rate will depreciate (Country B). Country A’s currency will appreciate by (1.06/1.03) – 1 = 0.0291, or 2.91%. Country B’s currency will depreciate by (1.03/1.06) – 1 = -0.0283, or 2.83%. Country A’s currency will trade at a forward premium since it is the country with the lower interest rate, while Country B’s currency will trade at a forward discount. The carry trade is based on a violation of uncovered interest rate parity which says the forward exchange rate that is calculated through the covered interest rate parity is an unbiased estimate of the spot exchange rate (therefore the carry trade would earn a zero return).
Currency Management
Currency trading based on economic fundamentals would be most likely to sell a currency forward if the country issuing the currency is experiencing:
Higher relative inflation is associated with declining value of the currency and would tend to encourage sale of the currency by the manager.
Currency Management
An Mexican investor with a US dollar portfolio invested in US bonds has a four-month investment time horizon. The investor is concerned about currency volatility. He is contemplating an appropriate and costeffective currency management strategy and has noted that he is not overly concerned if he misses out on potential currency gains. The investor should:
The investor should fully hedge his US dollar portfolio given that currency volatility can be very high in the short term, especially for an emerging market currency like the Mexican peso. While a fully-hedged portfolio would only hedge the portfolio’s current market value, and leave any portfolio gains or losses unhedged, the investor noted that he is not concerned about missing out on potential currency gains. A “no hedge” scenario would expose the investor to potentially large currency movements in the short term. An active currency management strategy is costly and the costs are likely not justified under a very short time horizon (four months) and generating currency gains is not one of the investor’s objectives.
Currency Management
Which of the following statements regarding managing emerging market currency exposures is correct?
A. On the assumption that increasing yields for emerging market currencies, it will lead to negative roll yield for investors who are selling such currencies forward.
B . Transaction costs for emerging market currencies are generally similar when comparing exiting trades versus entering trades.
C. Value at risk is an appropriate measure of risk for emerging market currencies.
A.
Increasing yields will lead to larger forward discounts. The result is negative roll yield for investors who are required to sell such currencies forward.
Currency Management
A currency trader wants to implement a long strangle strategy on a currency pair and is considering either a 10- delta or 40-delta strategy. Relative to the 10-delta strangle, the 40- delta strangle would:
A long strangle consists of a long position in both an out-of-the-money (OTM) call and put option with the same absolute deltas, strikes prices, maturities and underlying currency. Because both options are OTM with the absolute value of their deltas less than 0.5, the intrinsic value of both options is zero. The 40-delta strangle is less OTM (or more in-the-money) than the 10-delta strangle and would therefore, be more expensive with a better payoff structure.
Currency Management
A Canadian manager has a large portfolio with exposures to numerous foreign currencies, including the U.S. dollar (USD), the euro (EUR), the British pound (GBP), the Swiss franc (CHF), and some emerging market currencies. When hedging the portfolio’s foreign currency risk, which of following hedges would the manager most likely utilize?
A macro hedge is a type of cross hedge that addresses portfolio-wide risk factors rather than the risk of individual portfolio assets. One type of currency macro hedge uses a derivatives contract based on a fixed basket of currencies to modify currency exposure at a macro (portfolio) level. The currency basket in the contract may not precisely match the currency exposures of the portfolio, but it can be less costly than hedging each currency exposure individually. The manager must make a choice between accepting higher residual currency risk versus lower cost. A direct hedge is possible for widely-traded currencies such as the USD, EUR, and GBP. However, because the portfolio contains some emerging market currencies, those currencies are not likely to be efficiently hedged using direct hedges due to high transaction costs and the potential non-existence of an appropriate hedging contract. A cross hedge is likely most efficient for the emerging market currencies (to reduce transaction costs) but not necessary for widely traded currencies such as the USD, EUR, and GBP.
Currency Management
Which of the following statements regarding non-deliverable forwards (NDFs) is correct?
A . The pricing of NDFs re ects supply and demand conditions.
B. NDFs usually have higher credit risk than regular forward contracts.
C. The controlled currency is usually a major currency.
A
The pricing of NDFs does not necessarily follow covered interest rate parity; pricing reflects the supply and demand conditions in the offshore market, which may be different than the onshore market of the specific emerging market country. The non-controlled currency is usually the USD or some other major currency. The controlled currency is the emerging market currency. The credit risk of an NDF is usually less than that of a regular forward contract because there is no delivery of the notional amounts required.
Currency Management
Cristina has a long exposure to the Brazilian real (BRL) and wants to use options to hedge against a modest depreciation of the BRL. She is primarily concerned with keeping upside potential as well as minimizing the cost of buying options. Which of the following derivative positions will best achieve Cristina’s objectives?
Cristina can hedge a potential BRL depreciation with put options although taking a long put option, especially if it is in-the-money, is expensive. Therefore, she can use a put spread to subsidize a portion of the cost of the long put. A put spread involves buying an out-of-the-money (OTM) put option and selling an even further OTM put option (for example, the investor can buy a 40-delta BRL put and sell a 20-delta BRL put). The more OTM put will subsidize a portion of the long put’s cost, although the investor loses downside protection below the more OTM put’s strike price. If the BRL appreciates, the put options will be worthless and the investor keeps all the upside potential. A collar involves buying a put and selling a call with the same delta. The sale of the call subsidizes the cost of the long put. However, while the position provides downside protection, the short call position will limit the currency’s upside potential. A seagull spread essentially combines a put spread with a collar (buy an OTM put, sell a more OTM put, sell an OTM call), and therefore achieves the objective of minimizing option costs but provides limited upside potential due to the short call position.
Currency Management
A U.S.-based investor has purchased a 15,000,000 peso office building in Mexico. He has hedged his investment by selling forward futures at $0.1098/peso. Two months later, the futures exchange rate has fallen to $0.0921/peso. The investor’s net change in the futures position is:
The realized gain on the futures position is: V0(-Ft + F0) = 15,000,000 pesos × (-$0.0921/peso + $0.1098/peso) = $265,500.
Currency Management
A U.S. investor who holds a £2,000,000 investment wishes to hedge the portfolio against currency risk. The investor should:
The realized gain on the futures position is: V0(-Ft + F0) = 15,000,000 pesos × (-$0.0921/peso + $0.1098/peso) = $265,500.
Currency Management
The cost to hedge a long position in the EUR is reduced by:
A long position in the euro is hedged by selling the euro forward. Positive roll yield is a reduction in hedging cost. Positive roll yield for the seller of the euro occurs if the forward exchange rate for the euro is above the spot exchange rate. This will occur if eurozone interest rates are relatively low.
- Overview of Fixed Income Portfolio Management
The total-return mandate of a bond portfolio specifies a return objective of 75 basis points over the benchmark index. The mandate permits the portfolio’s duration to deviate significantly from that of the benchmark index. If the mandate also allows the portfolio to exhibit higher turnover than the benchmark index, the portfolio most likely requires the use of:
Significant outperformance of the benchmark index (more than 50 basis points), large risk factor mismatches, and high turnover relative to the benchmark are typical features of active bond portfolio management
- Overview of Fixed Income Portfolio Management
Which of the following statements about the taxation of fixed-income investment in various tax jurisdiction in the world is most accurate?
A. Capital gains are generally taxed at a higher rate than interest income.
B. Capital losses can generally be used to offset any source of income
C. Taxing zero-coupon bonds on a accrual basis in some countries means that the return will be taxed partly as interest rate and partly as a capital gain.
C.
In some countries imputed interest may be calculated that is taxed throughout a zero coupon bond’s life. That means the return on the zero-coupon bond is taxed partly as
3 Overview of Fixed Income Portfolio Management
The total-return mandate of a bond portfolio specifies that the manager should achieve
1) a return objective of 20 basis points over the benchmark index,
2) an active risk of less than 50 basis points, and
3) a close matching of the benchmark index’s primary risk factors. The mandate most likely requires the use of:
4Overview of Fixed Income Portfolio Management
Jim is a new associate in operations at a mid-sized fixed income consulting firm. Jim is trying to learn the benefits of cash flow 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 Jeff tells him that the key features of cash flow matching include making no yield curve assumptions, matching the bond’s portfolio’s cash flow to existing liabilities and frequent rebalancing is not required.
Jim also called his friend Ted whotells him the benefits of cash flow matching include: accommodating multiple yield curve assumptions, frequent rebalancing and the ability to handle increased complexity, so many advanced traders like this strategy overall. Which of Jim’s friends explanation of cash flow matching is most accurate?
5Overview of Fixed Income Portfolio Management
When investors display a “flight to quality” in periods of market stress, the investment actions are most likely to increase the correlation between:
6Overview of Fixed Income Portfolio Management
In the context of total return mandates, what feature are most likely indicative of pure indexing?
7Overview of Fixed Income Portfolio Management
What factors are likely to increase the liquidity premium on a bond issue?
Factor 1: The bond’s issuer has a significant number of outstanding bond issues
Factor 2: The bond issue will be included in domestic and global bond indexes
8Overview of Fixed Income Portfolio Management
Provide a statement to descriptively explain horizon matching bond immunization strategy.
9Overview of Fixed Income Portfolio Management
An institutional portfolio manager is attempting to determine the expected return of a bond portfolio. The bonds in the portfolio are mostly option-free. The manager also expects a moderate change in interest rates but is unsure of the direction. Which of the following statements is correct?
A, The computation of yield income is based on actual amounts
B. Convexity is likely to be an important consideration
C. The easiest portion of the expected return to compute is the rolldown return. Explanation
10Overview of Fixed Income Portfolio Management
Liquidity can be thought of as the ability to make a large transaction quickly with minimal market price impact. What is most correct relative to bond liquidity concerns?
11Overview of Fixed Income Portfolio Management
Explain bonds and inflation.
12Overview of Fixed Income Portfolio Management
Amanda Smith is a new member of a large pension fund and her team is focused on fixed income investing. Amanda has been researching inflation-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 find:
13Overview of Fixed Income Portfolio Management
A disadvantage of matrix pricing for bonds is that it:
14Overview of Fixed Income Portfolio Management
A total return strategy focuses on either absolute or relative returns rather than matching returns with liabilities. What is a total return option for bond investors?
15Overview of Fixed Income Portfolio Management
Leslie currently has 40% of her overall portfolio invested in a diversified fixed-coupon bond portfolio with an average duration of 8 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 diversified ETFs. Leslie primarily wants to reduce the overall risk of her portfolio and also keep up with inflation until she retires in 16 years. Leslie is a professional photographer and has a limited understanding of the financial markets. During a recent meeting with her financial advisor, Leslie was informed of some changes she should consider making to her portfolio. Her advisor identified that the correlation coefficient of Leslie’s current bond portfolio with her equity holdings is - .05. Also, the correlation coefficient between her equity holdings and an ETF consisting of inflation-linked bonds is .23. Finally, the approximate correlation coefficient between Leslie’s current fixed-income portfolio and the proposed inflation-linked ETF is relatively high at .55. Her advisor recommends that Leslie should diversify her current fixed-coupon bond holdings by adding inflation-linked bonds to her portfolio. The following action Leslie would take considering her primary goal is to reduce her portfolio risk and also keep up with inflation until she retires is most likely:
Prep, Prime Hour. 2024 CFA Level 3 Question Bank: Practice Learning Module wise Questions & Answers (p. 26). Kindle Edition.
16Overview of Fixed Income Portfolio Management
Investors may prefer a potentially more lucrative liability-based bond strategy. What best describes a contingent immunization strategy?
17Overview of Fixed Income Portfolio Management
An analyst makes the following statements about the key features of a pure indexing approach to bond portfolio management:
Statement 1: The portfolio must hold all the bonds in the same proportions as the benchmark index
Statement 2: The risk factors of the portfolio and the benchmark index are matched exactly
Which statement is correct?
18Overview of Fixed Income Portfolio Management
Michelle Crozier, a fixed-income strategist, is analyzing the expected one-year return of the bond portfolio shown in the following table: Notional principal $100 million Current average bond price $102.50 Average coupon rate (paid semiannually) 2.25% Sector allocation Government 45.2% Agency 10.7% Corporate (plain vanilla) 39.0% Corporate (callable) 5.1% Based on this data, Crozier is most likely to forecast the expected change in the portfolio’s price based on her yield and yield spread view using:
19Overview of Fixed Income Portfolio Management
What is true about the general taxation of mutual funds in various jurisdictions in world?
20Overview of Fixed Income Portfolio Management
When managing a fixed-income portfolio for a tax-exempt investor, what strategies are most likely to be applied?
21Overview of Fixed Income Portfolio Management
When managing a fixed-income portfolio for a tax-exempt investor, what statement is most accurate?
statement 1: Taxable investors should realize capital losses early and defer the realization of capital gains
statement 2: Taxab;e investors should evaluate the differences in the taxation of interest income and capital gains when selecting portfolio assets
22Overview of Fixed Income Portfolio Management
A trainee analyst makes the following statements about the following statements about the use of leverage in fixed-income portfolio management:
Statement 1 The degree to which leverage affects portfolio returns is dependent on the amount of borrowed funds relative to the portfolio’s equity
Statement 2: The use of leverage will always increase overall portfolio returns.
Which statement is correct?
23Overview of Fixed Income Portfolio Management
Selected data relating to a diversified portfolio of euro-denomoinated bonds are shown in the following table:
Notional Principal €200 million
Current Average Bond Price €108.65
Average Coupon Rate 2.0%
Average Effective Duration 5.72
Average Effective Convexity 18
Based on this data and an expected average yield and yield spread change of 42 basis points, the expected change in the portfolio’s price is:
24Overview of Fixed Income Portfolio Management
A bond analyst makes the following notes about a duration-matching approach to a fixed income mandate:
Note 1: Liquidity of the asset portfolio is an important consideration
Note 2: Callable corporate bonds cannot be included in the asset portfolio.
Which note is correct?
25Overview of Fixed Income Portfolio Management
The following data is selected data on Omega Fixed-Income Mutual Fund:
Current average bond price: $105.00
Average modified duration: 8.50
Average annual coupon 1.50
PV of assets (millions) 120.00
Value of Portfolio’s equity (millions) 62.25
Value of borrowed funds (millions) 30.62
Borrowing rate 1.75
Return on Invested Funds 4.25
The leveraged portfolio return for this mutual fund is:
26Overview of Fixed Income Portfolio Management
Chris Lipczynski owns a large portfolio that is predominantly invested in domestic equities. He now desires to diversify the portfolio in order to reduce overall portfolio risk and to generate cash flows that maintain purchasing power over the next 20 years. His current portfolio has a correlation of -0.20 with a domestic fixed-coupon bond portfolio and a correlation of -0.05 with a domestic inflation-linked bond portfolio. The correlation between these two bond portfolio’s is 0.70. Which of the following asset allocations is most likely to satisfy Chris’ stated desires for his portfolio?
A. 80% domestic equities, 20% fixed-coupon bonds
B. 50% domestic equities, 30 % fixed-coupon bonds, 20% inflation-linked bonds
C. 50% domestic equities, 50% fixed-coupon bonds
27Overview of Fixed Income Portfolio Management
Which of the following statements is correct concerning a horizon-matching approach to immunization?
Statement 1: Short-term liabilities are immunized using cash-flow matching, while long-term liabilities are immunized using duration matching
Statement 2: It is a hybrid approach that combines immunization with active management of bond assets that are intended to satisfy long-term liabilities.
28Overview of Fixed Income Portfolio Management
An institutional portfolio manager is managing a fixed-income portfolio with a wide range of bonds and would like to engage in securities lending to enhance returns. What is true about securities lending?
29Overview of Fixed Income Portfolio Management
The return volatility exhibited by inflation-linked bonds is best described as:
30Overview of Fixed Income Portfolio Management
Safeera Khan owns a large portfolio that is invested in domestic equities. Khan’s portfolio has a correlation of -0.20 with a domestic fixed-coupon bond portfolio and a correlation of -0.10 with a domestic floating-coupon bond portfolio. Khan is most likely to diversify her portfolio into domestic floating-coupon bonds in order to what?
A
31Overview of Fixed Income Portfolio Management
A US investor who wishes to construct a dedicated portfolio of domestic bonds over a long term horizon is most likely to use a combination of:
32Overview of Fixed Income Portfolio Management
An investment analyst states that the following conditions are required when implementing a duration-matching approach to a fixed-income mandate:
Condition 1: The duration of the portfolio of bond asset and the duration of the liabilities must be the same
Condition 2: The present value of the portfolio of bond assets must exceed the present value of the liabilities at current interest rates. Which of these conditions are correct?
33Overview of Fixed Income Portfolio Management
Forced liquidation of a leveraged fixed-income portfolio may be required when the portfolio’s value:
A. Falls, increasing the ratio of borrowed funds to the portfolio’s equity and increasing the portfolio’s leverage.
B. Rises decreasing the ratio of borrowed funds to the portfolio’s equity and decreasing the portfolio’s leverage.
C. Falls, decreasing the ratio of borrowed funds relative to the portfolio’s equity and increasing the portfolio’s leverage
34Overview of Fixed Income Portfolio Management
What is an accurate statement regarding listing the typical liquidity of fixed income sub-sectors from highest to lowest?
.0
35Overview of Fixed Income Portfolio Management
Which statement relating to the use of futures contract in leveraging fixed income portfolios is most accurate?
Statement 1: Bond futures contracts enable investors to obtain exposure to a large amount of bonds without having to purchase the underlying bond.
Statement 2: The leverage obtained by using a futures contract is calculated as the ratio of the margin amount to the notional value of the futures contract.
36Overview of Fixed Income Portfolio Management
In which of the following investment vehicles does an investment manager’s decisions on when to realize capital gains affect the timing of capital gains tax payments by taxable investors?
Investment Vehicle 1: A mutual fund with pass-through treatment of capital gains
Investment Vehicle 2: A separately managed account
37Overview of Fixed Income Portfolio Management
What is correct relative to the effects of liquidity on bond portfolio management?
38Overview of Fixed Income Portfolio Management
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.
What is true regarding the hair cut?
39Overview of Fixed Income Portfolio Management
Selected data relating to a diversified portfolio of sterling-denominated bonds are shown below:
Notional Principal £120 million
Current Average Bond Price £ 97.25
Average Coupon Rate 2.0%
Average Effective Duration 6.38
Average Effective Convexity 23
Based on this data and an expected average yield and yield spread change of -0.29%, the expected change in the portfolio’s price is closest to:
A. -1.84%
B. 2.79%
C. 1.86%
40Overview of Fixed Income Portfolio Management
What is true regarding fixed-income investing and pricing?
41Overview of Fixed Income Portfolio Management
What concept is a good tax management strategy for a bond portfolio manager?
A. Avoid short-term turnover when a bond is trading at a loss
B. Focus on high current yielding bonds with short holding periods
C. Extend holding periods as long as practical
42Overview of Fixed Income Portfolio Management
Which of the following statements relating to fixed-income portfolio management for a tax-exempt investor is most accurate?
Statement 1: The investor’s objective is to maximize risk adjusted pretax returns
Statement 2: All else equal, the investor should prioritize the sale of overvalued bonds over undervalue bonds.
43Overview of Fixed Income Portfolio Management
What factor is most likely to increase the bid-ask spread of a bond issue?
44Overview of Fixed Income Portfolio Management
Selected data relating to a fixed-income portfolio are shown in the following table:
Amount of portfolio’s equity
£50 Million
Amount of borrowed funds £100 Million
Return on invested assets 4.8%
Rate paid on borrowed funds 2.2%
The leveraged portfolio is closest to:
A. 5.7%
B. 6.1%
C. 10.0 %
45Overview of Fixed Income Portfolio Management
Jake Tyler is new to investing and has learned that correlation among assets is important in determining diversification benefits. 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 more volatile than equities
B. Bonds are generally less volatile than equities
C. Bonds have the same volatility as equities
46Overview of Fixed Income Portfolio Management
What are common fixed-income derivatives that are traded on exchanges
47Overview of Fixed Income Portfolio Management
Pierre Labross, a trainee bond analyst, has been asked by his supervisor to analyze the factors affecting bond market liquidity. He makes the following notes after his initial research:
Note 1: The liquidity of sovereign government bonds of different countries is generally similar
Note 2: On-the-run issues are typically more liquid than off-the-run issues of comparable bonds.
Which note is most accurate?
48Overview of Fixed Income Portfolio Management
Nick Johnsen manages a well-diversified portfolio of government and corporate bonds. He is considering the use of interest rate swaps and structured financial instruments to leverage his portfolio’s returns. If Johnsen expects interest rates to rise over the next five years, what positions is most likely to benefit from his interest rate expectation?
49Overview of Fixed Income Portfolio Management
What features are provided by fixed-income securities, as an asset class?
50Overview of Fixed Income Portfolio Management
Which statement is most correct relative to the way that a repurchase (repo) agreement is used to create portfolio leverage?
A. These agreements require very specific securities to be used as collateral
B. Repos are a long-term funding solution for short sellers
C. Repos require collateral whose value is higher than the amount being borrowed..
1Liability-Driven and Index-Based Strategies
What is a benefit of a bond ladder strategy?
2Liability-Driven and Index-Based Strategies
A UK-based company uses a duration-matching approach to immunize a significant portion of its corporate debt liabilities. The immunizing portfolio consists of high-quality, coupon-paying bonds with superior credit quality compared to the company’s debt liabilities. Based on this information only, the company’s immunization strategy is most likely to face:
3Liability-Driven and Index-Based Strategies
Maya Jonas manages a portfolio that is close to pure indexing, however, she wants to be able to take some actions to reduce the cost of pure indexing. Currently interest rate volatility is expected to be low. Which of the following activities is Jonas most likely to do?
A. Overweight putable bonds
B. Overweight callable bonds
C. Overweight convertible bonds
4Liability-Driven and Index-Based Strategies
Hans Wilsdarf specializes in risk management strategies with BezelLimited and has been hired to defease $5 Million of fixed-income liabilities for a local municipality. The bonds under consideration are putable in May of 2021, pay interest semi-annually of 4.25%, and mature in 2030. Based on the bond’s underlying structure, the amount of cash outlay is known but the timing of cash outlay is unknown. These liabilities would be classified as:
A. Type I
B. Type IV
C. Type II
5Liability-Driven and Index-Based Strategies
The Bloomberg Barclays US Long Treasure Index measures US dollar-denominated, fixed-rate nominal debt issued by the US Treasury with 10 years or more to maturity. This index is most likely to be:
6Liability-Driven and Index-Based Strategies
Which of the following statements relating to an immunization strategy for a single liability based on the concept of zero replication are correct?
Statement 1: The Macaulay duration of the portfolio of coupon-paying bonds must be continuously matched to the Macaulay duration of the ideal zero-coupon bond
Statement 2: Immunization will be achieved if the change in the cash flow yield on the portfolio of coupon paying bonds matches the change in the yield to maturity on the ideal zero coupon bond
Liability-Driven and Index-Based Strategies
The defined benefit pension plan of a US 7Company has a large surplus but a significant negative basis point value (BPV) duration gap. The plan manager has discretion to hedge 30% ti 70% of the duration gap, with a 50% hedge considered the default position. She is considering three swap-based hedging choices
Choice 1: Enter a 3.1% receive-fixed, pay LIBOR swap
Choice 2: Go long a receiver swaption with a strike rate of 2.5% and an expiration date coinciding with the next reporting date of the plan’s funded status
Choice 3: Enter into a zero-cost collar composed of buying the receiver swaption in Choice 2 and selling a payer swaption with a strike rate of 3.8% and the same expiration date as the receiver swaption
If the plan manager expects the swap rate on compable receive-fixed swap to stay within the 2.5% to 3.5% range and does not want to incur a loss on the hedge based on her view of swap rates, she would most appropriately use which choice?
8Liability-Driven and Index-Based Strategies
An investor is looking for a fixed-income investment. She states that they may need to suddenly liquidate her investment and requires a quick sale at the best possible price. What type of fixed-income investment is least suitable for the investor?
A. Fixed-income mutual fund
B. Laddered Fixed-Maturity Corporate Bond ETF’s
C. Laddered Corporate Bond Portfolio
9Liability-Driven and Index-Based Strategies
A portfolio manager immunized a single liability in 10 years by purchasing zero-coupon bonds that mature on the same date as the liability’s due date. What statement is correct relating to the manager’s immunization strategy?
Statement 1: There is no price risk and no cash flow reinvestment risk associated with this immunization strategy
Statement 2: This immunization strategy suffers from structural risk due to shifts and twists of the yield curve
10Liability-Driven and Index-Based Strategies
A portfolio analyst wishes to immunize a single $5 million liability due in 10 years. He is evaluating a portfolio of coupon-paying bonds that could be used for this purpose in an upward-sloping yield curve environment. He calculates the Macaulay duration of the portfolio by taking the market-value weighted average of the Macaulay duration of the portfolio’s component bonds. If the analyst uses the result of his average duration calculation when constructing his immunization strategy, he would most likely introduce into his immunizing portfolio:
A. Model Risk
B. Spread Risk
C. Asset Liquidity
11Liability-Driven and Index-Based Strategies
The most likely advantage of using open-ended bond mutual funds to gain passive fixed-income expose for retail investors is that:
A. They offer broad diversification without a large investment
B. Trading at the fund’s net asset value takes place continuously throughout the day
C. There are no penalties for early redemption
12Liability-Driven and Index-Based Strategies
A fixed income strategist is analyzing the primary risk factors driving the returns on the Bloomberg Barclays US Aggregate Index. She makes the following statements regarding spread durations:
Statement 1: Spread duration measures the change in the price of a non-Treasury bond for a change in the bonds spread relative to a benchmark
Statement 2: Spread duration is irrelevant to the performance because the index consists only of Trasury securities
Which statement is correct?
13 Liability-Driven and Index-Based Strategies
A portfolio manager makes the following statements when explaining the construction of a laddered bond portfolio to an individual investor
Statement 1: By selecting bond with maturities spread out over your investment horizon, there should be no further transactions to consider after the initial bond purchase
Statement 2:’ Because there is likely to be a bond that is close to maturity at any particular time, the need to sell an illiquid bond to meet a cash flow need is reduced
Which of these statements is correct?
14Liability-Driven and Index-Based Strategies
Which of the following statements regarding asset portfolio characteristics in the context of immunizing multiple liabilities is most accurate?
A. The asset portfolio’s initial market value should equal or exceed the liability market value
B. The asset dispersion of cash flows and convexity should equal or be slightly less than those of the liabilities
C. The asset portfolio’s basis point value (BVP) should exceed the BVP of the liabilities
15 Liability-Driven and Index-Based Strategies
skip
16 Liability-Driven and Index-Based Strategies
Assume an analyst is immunizing a single liability using a barbell portfolio. This portfolio is composed of 50% short term bonds and 50 long term bonds with the same Macaulay duration as a zero coupon that provides perfect immunization. Which type of yield credit shift is the most detrimental to the relationship between the present value of the assets (PVA) and the present value of liabilities (PVL)?
A. A positive butterfly twist
B. A negative butterfly twist
C. A flattening twist
17Liability-Driven and Index-Based Strategies
Which of the following scenarios most accurately illustrates the use of liability-driven investing?
Scenario 1: A commercial bank managing the interest rate exposures of both assets and liabilities on an ongoing basis
Scenario 2: An asset manager structuring a portfolio of bonds to immunize corporate debt obligations
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Liability-Driven and Index-Based Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Yield Curve Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
Fixed Income Active Management Credit Strategies
