CFA Level 3 - Fixed Income Session 10 - Reading 25

CFA Level 3 – Fixed Income, Session 10 – Reading 25

(Notes, Practice Questions, Sample Questions)

1. Which of the following statements regarding leverage is least accurate?

A)A leverage-based strategy decreases portfolio returns when the return on the strategy is greater than the cost of borrowed funds.
B)Leverage is beneficial only when the strategy earns a return greater than the cost of borrowing.
C)Leverage refers to using borrowed funds to purchase a portion of the securities in the portfolio.

[Explanation: C) A leverage-based strategy increases, not decreases portfolio returns when the return on the strategy is greater than the cost of borrowed funds]
2. Which of the following best characterizes leveraging? Leveraging involves:

A)exploiting mispricings in the market.
B)borrowing funds to implement a trade.
C)writing options

[Explanation: B) 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]
3. Which of the following CORRECTLY describes a repurchase agreement?

A)The sale of a security with a commitment to repurchase the same security at a specified future date and a designated price.
B)The sale of a security with a commitment to repurchase the same security at a future date left unspecified, at a designated price.
C)The purchase of a security with a commitment to purchase more of the same security at a specified future date.

[Explanation: A) A repurchase agreement is an agreement whereby the seller of a security agrees to “repurchase” it from the buyer on an agreed upon date at an agreed upon price.

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Repos are typically used by securities dealers as a means for obtaining funds to purchase securities]
4. An agreement whereby the seller of a security agrees to “repurchase” it from the buyer on an agreed upon date at an agreed upon price is called a:

A)commercial paper.
B)repurchase agreement.
C)negotiable certificate of deposit.

[Explanation: B) An agreement whereby the seller of a security agrees to “repurchase” it from the buyer on an agreed upon date at an agreed upon price is called a repurchase agreement]
5. Which of the following is least likely to expose the lender in a repurchase agreement (repo) to credit risk related to the delivery of the collateral?

A)The borrower files for bankruptcy before the collateral is delivered.
B)The borrower sells the collateral prior to delivery.
C)The borrower has their bank hold the collateral instead of the lender in the repo agreement.

[Explanation: C) While the lender would prefer to have possession of the collateral, having the borrower’s bank hold the collateral is the least likely of the above to expose the lender to credit risk]
6. 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, asset-backed 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 keep the portfolio’s duration equal to that of the index. However, when market conditions warrant, the portfolio composition will be allowed to deviate slightly from the index from time to time in order to capitalize on short-term opportunities. In specific, 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. Mendoza’s normal approach to the management of Thompson’s bond portfolio would most likely be classified as:

A)enhanced indexing by matching primary risk factors.
B)indexing by minor risk factor mismatching.
C)active management by larger risk factor mismatches.

[Explanation: B) 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 is allowed to deviate from the index to capitalize on market opportunities, but he will generally mimic the index. Also, as noted in the vignette, this strategy assumes more tracking risk.]
7. In the course of managing Thompson’s portfolio, Mendoza will utilize which of the following value-added strategies?

A)Market selection.
B)Yield curve management.
C)Sector selection.

[Explanation: B) 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. ]

8. Which one of the following statements regarding repo transactions is most accurate?

A)The credit risk of a repo agreement depends solely upon the quality of the collateral.
B)As a short-term investment, a properly structured repurchase agreement is considered to be a high-quality investment.
C)When a securities dealer uses a repurchase agreement to borrow funds, it is called a reverse repo transaction.

[Explanation: B) 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.]
9. Mendoza decides to loan out $4,000,000 of the portfolio’s Treasury securities on a 30-day repo. Assuming a repo margin of 3% and a repo rate of 4.5%, calculate the cash due at the conclusion of the trade.

A)$3,894,550.
B)$3,894,351.
C)$3,880,000.

[Explanation: A) Amount of Loan = $4,000,000 × (100%- 3%) = $3,880,000.
Cash due at conclusion of repo = $3,880,000 + ($3,880,000 × 4.5% × (30/360)) = $3,894,550.]
10. Which of the following factors is least likely to cause a lower repo rate from the perspective of the lender?

A)Delivery of the collateral to the lender.
B)Collateral with a short term to maturity.
C)Hot collateral.

[Explanation: B) The repo rate is a function of the repo term and not a function of the maturity of the collateral securities]
11. 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 leveraged portfolio?

A)3.10 years.
B)2.82 years.
C)3.44 years.

[Explanation: C) 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:
Dp = (Di</SUB)I – DI – D</SUB)I – DBB)/E
Dp = [(3.1)( 5,000,000) – (0)(500,000)] / 4,500,000 = 3.44
Where:
Dp = Duration of portfolio
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]
12. 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 increases?

A)Credit spread risk.
B)Interest rate risk.
C)Default risk.

[Explanation: A) 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.]
13. Which of the following is the best explanation of credit spread risk? Credit spread risk refers to the risk that an:

A)asset’s bid-ask spread will increase.
B)asset will be downgraded in the future.
C)asset’s appropriate discount rate increases relative to the comparable risk-free rate.

[Explanation: C) 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]

14. 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:

A)sector selection.
B)duration management.
C)bond market selection.

[Explanation: B) 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]
15. 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:

A)higher country beta and higher bond duration will lead to higher interest rate risk.
B)lower country beta and higher bond duration will lead to lower interest rate risk.
C)lower country beta and lower bond duration will lead to higher interest rate risk

[Explanation: A) 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]
16. 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:

A)5 and a country beta equal to 0.2.
B)2 and a country beta equal to 0.5.
C)4 and a country beta equal to 0.3.

[Explanation: C) 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]
17. 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:

A)would choose the foreign bond.
B)would choose the domestic bond.
C)would be indifferent between the two bonds.

[Explanation: C) Both bonds have the same sensitivity to domestic rates: 6.0 × 0.8 = 4.8]
18. Which of the following is a valid reason for NOT using forwards to hedge exposure to currency risk? The portfolio manager expects:

A)the future currency exchange rate to be less than the forward exchange rate.
B)that the percentage return from exposure to a currency is greater than the forward discount or premium.
C)home interest rates to rise relative to foreign interest rates.

[Explanation: B) 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]
19. Which of the following most accurately describes the purpose of using break-even analysis (forward rates) to make relative value decisions? Break-even analysis is used to determine:

A)whether or not to hedge.
B)the currency risk isolated from interest rate risk for different markets.
C)the credit risk isolated from interest rate risk for different markets.

[Explanation: A) The strategic outlook is what you “expect” to happen to the currency. The market price can be determined from the forward rate. Comparing the two dictates whether you should hedge or not hedge (which is the ultimate decision)]
20. 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:

A)quantify the amount of spread widening that would erase the yield advantage from investing in a higher yielding market.
B)quantify the correct amount of currency exposure to hedge.
C)identify mispriced bonds in foreign markets and to take advantage of the mispricing

[Explanation: A) 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]
21. 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:

A)5.21472 bp, due to a decline in the yield.
B)10.42945 bp due to a decline in the yield.
C)5.21472 bp due to an increase in the yield.

[Explanation: A) 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 advantage.]
22. 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:

A)4.12783 bp due to a decrease in the yield for Bond B.
B)3.99563 bp due to an increase in the yield for Bond B.
C)4.81579 bp due to an increase in the yield for Bond B.

[Explanation: C) 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]
23. 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 yield advantage?

A)18.08219 bp due to a decline in the yield.
B)13.89474 bp due to a decline in the yield.
C)14.72190 bp due to an increase in the yield

[Explanation: A) 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 meaning interest rates are going to go down by this much 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]
24. When compared to the debt issued by corporations in developed nations, the sovereign debt of emerging market governments tend to have a:

A)lower level of standardized covenants and a less enforceable seniority structure.
B)lower level of standardized covenants but a more enforceable seniority structure.
C)higher level of standardized covenants but a less enforceable seniority structure

[Explanation: A) 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]
25. In the emerging market debt market, it is generally true that volatility is:

A)low, and the returns have significant positive skewness.
B)high, and the returns have significant positive skewness.
C)high, and the returns have significant negative skewness.

[Explanation: C) Volatility in the emerging market debt market is high, and the returns are also frequently characterized by significant negative skewness]

26. 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 been:

A)positive and are uncorrelated.
B)positive and are highly correlated.
C)negative and are uncorrelated

[Explanation: A) 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]

27. 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:

A)never use consultants but do make choices using qualitative factors.
B)frequently use consultants but never make choices using qualitative factors.
C)frequently use consultants and make choices using qualitative factors

[Explanation: C) These are common steps in the process of choosing both equity and fixed-income managers]
28. When the sponsor is choosing a fixed-income manager, with respect to the fees the manager charges, the evidence shows:

A)that there is no relationship between fees and information ratios.
B)that fixed-income managers with the highest fees have the lowest information ratios.
C)that fixed-income managers with the highest fees have the highest information ratios

[Explanation: B) Just like the equity markets, a company should avoid hiring managers with higher fees. The evidence shows that fixed-income managers with the highest fees have the lowest information ratios]