Fixed-Income Portfolio Management-Part II
Test ID: 7428091
Question #1 of 72
Question ID: 466164
In choosing equity managers, firms frequently use consultants and make choices using qualitative factors such as philosophy,
market opportunity, and delegation of responsibility. In choosing a fixed-income manager, firms:
ᅚ A) frequently use consultants and make choices using qualitative factors.
ᅞ B) never use consultants but do make choices using qualitative factors.
ᅞ C) frequently use consultants but never make choices using qualitative factors.
These are common steps in the process of choosing both equity and fixed-income managers.
Questions #2-4 of 72
John Hanes serves as a portfolio manager for Stackhouse Investments. One of his clients, the Red Wing Corporation, holds a $50 million
face value position in a T-bill that matures in 182 days on March 21 (today is September 21). Red Wing also owns a $100 million position
in a floating rate note (FRN) that matures in one year, pays LIBOR plus 25bp and has interest rate reset dates on December 21, March
21, and June 21. Red Wing has indicated that they need to sell the T-bill investment sooner than anticipated to fund an unexpected series
of cash outflows.
Question #2 of 72
Question ID: 466115
Which of the following positions would effectively shorten the maturity of your client's Treasury bill investment and hedge your client
against adverse movements in interest rates until the sale date given that one T-bill contract controls $1,000,000 in T-bills?
ᅞ A) Buy 50 T-bill futures contracts.
ᅞ B) Sell 500 T-bill futures contracts.
ᅚ C) Sell 50 T-bill futures contracts.
Since the client owns $50 million of face value of the T-bill, we should sell 50 December T-bill futures contracts. We sell 50 contracts
because each contract controls a $1 million T-bill with a 90-92 day maturity upon expiration of the futures.
Question #3 of 72
Question ID: 466116
Assuming interest rates rise, which of the following CORRECTLY describes the outcome regarding the ultimate disposal of the T-bill?
ᅚ A) The T-bill will lose value, but the short T-bill futures contracts will gain in value to
offset the loss.
ᅞ B) The T-bill futures contract will lose value, but the Treasury bill will gain in value to offset the
ᅞ C) The holdings of T-bill futures contracts will have to be reduced (rebalanced) in order to
maintain the current hedged relationship.
This position will also hedge your client against adverse movements in interest rates should he decide to sell before the expiry of the T-bill
futures. If interest rates rise, the T-bill will lose value, but the short T-bill futures position will gain value to offset this loss.
Question #4 of 72
Question ID: 466117
Which of the following is a methodology that could be employed to convert your client's FRN to a one-year fixed rate structure?
ᅞ A) Enter into an interest rate collar.
ᅚ B) Enter into a one-year, quarterly, receive-fixed interest rate swap.
ᅞ C) Purchase an interest rate cap.
The swap will have a single fixed rate that will be received on a quarterly basis. The LIBOR payments from the swap will cancel with the
LIBOR receipts from the client's FRN. The net cash flow will be the swap fixed rate plus 25bp.
Question #5 of 72
Question ID: 466109
An analyst is assessing the risk of a bond portfolio by applying measures of risk to the returns of the portfolio and the bonds.
The portfolio includes a large position in bonds with embedded derivatives. Using the standard deviation as a risk measure for
the bond portfolio is:
ᅞ A) appropriate because the existence of the embedded derivatives would make
the distribution of returns not normal.
ᅚ B) not appropriate because the existence of the embedded derivatives would make the
distribution of returns not normal.
ᅞ C) not appropriate because the existence of the embedded derivatives would make the
distribution of returns normal.
The standard deviation is a measure for normal distributions. Embedded options would make the distribution of the bond
returns not normal. Therefore, the standard deviation would not be an appropriate measure.
Question #6 of 72
Question ID: 466142
Which foreign bond has the greatest expected excess return and what is the excess return?
Bond with Greatest
ᅚ A) Bond i
ᅞ B) Bond j
ᅞ C) Bond j
The expected excess return is equal to the difference between the return for a bond and the cash market in a particular
Bond i: 4.63 - 2.75 = 1.88
Bond j: 6.45 - 4.58 = 1.87
Question #7 of 72
Question ID: 466111
Which of the following statements about bond portfolio management is least accurate?
ᅞ A) A portfolio managers sold a floor to finance the purchase of a cap in
anticipation of higher interest rates on a floating-rate liability.
ᅞ B) A portfolio manager with a $50 million face value in bonds and a futures contract with
$100,000 face value should use 500 futures contracts according to the Face Value
ᅚ C) To increase the duration of a bond portfolio through futures, the portfolio manager
should sell futures contracts.
To increase the duration of a bond portfolio through futures, the portfolio manager should buy futures contracts.
Question #8 of 72
Question ID: 466119
Which of the following is NOT an advantage of using financial futures for asset allocation purposes instead of the cash market securities?
ᅞ A) Large orders have a very small market impact in the futures market.
ᅚ B) Futures are priced exactly the same as the underlying asset but are more liquid.
ᅞ C) Futures have lower brokerage fees.
Futures are not priced exactly the same as the underlying cash asset. The difference between the two prices is the basis which is
normally not equal to zero.
Question #9 of 72
Question ID: 466150
Jack Hopper, CFA, manages a domestic bond portfolio and is evaluating two bonds. Bond A has a yield of 5.60% and a
modified duration of 8.15. Bond B has a yield of 6.45% and a modified duration of 4.50. Hopper can realize a yield gain of 85
basis points with Bond B if there are no offsetting changes in the relative prices of the two bonds. Hopper has an expected
holding period of six months. The breakeven change in the basis point (bp) spread due to a change in the yield on bond A is:
ᅞ A) 5.21472 bp due to an increase in the yield.
ᅞ B) 10.42945 bp due to a decline in the yield.
ᅚ C) 5.21472 bp, due to a decline in the yield.
By purchasing Bond B Hopper can realize a yield gain of (6.45 - 5.60) = 85 basis points if the yield spread does not increase. The yield
advantage for the 6-month time horizon is (85/2) = 42.5 basis points to bond B. This is the yield advantage that must be offset in order to
break even, hence we use 42.5 basis points in the formula to indicate the price of bond A will increase. Since we are looking at this from
the standpoint of a change in yield on Bond A: (0.425/-8.15) x 100 = -5.21472, implying that the change in yield for bond A is -5.21472bp
and the spread must increase by 5.21472 basis points. This change will result in capital gains for Bond A, which will offset B's yield
Question #10 of 72
Question ID: 466151
Steve Kiteman, CFA, manages a domestic bond portfolio and is evaluating two bonds. Bond A has a yield of 6.42% and a
modified duration of 11.45. Bond B has a yield of 8.25% and a modified duration of 9.50. Kiteman has an expected holding
period of three months. The breakeven change in the spread due to a change in the yield on bond B is:
ᅞ A) 4.12783 bp due to a decrease in the yield for Bond B.
ᅚ B) 4.81579 bp due to an increase in the yield for Bond B.
ᅞ C) 3.99563 bp due to an increase in the yield for Bond B.
The Bond B has a yield advantage of 183 basis points. With a three-month investment time horizon, the yield advantage is
(183/4) = 45.75 basis points. Since we are looking at this in terms of Bond B: (-0.4575/-9.50) x 100 = +4.81579bp, implying
that the spread must increase by 4.81579 basis points. Hence, in terms of the yield on Bond B, the breakeven change in
yield is +4.81579bp, or an increase in the yield on Bond B (thus resulting in the widening of the spread between A and B by
this amount). This change will result in capital losses for Bond B, which will offset B's original yield advantage. Note that the
CFA curriculum specifies using the bond with the greater duration which in this case would be bond A although as we have
demonstrated in this question the bond with the shorter duration can also be used. Thus, if you are not told which bond to use
to perform the calculation you should use the one with the greater duration.
Question #11 of 72
Which of the following statements regarding leverage is least accurate?
ᅚ A) A leverage-based strategy decreases portfolio returns when the return on the
strategy is greater than the cost of borrowed funds.
ᅞ B) Leverage refers to using borrowed funds to purchase a portion of the securities in the
Question ID: 466088
ᅞ C) Leverage is beneficial only when the strategy earns a return greater than the cost of
A leverage-based strategy increases, not decreases portfolio returns when the return on the strategy is greater than the cost
of borrowed funds.
Questions #12-17 of 72
Joy Richards' bond portfolio consists of three issues: Bond A, B, and C. She has approached her investment advisor, Susan
Cupp, CFA, to assess her portfolio and consider possible adjustments. The table below illustrates Richards' positions.
Richards asks what is the effective duration of the portfolio, and what is the change in the portfolio value for a 25 basis point
parallel shift in the yield curve.
Richards wishes to investigate the use of leverage to increase return. Cupp says Richards should consider doubling her
position in Bond C to $80,000 using the proceeds from a loan. Richards asks about sources of funds for such a leveraged
position. Cupp says Richards could use the proceeds from a 3-month repurchase (repo) agreement, or Richards could sell
short zero-coupon bonds with a duration of 3. Richards asks Cupp to estimate the value of the leveraged portfolio in each
case after a 25 basis point downward parallel shift in the yield curve.
Richards asks about the different factors that could affect the repo rate specifically focusing on the scenario where the
collateral is in limited supply due to high demand for the collateral.
Question #12 of 72
Question ID: 466095
The effective duration of Richards' portfolio is closest to:
ᅞ A) 5.9.
ᅞ B) 6.6.
ᅚ C) 6.8.
The duration of a portfolio is the weighted average of the durations in the portfolio. The value of the portfolio is $153,000.
Duration = (52/153) × 8.2 + (61/153) × 6.8 + (40/153) × 5
Duration = 6.8
(Study Session 9, LOS 20.g)
Question #13 of 72
Question ID: 466096
For a 25 basis point change in yield, the change in Richards' portfolio is closest to:
ᅚ A) $2,603.
ᅞ B) $4,666.
ᅞ C) $2,257.
Duration = (52/153) × 8.2 + (61/153) × 6.8 + (40/153) × 5 = 6.8
Entering this into the following formula gives us the change in value of the portfolio:
Change in value of the portfolio = (market value) × (duration) × (expected change in yield)
Change in value of the portfolio = $153,000 × 6.8 × 0.0025 = $2,601
(Study Session 10, LOS 22.d)
Question #14 of 72
Question ID: 466097
Richards asks Cupp to explain the difference between duration and spread duration. Which of the following statements
regarding duration and spread duration is least accurate?
ᅞ A) Spread duration measures the sensitivity of non-Treasury issues to a change in
their spread above Treasuries of the same maturity.
ᅚ B) A parallel change in the yield curve will cause the spread duration to also change.
ᅞ C) Spread duration measures used for fixed rate bonds include the nominal spread,
zero-volatility spread, and option-adjusted spread (OAS).
Spread duration measures the percentage change in the total value of the portfolio given a parallel change in the spread over
Treasuries. A parallel change in the yield curve will cause the yields on all bonds including Treasuries to change by the same
amount thus the spread duration will not change. (Study Session 9, LOS 20.h)
Question #15 of 72
Using the repo agreement, what is the effective duration of the equity invested?
ᅚ A) 8.05.
ᅞ B) 6.22.
ᅞ C) 8.28.
The repo agreement described has a duration of 0.25.
Duration of bond positions = (52/193) × 8.2 + (61/193) × 6.8 + (80/193) × 5 = 6.43
The duration of the equity invested can be found as:
DE = (DiI - DBB)/E
DE = duration of equity
Di = duration of invested assets
DB = duration of borrowed funds
Question ID: 466098
I = amount of invested funds
B = amount of borrowed funds
E = amount of equity invested
Using the information provided in the question:
DE = [(6.43)(193,000 − (0.25)(40,000)] / 153,000 = (1,230,990 − 10,000) / 153,000 = 8.05
(Study Session 10, LOS 22.a & b)
Question #16 of 72
Question ID: 466099
If Richards uses the zero-coupon bonds to leverage her portfolio, what is the change in value of the leveraged portfolio for a
25 basis point change in interest rates?
ᅚ A) $2,803.
ᅞ B) $4,300.
ᅞ C) $3,100.
Since the zero-coupon bonds have a duration of 3, the change in the value of the portfolio will be negatively affected by that
We can solve this by recognizing the change in the value of the portfolio is the sum of the change in each bond in the portfolio
and the short position. For a 25 bp change, we can write:
Change in Bond A = $52,000 × 8.2 × 0.0025 = $1,066
Change in Bond B = $61,000 × 6.8 × 0.0025 = $1,037
Change in Bond C = $80,000 × 5 × 0.0025 = $1,000
Change in zero-coupon bond = $40,000 × 3 × 0.0025 = $300
Total change in the portfolio = $1,066 + $1,037 + $1,000 − $300 = $2,803
(Study Session 9, LOS 20.g)
Question #17 of 72
Question ID: 466100
The scenario Richards mentions regarding the supply and demand for the collateral in the repurchase agreement should
cause the repo rate to be:
ᅚ A) lower.
ᅞ B) higher.
ᅞ C) stay the same.
No single repo rate exists for all repurchase agreements. The particular repo rate depends upon a number of factors.
If the availability of the collateral is limited, the repo rate will be lower. The lender may be willing to accept a lower
rate in order to obtain a security they need to make delivery on another agreement.
The repo rate increases as the credit risk of the borrower increases (when delivery is not required).
As the quality of the collateral increases, the repo rate declines.
As the term of the repo increases, the repo rate increases. It is important to note that the repo rate is a function of the
repo term, not the maturity of the collateral securities.
If collateral is physically delivered, then the repo rate will be lower. If the repo is held by the borrower's bank, the rate
will be higher. If no delivery takes place, the rate will be even higher.
The federal funds rate, the rate at which banks borrow funds from one another, is a benchmark for repo rates. The
higher the federal funds rate, the higher the repo rate.
As the demand for funds at financial institutions changes due to seasonal factors, so will the repo rate.
(Study Session 10, LOS 22.b)
Question #18 of 72
Question ID: 466107
An analyst is considering various risk measures to apply to a bond portfolio. He requires a measure that will use as much data
as possible so little information will be lost. Given this requirement, as he considers using the semivariance and/or value at
risk, he would reject:
ᅚ A) the semivariance but not value at risk.
ᅞ B) both value at risk and the semivariance.
ᅞ C) value at risk but not the semivariance.
The measures to compute value at risk uses the total distribution of returns above and below the mean. The semivariance
only uses half the data, the portion of data below a given value so it is statistically less accurate. VAR does not give an
indication as to the magnitude of the worst possible outcome.
Question #19 of 72
Question ID: 466130
Which type of credit risk is defined as the risk that the issuer will not meet the obligations of the issue?
ᅞ A) Credit spread risk.
ᅞ B) Downgrade risk.
ᅚ C) Default risk.
Default risk refers to the risk that the debt issuer will fail to pay its obligations of the issue. Downgrade risk refers to the
possibility that the credit rating of an asset or issuer is downgraded by a major credit-rating organization. Credit spread risk
refers to the risk of an increase in the yield spread of an asset.
Question #20 of 72
Which of the following is NOT an advantage of using financial futures for asset allocation?
ᅞ A) Time savings.
ᅚ B) More precise hedging.
ᅞ C) Less portfolio disruption.
Question ID: 466112
Using financial futures contracts will save time and cause less portfolio disruption. However, futures contracts expose the
manager to basis risk, wherein the futures contract and the portfolio are not perfectly correlated, leading to return differences
between the futures position and the underlying exposure that is being replicated.
Question #21 of 72
Question ID: 466139
A U.S. investor holds a bond portfolio that includes bonds that are an obligation of a British company and denominated in
British pounds. In estimating the sensitivity of the value of that foreign position to rates in the United States, with respect to the
country beta for Great Britain and the British bond's duration, it is most correct to say a:
ᅞ A) lower country beta and lower bond duration will lead to higher interest rate risk.
ᅞ B) lower country beta and higher bond duration will lead to lower interest rate risk.
ᅚ C) higher country beta and higher bond duration will lead to higher interest rate risk.
The duration contribution to the domestic portfolio is the product of the country beta and the bond's duration. It is most correct
to say that when both go up, the interest rate risk increases.
Question #22 of 72
Question ID: 466126
The Reliable Insurance Company sells fixed rate annuities as part of its product mix and uses the proceeds to invest in floating
rate notes. What kind of interest rate change should they hedge against and which is the most appropriate hedging strategy?
They would be concerned with interest rates:
ᅞ A) decreasing and would hedge this risk by buying a cap and selling a floor.
ᅞ B) increasing and would hedge this risk by selling a floor and buying a cap.
ᅚ C) decreasing and would hedge this risk by selling a cap and buying a floor.
An insurance company that sold a fixed rate annuity and invests the proceeds in a floating rate note would be concerned that
interest rates would decrease thus causing the return on their floating rate note to be less than what they owe on the fixed rate
annuity. They can mitigate this risk by selling a cap and using the proceeds to buy a floor which would payoff in the event that
interest rates decreased below the floor strike price.
Questions #23-28 of 72
FI Investment Co. (FI) has recently observed an increase in the credit risk of their fixed income portfolios. Management has
never used credit derivatives to hedge this risk, but thinks that this might be time to try them. Bill Bales, one of the portfolio
managers, is instructed to learn about the basics of credit derivatives and then use them to hedge credit risk in FI's portfolios.
First, Bales looks at why investors would sell credit protection. He makes some notes as to why credit protection would be
1. Sellers are hedging their fixed income positions.
2. Sellers may expect a ratings upgrade for the asset/issuer as a likely outcome.
3. Sellers may sell credit protection options to enhance portfolio income, assuming the options finish in-the-money.
4. Sellers believe that a takeover by another firm is unlikely.
Next, Bales explores the use of binary credit options. He realizes there are quite a few of them. To put them in perspective, he
develops a list of binary credit options that might be appropriate for FI portfolios:
1. A call option that has its value tied to the difference between the market spread and a reference spread and the payoff is
an increasing function of the credit spread.
2. A put option that allows the holder to put the bond back to the issuer at a fixed-price if the credit rating falls.
3. A call option that pays the difference between a reference value and the market value of the bond after a downgrade.
4. A call option that pays additional coupon income in the event of a downgrade.
Bales' research indicates that not only can credit derivates be used to protect FI's fixed income portfolios from certain types of
risks, but they can also be employed to lower the firm's borrowing costs. Bales is able to convince FI's CEO Tim Brown to
issue the following bond:
A 5-year, annual pay, $20 million bond offering at a rate of LIBOR plus 150 basis points.
LIBOR is 6.5%.
The bonds will be issued with a binary credit put, with a strike price at par.
One year from today (t=1) (the day after the coupon payment is made) LIBOR moves to 7% and the yield on the bond is at
Question #23 of 72
Question ID: 466132
Regarding the sellers of credit protection, which statement is most accurate?
ᅚ A) Statement 2.
ᅞ B) Statement 3.
ᅞ C) Statement 1.
Sellers of credit protection are speculators that are motivated by potential increases in credit quality. They believe in a possible
ratings upgrade, takeover, or redemption of outstanding bonds due to the availability of lower cost financing sources. (Study
Session 10, LOS 22.g)
Question #24 of 72
Question ID: 466133
Regarding a total return credit swap which of the following statements is least accurate?
ᅞ A) The swap can hedge many types of risk with a single contract.
ᅚ B) The total return payer owns the underlying assets.
ᅞ C) The total return payer receives an amount based on a specified reference at the
swap's settlement dates.
The total return payer may or may not own the underlying securities. Entering into a credit swap as the total return payer
without owning the underlying assets is a way to short a bond. A total return credit swap does hedge many types of risk. Also,
the number of transactions will likely be less than trading the underlying, and the total return receiver pays an amount based
on a specified reference at the swap's settlement dates. (Study Session 10, LOS 22.g)
Question #25 of 72
Question ID: 466134
Suppose the investor who buys FI's bond issue holds 1,000 bonds with a $1 million face value position. Subsequently a credit
downgrade occurs and the bond declines in value to $700. If the strike price is $1,000 what is the option value per $1,000 par
ᅞ A) $700.
ᅞ B) $300,000.
ᅚ C) $300.
The following equation is used:
OV = max[(strike - value), 0]
= (1,000 − 700) = $300.
(Note: if protection were purchased on the entire position, the overall payoff would be $300,000 (= $300 × 1,000), less the cost
of purchasing the options.) (Study Session 10, LOS 22.g)
Question #26 of 72
Question ID: 466135
Assume that instead of a binary credit put option, FI intends to issue the bond with a credit spread call option. The bond's risk
factor is 2 and assume it is now one year from today. The value of the credit call option is closest to:
ᅞ A) the credit call is out-of-the-money.
ᅚ B) $300,000.
ᅞ C) $225,000.
The value of the credit call is equal to the actual spread over the benchmark versus the specified spread over the benchmark
times the principal times the risk factor. Note that the payoff is not binary - the payoff to the option will increase as the spread
over the benchmark gets larger.
(0.0925 − 0.0700 − 0.0150) × $20,000,000 × 2 = $300,000
(Study Session 10, LOS 22.g)
Question #27 of 72
Question ID: 466136
With regard to the binary credit options, which of the statements given are least accurate?
ᅚ A) Option 1.
ᅞ B) Option 4.
ᅞ C) Option 2.
The key to a binary option is that it assumes one of two possible states. The option either pays or does not pay. The value
does not continue to rise (or fall) based on the value of the underlying. Thus, a call that has a payoff as an increasing function
of the credit spread would not be binary. (Study Session 10, LOS 22.g)
Question #28 of 72
Question ID: 466137
FI holds a large position with a 10-year maturity. Recently, Bales has observed a significant increase in the spread relative to
the 10-year Treasury. Today he learns that Moody's has changed the rating on the bond from investment grade to
speculative. In terms of credit risk, FI is dealing with:
ᅞ A) credit spread, default and downgrade risk. Credit spread risk can be managed
with credit options and credit forwards. Downgrade risk can be managed with
either credit forwards or swaps. Default risk can only be managed with swaps.
ᅚ B) credit spread and downgrade risk. Credit spread risk can be managed with credit
spread options, credit spread forwards, and total return swaps. Downgrade risk can
be managed with credit options, credit swaps, and total return swaps.
ᅞ C) credit spread and default risk. Credit spread risk can be managed with credit options
and credit forwards. Default risk can be managed with credit forwards, swaps, and
These are examples of credit spread and downgrade risks. Credit spread risk is the risk that the yield premium over the
relevant risk free benchmark will increase. Downgrade risk reflects the possibility that the credit rating of an asset/issuer is
downgraded by a major credit-rating organization. The investor can use credit spread options, credit spread forwards, or total
return swaps to manage credit spread risk. Credit options, credit swaps, and total return swaps can be used to manage
downgrade risk. (Study Session 10, LOS 22.g)
Question #29 of 72
Question ID: 466121
A portfolio manager is considering increasing the dollar duration of a portfolio by either buying more bonds or buying futures
contracts. Having used a reliable model to determine a bond position and a futures position that have equal dollar durations,
choosing to add the futures position to the existing portfolio will increase the final portfolio's dollar duration:
ᅞ A) more than the proposed bond position.
ᅞ B) significantly, but less than the proposed bond position.
ᅚ C) by an amount equal to the proposed bond position.
Theoretically, using bonds or futures can accomplish the same goal.
Question #30 of 72
Question ID: 466113
Which of the following is NOT an advantage of using futures instead of cash market instruments to alter portfolio risk?
ᅞ A) Lower transaction costs.
ᅚ B) Higher margin requirements.
ᅞ C) Greater leverage opportunities.
Lower margin requirements are one of the advantages of using futures instead of cash market instruments. The margin
requirements are lower for futures, which allows for greater leverage.
Question #31 of 72
Question ID: 466152
Mary Brickland, CFA, is analyzing two different domestic bonds. Bond A has the longer modified duration at 9.50 with a yield of
9.12%. Bond B has a modified duration of 7.30 and a yield of 7.80%. Brickland has an investment-holding period of one year
and expects a favorable credit quality change for Bond B to increase its market value during this time frame. If Brickland buys
Bond B, what is the required basis point change in the spread (in terms of the required yield on Bond B) to offset Bond A's
ᅚ A) 18.08219 bp due to a decline in the yield.
ᅞ B) 13.89474 bp due to a decline in the yield.
ᅞ C) 14.72190 bp due to an increase in the yield.
Bond A has a yield advantage of 132 basis points relative to Bond B. An increase in Bond B's credit rating will increase its price
and lower its yield. Since we are looking at this in terms of Bond B: (1.32/-7.30) x 100 = -18.08219bp, the breakeven change in
yield is -18.08219bp, or a decline in the yield on Bond B resulting in the widening of the spread between A and B by this
amount. The increase in price for Bond B will result in capital gains for Bond B, which will offset A's original yield advantage.
Note that the CFA curriculum specifies using the bond with the greater duration which in this case would be bond A although
as we have demonstrated in this question the bond with the shorter duration can also be used. Thus, if you are not told which
bond to use to perform the calculation you should use the one with the greater duration.
Question #32 of 72
Question ID: 466123
A manager of a fixed-income portfolio sells futures contracts identical to contracts it already owns. With respect to the portfolio
under management, the effect of this will be to:
ᅞ A) increase the value.
ᅚ B) decrease dollar duration.
ᅞ C) increase modified duration.
The only one of the choices we know for sure is that dollar duration will decline. The act of closing a futures contract does not
necessarily change a portfolio's value one way or another. The modified duration is a weighted average of the durations of the
positions and not the dollar durations, it may go up or down.
Questions #33-38 of 72
Jill Jebson and Tom Dickens are investors in the United States who are considering the possibility of investing in bonds from
several different countries. Their prospective choices are in the table below. The rates on the bonds and the risk-free return
are annualized. The horizon is one year unless stated otherwise.
local bond return
modified duration of bond
Jebson and Dickens analyze the returns under several assumptions. First, they estimate the breakeven change in spread
ignoring the forward discount or premium. They then incorporate the forward discount and premium into the analysis.
Jebson says that after purchasing any one of the bonds that have a yield disadvantage to the U.S. bond, one way to make up
for the yield differential would be to have a yield decrease in the foreign country. Dickens says that an increase in market yield
of the U.S. bond can also make up the yield differential.
Jebson and Dickens explore the role duration plays in determining the yield disadvantage one bond has relative to another.
Jebson says that if there is a 10 basis point decrease in all bond yields, including the risk-free rates, then the U.S. bond would
be the best investment. Dickens says that such a shift in yields would significantly affect the breakeven yield changes needed
for the foreign bonds to provide the same return as the U.S. bond.
Question #33 of 72
Question ID: 466154
Jebson and Dickens both cite ways a market move can make up for a yield disadvantage of each foreign bond, after
purchase, relative to the U.S. bond. With respect to their statements:
ᅞ A) Jebson is correct and Dickens is wrong.
ᅚ B) Jebson and Dickens are both correct.
ᅞ C) Jebson and Dickens are both wrong.
If a foreign bond is at a yield disadvantage based upon the yield when purchased compared to the U.S. bond, then either a
decrease in the foreign bond yield (i.e., increase in price) or an increase in the U.S. bond yield (i.e., decrease in price) will
make up for the yield disadvantage. (Study Session 10, LOS 22.k)
Question #34 of 72
Question ID: 466155
With respect to the affect of a negative 10 basis point shift in bond yields and the risk-free rate:
ᅞ A) Jebson is wrong and Dickens is correct.
ᅚ B) Jebson is correct and Dickens is wrong.
ᅞ C) Jebson and Dickens are both correct.
Jebson is correct because the decrease in bond yields will increase the price of the U.S. bond by the largest amount. This is
because it has the highest duration. Such a shift, if it includes the risk-free rates, will not significantly affect the breakeven
changes in the spread. The absolute amount of the yield disadvantage or advantage would not change. The duration
measures would not change much as a result of a relatively small shift like 10 basis points. (Study Session 10, LOS 22.k)
Question #35 of 72
Question ID: 466156
For a 6-month time horizon, and ignoring the currency differential, what would be the breakeven change in yield between the
Canadian and U.S. bonds?
ᅚ A) U.S. bond yield increases by 5.65 basis points.
ᅞ B) Canadian bond yield increases by 10.29 basis points.
ᅞ C) Canadian bond yield decreases by 5.65 basis points.
The yield differential for a six-month horizon is (5.5% − 4.8%) / 2 = 0.35%. Thus, either the Canadian bond yield must
decrease (increase in price of the Canadian bond) or the U.S. bond yield must increase (decrease in price of the U.S. bond).
The breakeven yield change in basis points = 100 × (% change in price / −duration).
The change in the U.S. bond yield is 100 × (−0.35 / −6.2) = 5.65 basis points.
The change in the Canadian bond yield is 100 × (0.35 / −3.4) = −10.29 basis points.
The calculation should be based on the bond with the higher duration which is the U.S. bond.
(Study Session 10, LOS 22.k)
Question #36 of 72
Question ID: 466157
Based on the information in the table, including the currency differential, which of the following foreign bonds is least likely to
have a yield disadvantage compared to a U.S. bond?
ᅞ A) Japanese bond.
ᅞ B) European bond.
ᅚ C) British bond.
A bond in a foreign currency trades at a yield disadvantage if the forward discount/premium combined with the yield differential
has a negative value. In other words, a disadvantage exists if:
(foreign bond yield − domestic bond yield) − (foreign risk-free rate − domestic risk-free rate) < 0
A symbolic representation would be:
(Rj − Rd) − (cj − cd) < 0.
The assumption is the difference in the risk-free rate, represented by cj − cd, is an accurate measure of the forward premium
or discount, which, in fact, must be the case for freely-traded currencies under covered interest rate parity. The difference is
the foreign currency discount if cj − cd > 0 or premium if cj &£8722; cd < 0. In this case we find that a disadvantage exists for all
the bonds except the British bond:
British bond: 6.5% − 5.5% − (3.2% − 2.2%) = 0%
Canadian bond: 4.8% − 5.5% − (1.9% − 2.2%) = −0.4%
European bond: 5.2% − 5.5% − (2.4% − 2.2%) = −0.5%
Japanese bond: 3.5% − 5.5% − (1.2% − 2.2%) = −1.0%
(Study Session 10, LOS 22.k)
Question #37 of 72
Question ID: 466158
For a 1-year horizon, and including the effect of the currency differential, an increase in the yield of the U.S. bond by 16.13
basis points would represent the breakeven spread change for the U.S. bond and which other bond?
ᅞ A) British bond.
ᅚ B) Japanese bond.
ᅞ C) European bond.
The formula is:
100 × (% change in price of U.S. bond) / (-modified duration of U.S. bond) = breakeven yield spread change.
British bond = 100 × (0) / (−6.2) = 0 bp
Canadian bond = 100 × (−0.4) / (−6.2) = 6.45 bp
European bond = 100 × (−0.5) / (−6.2) = 8.06 bp
Japanese bond = 100 × (−1.0) / (−6.2) = 16.13 bp
(Study Session 10, LOS 22.k)
Question #38 of 72
Question ID: 466159
For a 1-year horizon, and including the effect of the currency differential, determine which of the following is closest to the
breakeven yield change for the Canadian and Japanese bonds.
ᅚ A) Canadian bond yield increases by 17.6 basis points.
ᅞ B) Japanese bond yield increases by 25 basis points.
ᅞ C) Canadian bond yield decreases by 25 basis points.
The Japanese bond is at a yield disadvantage: 3.5% − 4.8% − (1.2% − 1.9%) = −0.6%
Thus, either a Japanese bond yield decrease or a Canadian bond yield increase will represent a breakeven change.
The change in the Canadian bond yield is 100 × (−0.6) / (−3.4) = 17.6 bp
The change in the Japanese bond yield is 100 × (0.6) / (−2.4) = −25 bp
The most correct answer is a 17.6 basis point increase in the Canadian bond yield because it has the higher duration.
(Study Session 10, LOS 22.k)
Question #39 of 72
Question ID: 466127
Which of the following refers to the risk that a bond-rating agency may lower the credit rating on a bond issue?
ᅞ A) Bond rating risk.
ᅞ B) Credit spread risk.
ᅚ C) Downgrade risk.
Downgrade risk refers to the risk that a bond-rating agency lowers (or downgrades) the credit rating on the bond issue.
Question #40 of 72
Question ID: 466089
Which of the following is an advantage of leverage? Leverage:
ᅚ A) magnifies the return from a security for a given price change.
ᅞ B) decreases the risk for a given return potential.
ᅞ C) increases the return potential without incurring larger risk.
Leveraging increases the return potential but also increases the risk, resulting in a wider range of possible outcomes.
Question #41 of 72
Question ID: 466149
Which of the following statements concerning how breakeven rate analysis can be used to make relative value or currency
hedging decisions between foreign bond markets is CORRECT? Break-even analysis can be used to:
ᅞ A) identify mispriced bonds in foreign markets and to take advantage of the
ᅚ B) quantify the amount of spread widening that would erase the yield advantage from
investing in a higher yielding market.
ᅞ C) quantify the correct amount of currency exposure to hedge.
Breakeven rate analysis can be used to determine how many basis points the spread would have to change in order for yield
advantages to be eliminated.
Question #42 of 72
Question ID: 466147
Which of the following is a valid reason for NOT using forwards to hedge exposure to currency risk? The portfolio manager expects:
ᅚ A) that the percentage return from exposure to a currency is greater than the forward
discount or premium.
ᅞ B) home interest rates to rise relative to foreign interest rates.
ᅞ C) the future currency exchange rate to be less than the forward exchange rate.
If the return from being exposed to a currency is greater than the forward premium, then using the forward to hedge will result in a return
less than that if there were no hedge.
Questions #43-47 of 72
Carlos Mendoza is a portfolio manager for a money management firm that caters to high net worth individuals. Mendoza's firm
has recently acquired the account of a new client, Forrest Thompson, and Mendoza has just met with him to establish his
investment profile, return requirements, and tolerance for risk. Subsequent to the meeting, Mendoza has written an investment
policy statement for Thompson that outlines approximate asset class allocations. Thompson informed Mendoza that his main
investment objective is to maximize current income rather than to pursue aggressive growth opportunities. With this in mind,
Mendoza suggested that approximately 40 percent of the portfolio's assets should be allocated to fixed income securities, 40
percent in domestic equities, with the remainder in cash or cash equivalents. In accordance with Thompson's tolerance for
risk, suitable fixed-income investments have been defined as U.S. Treasury securities, mortgage-backed securities, assetbacked securities, and corporate bonds. All investments purchased for the portfolio must be rated investment grade or higher.
For the fixed income portion of the portfolio, Mendoza, with the approval of Thompson, has established the Salomon Brothers
Broad Investment Grade Index (BIG) as the return benchmark. Mendoza will typically seek to alter the portfolio composition to
deviate slightly from the index in order to capitalize on short-term opportunities. Specifically, Mendoza is authorized to alter the
portfolio duration, within a specified range, to take advantage of any anticipated rate shifts. Because deviations from the index
have the potential to lead to increased exposure to tracking risk, the portfolio is expected to outperform the index by 50 basis
points, less management and transaction fees.
Thompson's portfolio was previously managed by another asset management firm that Thompson felt had exposed his
portfolio to excessive risk. One practice the other money manager frequently engaged in was to utilize repurchase
transactions as a short-term investment vehicle. From time to time, cash in Thompson's portfolio was loaned to broker-dealers
in exchange for Treasury securities, which were deposited in a custodial account at a mutually agreed-upon bank. The repos
were structured for time periods of thirty days or less, and Thompson was paid the prevailing rate of interest. Thompson has
never been quite sure what the risks involved in the repo transactions were, and thought the previous manager did not provide
him with enough information. Thompson has asked Mendoza to evaluate whether or not entering into repo agreements is an
appropriate practice given his risk tolerance, and Mendoza offered to outline the associated advantages and risks.
Thompson's inquiry about the basics of repo transactions leads Mendoza to examine other investment strategies that may or
may not be appropriate for Thompson's investment profile. Mendoza gives some consideration to introducing leverage to the
portfolio, but he is concerned that Thompson does not fully understand the implications of a leveraged portfolio. Mendoza
believes that without leverage, it will be difficult to achieve the stated objective of outperforming the BIG index by 50 basis
points. He decides to demonstrate the effect of leverage on a sample portfolio to enable Thompson to be able to make
informed decisions regarding basic portfolio management decisions. Mendoza constructs a hypothetical $5,000,000 bond
portfolio with an unleveraged duration of 3.1 years. He then runs scenario analyses utilizing several levels of leverage under
different changes in interest rates. Mendoza then calculates how the leverage affects the overall risk of the portfolio by
measuring the change in the portfolio's duration. He believes this is the best way to demonstrate to Thompson the potential
benefits and drawbacks from such a strategy.
Question #43 of 72
Question ID: 466102
Mendoza's normal approach to the management of Thompson's bond portfolio would most likely be classified as:
ᅞ A) enhanced indexing by matching primary risk factors.
ᅞ B) indexing by minor risk factor mismatching.
ᅚ C) active management by larger risk factor mismatches.
Indexing by minor risk factor mismatching allows minor mismatches in certain risk factors of the index, such as sector and
quality, but is generally supposed to have the same duration as the index. Mendoza usually deviates from the composition of
the index to capitalize on market opportunities which results in a different duration for the portfolio than that of the index. Also,
as noted in the vignette, this strategy assumes more tracking risk. (Study Session 9, LOS 20.b)
Question #44 of 72
Question ID: 466103
In the course of managing Thompson's portfolio, Mendoza will utilize which of the following value-added strategies?
ᅚ A) Yield curve management.
ᅞ B) Market selection.
ᅞ C) Sector selection.
Since Mendoza plans to alter the portfolio duration, within a specified range, to take advantage of any anticipated interest rate
changes, he plans to use an interest rate expectations strategy also referred to as duration management or yield curve
management which involves forecasting interest rates and adjusting the portfolio accordingly. (Study Session 10, LOS 22.h)
Question #45 of 72
Question ID: 466104
Which one of the following statements regarding repo transactions is most accurate?
ᅞ A) When a securities dealer uses a repurchase agreement to borrow funds, it is
called a reverse repo transaction.
ᅚ B) As a short-term investment, a properly structured repurchase agreement is
considered to be a high-quality investment.
ᅞ C) The credit risk of a repo agreement depends solely upon the quality of the collateral.
A repurchase agreement is generally considered to be a high-quality money market investment. Repos are considerably much
more risky when used as a source of funds to create leverage. (Study Session 10, LOS 22.b)
Question #46 of 72
Which of the following factors is least likely to cause a lower repo rate from the perspective of the lender?
ᅞ A) Delivery of the collateral to the lender.
ᅞ B) Hot collateral.
ᅚ C) Collateral with a short term to maturity.
Question ID: 466105
The repo rate is a function of the repo term and not a function of the maturity of the collateral securities. (Study Session 10,
Question #47 of 72
Question ID: 466106
Utilize the hypothetical portfolio constructed by Mendoza and assume the portfolio is leveraged by 10 percent using a 30-day
repo transaction. What is the duration of the equity invested?
ᅞ A) 3.10 years.
ᅞ B) 2.82 years.
ᅚ C) 3.44 years.
10% leverage equals $4,500,000 in equity and $500,000 of debt.
The duration of the repo is very close to zero.
The duration of the portfolio is calculated as follows:
DE = (DiI - DBB)/E
DE = [(3.1)( 5,000,000) - (0)(500,000)] / 4,500,000 = 3.44
DE = Duration of equity invested
Di = Duration of invested assets
DB = Duration of borrowed funds
I = amount of invested funds
B = amount of borrowed funds
E = amount of equity invested
(Study Session 10, LOS 22.a)
Question #48 of 72
Question ID: 466120
Which of the following is an advantage of using futures instead of cash market instruments to alter portfolio risk?
ᅞ A) Futures provide higher returns than cash market instruments.
ᅞ B) Futures can be customized to match any specific customer needs.
ᅚ C) Transaction costs for trading futures are lower than trading in the cash market.
There are three main advantages to using futures over cash market instruments. All three advantages are derived from the
fact that there are low transactions costs and a great deal of depth in the futures market.
Compared to cash market instruments, futures:
1. Are more liquid.
2. Are less expensive.
3. Make short positions more readily obtainable, because the contracts can be more easily shorted than an actual bond.
Question #49 of 72
Question ID: 466129
Which of the following is the best explanation of credit spread risk? Credit spread risk refers to the risk that an:
ᅚ A) asset's appropriate discount rate increases relative to the comparable risk-free rate.
ᅞ B) asset will be downgraded in the future.
ᅞ C) asset's bid-ask spread will increase.
Credit spread risk is the risk of an increase in the yield spread on an asset. Yield spread is the asset's yield minus the relevant
risk-free benchmark. This risk is a function of potential changes in the market's collective evaluation of credit quality, as
reflected by the spread.
Question #50 of 72
Question ID: 466090
Which of the following best characterizes leveraging? Leveraging involves:
ᅞ A) exploiting mispricings in the market.
ᅞ B) writing options.
ᅚ C) borrowing funds to implement a trade.
Leverage refers to the use of borrowed funds to purchase a portion of the securities in a portfolio. A leverage-based strategy is used with
the objective of earning a return over and above the cost of borrowed funds.
Question #51 of 72
Question ID: 466138
One way that international bond portfolio managers attempt to enhance portfolio returns is to correctly anticipate interest rate
and yield curve changes. This strategy is called:
ᅞ A) bond market selection.
ᅞ B) sector selection.
ᅚ C) duration management.
With duration management, bond portfolio managers are able to increase returns by correctly forecasting interest rate shifts
and changes in the shape of the yield curve. By correctly estimating these changes, the bond manager can capitalize on the
inverse relationship between interest rate changes and the market value of bond issues.
Question #52 of 72
Question ID: 466128
Which of the following refers to the risk that the difference between the yield on a risky asset and the yield on a risk-free asset
ᅚ A) Credit spread risk.
ᅞ B) Interest rate risk.
ᅞ C) Default risk.
Credit spread risk refers to the risk that the difference between the yield on a risky asset and the yield on a risk-free asset, the
credit spread, increases. Default risk is the risk that the issuer will not pay principal or interest when due; and interest rate risk
refers to the risk of rising rates decreasing a bond's market value.
Question #53 of 72
Question ID: 466140
Which of the following foreign bond positions will have the highest sensitivity to changes in domestic interest rates? A foreign
bond that has a duration equal to:
ᅞ A) 5 and a country beta equal to 0.2.
ᅚ B) 4 and a country beta equal to 0.3.
ᅞ C) 2 and a country beta equal to 0.5.
The total sensitivity is given by the duration times the country beta. The product of 4 times 0.3 is the highest of the three.
Question #54 of 72
Question ID: 466161
Jill Upton, CFA, and Al Grey, CFA, are planning to add foreign bonds to the domestic portfolio, which they manage. They are
discussing the advantage of adding bonds issued by sovereign emerging market governments. Compared to bonds issued by
corporations, all of the following are advantages of sovereign emerging market government debt with EXCEPT:
ᅚ A) the bonds are free of default risk.
ᅞ B) the issuers can react more decisively to negative economic events.
ᅞ C) the issuers tend to have reserves to absorb shocks.
The other advantages listed are true along with lower default risk, but the bonds are not free of default risk. Governments
have and will default on bonds.
Question #55 of 72
Question ID: 466122
A manager buys a position in futures contracts that have a dollar duration (for a forecasted interest rate change) equal to
$22,500. Before buying the futures contracts, the manager's fixed income portfolio had a dollar duration (for the forecasted
interest rate change) equal to $40,500. The dollar duration of the combined position is:
ᅚ A) $63,000.
ᅞ B) $18,000.
ᅞ C) -$18,000.
This is an application of the formula DDP = DDP w/o futures + DDFutures position
Question #56 of 72
Question ID: 466110
Which of the following is an advantage of using financial futures for asset allocation purposes instead of the cash market securities?
ᅞ A) are traded over-the-counter which eliminates the market impact of large transactions.
ᅞ B) can be tailored to an investor's particular requirements.
ᅚ C) offer time savings.
It will take less time to execute the asset allocation shift using futures than with buying and selling individual stocks and bonds.
Question #57 of 72
Question ID: 466160
When compared to the debt issued by corporations in developed nations, the sovereign debt of emerging market governments
tend to have a:
ᅚ A) lower level of standardized covenants and a less enforceable seniority
ᅞ B) higher level of standardized covenants but a less enforceable seniority structure.
ᅞ C) lower level of standardized covenants but a more enforceable seniority structure.
Sovereign debt typically lacks an enforceable seniority structure, in contrast to private debt, and little standardization of
covenants exists among the various emerging market issuers.
Question #58 of 72
Question ID: 466125
A bond portfolio manager believes that interest rates are relatively stable and will not change much in the near future. The
best strategy the manager can pursue in the short term is to:
ᅚ A) enter into a covered call strategy using Treasury futures.
ᅞ B) do nothing.
ᅞ C) buy a protective put on Treasury futures.
In a stable interest rate environment the manager is not concerned about interest rates increasing which would decrease the
value of their bond portfolio. In this type of environment they can earn additional income by entering into a covered call
strategy which means they own the underlying asset, in this case bonds, and sell interest rate call options based on Treasury
futures contracts. This strategy will provide income in the form of premiums earned from the sale of the call options. If interest
rates decrease, the Treasury futures will increase in price and the call options will be exercised if the Treasury futures is above
the strike price reducing the seller of the call options return. The covered call strategy does not protect against an increase in
interest rates where bond values would decrease except for the amount of the premium earned on the sale of the call options.
Question #59 of 72
Question ID: 466162
In the emerging market debt market, it is generally true that volatility is:
ᅞ A) high, and the returns have significant positive skewness.
ᅚ B) high, and the returns have significant negative skewness.
ᅞ C) low, and the returns have significant positive skewness.
Volatility in the emerging market debt market is high, and the returns are also frequently characterized by significant negative
Question #60 of 72
Question ID: 466163
Executives of a company are in the process of hiring managers for the company's fixed-income portfolios. The company will
hire two managers. In selecting the managers, all other things being equal, it is optimal to hire managers whose alphas have
ᅚ A) positive and are uncorrelated.
ᅞ B) positive and are highly correlated.
ᅞ C) negative and are uncorrelated.
The company would want to hire managers who have a proven track record for adding value, i.e., who have had positive
alphas. It is better to hire managers whose alphas are uncorrelated because that would lower portfolio risk.
Question #61 of 72
Question ID: 466141
A bond-portfolio manager is considering adding a position to the portfolio. He is choosing between a domestic bond with a
duration equal to 4.8 or a foreign bond that has a duration of 6.0 and a country beta equal to 0.8. If the manager wishes to
add the bond with the lower sensitivity to domestic interest rates, the manager:
ᅚ A) would be indifferent between the two bonds.
ᅞ B) would choose the domestic bond.
ᅞ C) would choose the foreign bond.
Both bonds have the same sensitivity to domestic rates: 6.0 × 0.8 = 4.8.
Questions #62-64 of 72
Gil Johnson and Susan Craig are U.S.-based investors discussing some potential investments in foreign bonds. They have
gathered the information in the table below. The rates on the bonds and the risk free return are annualized, and the
investment horizon is one year. The expected exchange rate is that for one year from today.
British bond Canadian bond European bond Japanese bond U.S.
Local bond return 6.5%
Risk free return
Expected in 1 yr. $1.67/₤
Based on this information, Johnson and Craig consider not only which bonds to invest in, but also whether or not to hedge the
investment. They consider standard hedges, cross-hedges, and proxy hedges. With respect to these various types of hedges,
Johnson says that using some of them can actually increase risk. Craig says that some of the hedge strategies can also
Johnson says that the one strategy they will probably not employ is the proxy hedge. His reasoning is that the four currencies
are not all expected to either increase or decrease against the dollar. "A proxy hedge only makes sense when we have high
correlations for the currency movements," Johnson says. Craig agrees that they should not employ a proxy hedge, but her
reasoning is that there are probably no cost benefits in doing so.
Johnson and Craig then calculate the returns for each bond both in an unhedged position and with a standard hedge. They
also calculate the returns on the European bond assuming that they can cross hedge using each of the possible currencies.
Question #62 of 72
Question ID: 466144
Assuming the currency risk can be fully hedged which of the foreign bonds would offer the highest return?
ᅚ A) British bond.
ᅞ B) Japanese bond.
ᅞ C) Canadian bond.
Assuming the currency risk can be fully hedged with a forward contract the bond with the greatest excess return should be
purchased. The excess return is the nominal return - risk free rate. The excess return for the four foreign bonds is:
British bond = 6.5 - 3.2 = 3.3%
Canadian bond = 4.8 - 1.9 = 2.9%