Schweser QBank 2017 01 fixed income portfolio management part i

Fixed-Income Portfolio Management-Part I

Test ID: 7427986

Question #1 of 73

Question ID: 466019

If a portfolio manager is interested in the interest rate sensitivity of her portfolio as compared to a Treasury bond index, which
measure should she examine?
ᅞ A) Portfolio duration.
ᅞ B) Value at risk.
ᅚ C) Spread duration.
Explanation
Since the portfolio manager is interested in the interest rate sensitivity of her portfolio as compared to a Treasury bond index,
she should examine spread duration.

Question #2 of 73

Question ID: 466046

Which strategy for funding multiple liabilities is a combination of multiple liability immunization and cash flow matching?
ᅞ A) Contingent immunization.
ᅚ B) Horizon matching.
ᅞ C) Treasury yield curve plus spread approach.
Explanation
The horizon matching (or combination matching) approach uses a combination of multiple liability immunization and cash flow
matching.

Question #3 of 73

Question ID: 465988

A defined benefit pension plan is most likely to specify its benchmark:
ᅞ A) as a bond index.
ᅚ B) in terms of its liability structure.
ᅞ C) in terms of the Lehman Brothers Aggregate Bond Index.
Explanation
The pension plan defines its benchmark in terms of meeting a specific amount of cash to satisfy the liabilities (pension
benefits) on its books.

Question #4 of 73

Question ID: 466041


The manager of a bond portfolio must immunize the portfolio with respect to a given set of liabilities. The manager is choosing
between two immunization strategies: Strategy A and Strategy B. Strategy A has a lower return, lower risk, and a 99%
probability of providing the required return to meet the given set of liabilities. The manager should choose Strategy B:
ᅞ A) if that strategy's higher risk is justified by the higher return, and only if the
probability of meeting the liabilities is equal to or higher than that of Strategy
A.
ᅞ B) under no circumstances, because risk minimization is the point of immunization.
ᅚ C) if that strategy's higher risk is justified by the higher return, and the probability of
meeting the liabilities is equal to or only slightly lower than that of Strategy A.
Explanation
In immunizing a portfolio a manager must consider a trade off between risk minimization and return maximization. Taking on
extra risk under the indicated circumstances is appropriate. The probability of not meeting the liabilities can be allowed to
decrease a little. There is no strict rule about the return and risk levels remaining "proportional".

Question #5 of 73

Question ID: 466042

The manager of a bond fund is assessing several choices in attempting to immunize a portfolio to meet a lump-sum liability. If
maximizing the return of the portfolio by taking on more risk with active management is the goal of the manager, then the
manager should:
ᅞ A) not consider immunizing the portfolio at all because maximizing return is
incompatible with immunization.
ᅚ B) choose a portfolio with a high and positive cushion spread.
ᅞ C) choose a portfolio with a low and positive cushion spread.
Explanation
Maximizing return is not incompatible with immunization. The manager can engage in more active trading to maximize return
when the cushion spread is higher.

Question #6 of 73

Question ID: 466044

Which of the following explains the extension of cash flow matching for multiple liabilities? Cash flow matching for multiple liabilities is
achieved by:

ᅚ A) selecting a bond whose principal plus final coupon is equal to the last liability, then
selecting another bond whose principal plus final coupon along with the first bond's
coupon is equal to the second to last liability, and so on until all liabilities have been
matched.

ᅞ B) selecting bonds with present values equal to the present value of the liability stream and with
the same maturity.

ᅞ C) buying and selling bonds in a way to match the cash flows of a liability stream.

Explanation
The first bond is matched to the last liability, the remaining elements of the liability stream are reduced by the coupon payments of this
bond, and another bond is chosen for the next to last liability, adjusted for any coupon payments of the first bond selected. This process
is continued until all liabilities have been matched by payments on the securities selected for the portfolio.

Question #7 of 73

Question ID: 465975

If a bond portfolio manager specifies liabilities as a benchmark, she is attempting to earn a return that is:
ᅞ A) as high as possible.
ᅞ B) the least risky.
ᅚ C) equal to or higher than the return promised to the liability holders.
Explanation
The manager that specifies liabilities as a benchmark must ensure that the rate of return earned in the portfolio satisfies the
return promised to liability holders. (This objective may be accomplished by earning equal to or higher than the promised
return.)

Question #8 of 73

Question ID: 466001

The goal of enhanced indexing by small risk factor mismatches is to:
ᅚ A) match duration while allowing the manager to tilt the portfolio in favor of other
risk factors.
ᅞ B) choose a subset of risk factors to match and manage, which may or may not include
matching duration.
ᅞ C) match duration with a sample of bonds that are presumably undervalued so as to

produce a higher return.
Explanation
This is the goal of enhanced indexing by small risk factor mismatches.

Question #9 of 73

Question ID: 466010

A manager of a bond fund wishes to ensure funding of a predetermined liability. Contingent immunization is possible when the
prevailing available immunized rate of return is:
ᅞ A) lower than the required rate to ensure the funding, and it works best if interest
rates stay the same or decline.
ᅚ B) greater than the required rate to ensure the funding, and it works best if interest rates
stay the same or decline.
ᅞ C) greater than the required rate to ensure the funding, and it works best if interest rates
stay the same or increase.


Explanation
Contingent immunization is only possible if the prevailing available immunized rate of return is greater than the required rate to
ensure the funding. It works best if rates stay the same or decrease because the need to actually fully immunize never occurs.

Questions #10-13 of 73
Frank Meyers, CFA, is a fixed-income portfolio manager for a large pension fund. A member of the Investment Committee, Fred Spice, is
very interested in learning about the management of fixed-income portfolios. Spice has approached Meyers with several questions.
Specifically, Spice would like to know how fixed-income managers position portfolios to capitalize on their expectations on interest rates.
Meyers has decided to illustrate fixed-income trading strategies to Spice using a fixed rate bond and note. Both bonds have semi-annual
coupon periods. Unless otherwise stated all interest rate changes are parallel. The characteristics of these securities are show in Table 1.
He also considering Treasury Inflation-Protected Securities (TIPS).

Table 1:
Characteristics of Fixed Rate Bond and Fixed Rate Note

Fixed Rate Bond Fixed Rate Note
Price

107.18

100.00

Yield to Maturity

5.00%

5.00%

Periods to Maturity

18

8

Effective Duration

6.9848

3.5851

Question #10 of 73

Question ID: 466006

Spice asks Meyers about how a fixed-income manager would position his portfolio to capitalize on his expectations of increasing interest
rates. Which of the following would be the most appropriate strategy for Meyers to use to help answer Spice's query?

ᅚ A) Shorten his portfolio duration.
ᅞ B) Buy fixed rate bonds.
ᅞ C) Lenghten his portfolio duration.
Explanation
Shortening the portfolio duration makes the value of the portfolio less sensitive relative to interest rate changes. So if interest rates
increase the value of the portfolio will decrease less.

Question #11 of 73

Question ID: 466007

Spice asks Meyers to quantify the value changes from changes in interest rates. To illustrate, Meyers computes the value change for the
fixed rate note in Table 1. Specifically, he assumes an increase in the level of interest rate of 100 basis points. Using the information in
Table 1, which of the following is the best estimate of the change in value of the fixed rate note?

ᅞ A) -$7.17.


ᅞ B) $3.51.
ᅚ C) -$3.59.
Explanation
The change in value of the fixed rate note is computed as follows:
Dollar Duration Fixed Rate Note = Effective Duration x Price x (Change in Interest Rates)
Dollar DurationFixed Rate Note = 3.5851 x 100.0000 x 0.01 = 3.5851
Since the interest rate increased the value of the bond decreased by -$3.59.

Question #12 of 73

Question ID: 466008

Spice just does not seem to get it and asks Meyers to repeat the computation for the fixed rate bond in Table 1. Meyers obliges.
Specifically, he assumes an increase in the level of interest rate of 100 basis points. Using the information in Table 1, which of the
following is the best estimate of the change in value of the fixed rate bond?

ᅚ A) -$7.49.
ᅞ B) -$4.63.
ᅞ C) -$5.73.
Explanation
The change in value of the fixed rate bond is computed as follows:
Dollar Duration Fixed Rate Bond = Effective Duration x Price x (Change in Interest Rates)
Dollar DurationFixed Rate Bond = 6.9848 x 107.18 x 0.01 = 7.4863
Since the interest rate increased the value of the bond decreased by -$7.49.

Question #13 of 73

Question ID: 466009

Spice wonders how a fixed-income manager could position his portfolio to capitalize on the expectation of an upward shifting and twisting
term structure. To help Spice understand Meyers introduces the following scenario: long-term interest rates increasing by more than shortterm interest rates. Which of the following is the most appropriate strategy to profit under this scenario?

ᅞ A) Buy bonds and sell notes.
ᅚ B) Sell bonds and buy notes.
ᅞ C) Buy TIPS.
Explanation
Since long-term interest rates are expected to increase more than short-term interest rates bond prices are expected to decrease by more

than note prices. By short-selling bonds and buying notes the portfolio manager can profit from the difference in the relative price changes
between the bond and the note. TIPS protect against inflation particularly increases in short-term interest rates.

Question #14 of 73

Question ID: 466004


Potential performance and how that performance will vary can be assessed by which two factors, respectively?
ᅞ A) Trend analysis, scenario analysis.
ᅞ B) Scenario analysis, total return analysis.
ᅚ C) Total return analysis, scenario analysis.
Explanation
Potential performance can be estimated with total return analysis, and how that performance will vary can be estimated with
scenario analysis.

Question #15 of 73

Question ID: 465983

Enhanced indexing/minor risk factor mismatches is a bond portfolio management style that:
ᅞ A) minimizes transaction costs and management fees.
ᅞ B) has substantial deviation from the relevant bond index in the average quality of the
bonds.
ᅚ C) does not deviate from the duration of the relevant bond index.
Explanation
Enhanced indexing/minor risk factor mismatches does allow for some relative-value analysis by incorporating minor
mismatches in sector and quality risk factors. There is no deviation from the duration of the index.

Questions #16-21 of 73

John Gillian approaches Carl Mueller, CFA, about managing his bond portfolio. Gillian has two large bond positions. The first
of these is $2.8 million face value with a coupon rate of 7.6% (paid semiannually), ten years to maturity, and is currently priced
to yield 6.5%. The second position is $4.4 million face of zero coupon bonds that will mature in four years and are priced to
yield 5.3%. Gillian asks about interest rate forecasts for the next four years. Mueller says that he expects yields to remain
approximately the same (i.e. 6.5%) for maturities of six to 10 years. Gillian says that he needs to have at least $8 million in
value at the end of four years.
After further discussion with Gillian about his goals, Mueller determines that a contingent immunization strategy would be the
best approach for the coupon-bond position. Gillian asks Mueller to explain the strategy. Mueller says that it is a fairly simple
strategy that has only two requirements: determining an available target return and an appropriate safety net return.
Mueller begins computing the necessary inputs for the coupon-bond position. He first calculates the required terminal value
and associated target return. Given Gillian's goal for the total portfolio value, Mueller computes the safety net return, cushion
spread, and dollar safety margin.
Gillian asks how likely it is that Mueller will have to immunize the portfolio. He asks if Mueller's immunization strategy would be
required if there is a 50 basis point increase in the market yield today and the rates remain at that level for the next four years.

Question #16 of 73
Mueller's description of the requirements of a contingent immunization strategy is:

Question ID: 466029


ᅞ A) correct.
ᅞ B) incorrect because the strategy does not require an available target return although it
does require an appropriate safety net return.
ᅚ C) incorrect because it is incomplete.
Explanation
The strategy does require both an available target return and an appropriate safety net return. Mueller did not mention an
important third step: the establishment of effective monitoring procedures to ensure adherence to the contingent immunization
plan. (Study Session 9, LOS 20.i)

Question #17 of 73

Question ID: 466030

The most likely reason that Mueller did not discuss an immunization strategy for Gillian's zero-coupon bond position is:
ᅚ A) there was no need to do so.
ᅞ B) it is impossible to immunize zero coupon bonds.
ᅞ C) it is possible to immunize zero coupon bonds, but it is very costly.
Explanation
Since the maturity of the zero coupon bonds coincided with the investment horizon, there was no need to immunize that
position. There is neither reinvestment nor price risk. (Study Session 9, LOS 20.k)

Question #18 of 73

Question ID: 466031

The required terminal value for the coupon-bond position is:
ᅚ A) $3.6 million.
ᅞ B) $3.4 million.
ᅞ C) $4.43 million.
Explanation
Since Gillian requires a total of $8 million for his portfolio and the zero coupon bonds will mature with a value of $4.4 million,
the coupon bonds have a required terminal value equal to $8 million minus $4.4 million, or $3.6 million. (Study Session 9, LOS
20.i)

Question #19 of 73
The cushion spread for the coupon-bond position is:
ᅞ A) 2.20%.
ᅚ B) 2.09%.
ᅞ C) 2.04%.

Explanation
Cushion spread is the difference between current rates of return and the minimum required rate of return:
The current value of the coupon bond position is:

Question ID: 466032


INPUTS: N= 20, I/Y = 6.5%/2 = 3.25%, PMT = 7.6%/2 = 3.8% of $2.8 million = $106,400, FV = 2,800,000, CPT PV → PV =
−3,023,906 (ignore minus sign)
The minimum required return based upon the required terminal coupon-bond position value of $3.6 million and its present
value is (3,023,906)(1+X)8 = 3,600,000. Solving for X we then have:
(1+X)8 = 3,600,000 / 3,023,906
(1+X)8 = 1.1905
1+X = 1.1905.125
1+X = 1.02204
X = .02204
I = 2.204% X 2 = 4.41%
Cushion spread = 6.50 − 4.41 = 2.09%
(Study Session 9, LOS 20.i)

Question #20 of 73

Question ID: 466033

The dollar safety margin for the coupon-bond position is closest to:
ᅞ A) $0.226 million.
ᅞ B) $0.290 million.
ᅚ C) $0.237 million.
Explanation
This is the difference between the current value of the bond portfolio and the present value of the estimated terminal value

given the current return:
Current value of the portfolio = $3.024 million as determined in the previous question.
Assets required given a terminal value of $3,600,000 and current rates of return of 6.5%:
3,600,000 / (1.0325)8 = 2,787,289
Dollar safety margin = 3,023,906 − 2,787,289 = 236,617
(Study Session 9, LOS 20.i)

Question #21 of 73
Given the forecast of a 50 basis point increase in market yield on the coupon bonds, Mueller will:
ᅞ A) have to switch to a passive management strategy for the portfolio.
ᅚ B) be able to continue with an active management strategy for the portfolio.
ᅞ C) have to switch to an immunization strategy for the portfolio.
Explanation
For a 50 basis point increase in market yields to 7.0% the present value of assets will then become:

Question ID: 466034


N = 20, I/Y = 3.5, PMT = 106,400, FV = 2,800,000, CPT PV → PV = −2,919,384
Assets required at the new interest rate of 7.0% =
3,600,000 / (1.035)8 = 2,733,882
The present value of assets of $2.9 million > present value of assets required of $2.7 million thus a 50 basis point increase in
market yields will not trigger a switch to immunization to achieve the terminal value of $3.6 million for the coupon bonds.
(Study Session 9, LOS 20.i)

Question #22 of 73

Question ID: 466011

The manager of a bond fund is assessing several choices in attempting to immunize a portfolio. To meet a predetermined

liability, the manager needs a 6% return. Which of the choices below would be the best in pursuit of that goal? An immunized
strategy with a target return equal to:
ᅚ A) 6.4% with a 95% confidence interval at +/- 40 basis points.
ᅞ B) 6.0% with a 95% confidence interval at +/- 10 basis points.
ᅞ C) 6.0% with a 99% confidence interval at +/- 20 basis points.
Explanation
Of the three portfolios, the portfolio with a 6.4% target return and a +/-40 basis point confidence interval has the best chance
of achieving the specified return. The chance of not achieving that return is (1 - 95%) / 2 = 2.5% or one out of 40. The
portfolios with the 6% target return have only a 50% chance of achieving the specified return.

Question #23 of 73

Question ID: 465981

When the performance of an investment grade corporate bond portfolio is compared to a relevant bond index, which of the
following statements about tracking error is CORRECT?
ᅞ A) If the return on the bond portfolio is substantially lower than the return on the
bond index the tracking error is small.
ᅞ B) Tracking error refers to how closely the return on the bond index matches traders'
expectations and is not related to the return on the bond portfolio.
ᅚ C) If the return on the bond portfolio closely matches the return of the bond index the
tracking error is small.
Explanation
Tracking error is incurred when the return on the bond portfolio deviates from the return on the bond index. Greater deviation
means higher tracking error.

Question #24 of 73

Question ID: 466026

In a contingent immunization strategy, which of the following is a reason why the minimum target return might NOT be realized? The
minimum target return might not be realized because:


ᅞ A) interest rates move in a nonparallel manner.
ᅚ B) there is a rapid market yield movement.
ᅞ C) the yield volatility changes.
Explanation
A rapid market yield movement might not give the manager enough time to shift from an active strategy to immunization mode to achieve
the minimum target.

Question #25 of 73

Question ID: 466018

Which of the following is an absolute measure of the interest rate sensitivity of a portfolio?
ᅚ A) Portfolio duration.
ᅞ B) Value at risk.
ᅞ C) Spread duration.
Explanation
Portfolio duration is an absolute measure of the interest rate sensitivity of a portfolio.

Question #26 of 73

Question ID: 466014

A portfolio consists of positions in two bonds. The details of the positions are below:
Security

Market Value

Duration

Dollar Duration

Bond A:

$55,580

10.67

$5,930.39

Bond B:

$30,157

19.21

$5,793.16

The total dollar duration is $11,723.55. After a parallel shift of the yield curve, the results change to:
Security

Market Value

Duration

Dollar Duration

Bond A:

$52,133

10.67

$5,562.59

Bond B:

$26,874

19.21

$5,162.50

The new total dollar duration is $10,725.09. Which of the following adjustments will rebalance the portfolio to the original dollar
duration?

ᅚ A) Buy $4,848.37 of Bond A and $2,499.28 of Bond B.
ᅞ B) Sell $4,848.37 of Bond A and $2,499.28 of Bond B.
ᅞ C) Sell $2,499.28 of Bond A and buy $4,848.37 of Bond B.
Explanation


Rebalancing ratio = Desired DD / new DD = 11,723.55 / 10,725.09 = 1.093. To readjust back to the original dollar duration as
well as maintain the current proportions of each bond in the portfolio, we subtract 1.0 from the rebalancing ratio to arrive at the
necessary increase in the value of each bond in the portfolio and, thus, the total increase in the portfolio value (i.e., required
additional cash):
1.093 − 1 = 0.093; 0.093 × $79,007 = $7,347.65

The increases (in dollars) required for the individual bonds in the portfolio are:
Bond A:

$52,133 × 0.093 =

$4,848.37

Bond B:

$26,874 × 0.093 =

$2,499.28
$7,347.65

Question #27 of 73

Question ID: 465979

If a bond portfolio manager has specified the benchmark in terms of a bond index, she is attempting to earn a return that is:
ᅞ A) as high as possible.
ᅚ B) equal to or superior to the index.
ᅞ C) less risky than the index.
Explanation
The manager that uses an index as a benchmark is attempting to earn a rate of return that is equal to or superior to the index.

Question #28 of 73

Question ID: 465978

Why should a pension fund manager NOT manage against a typical broad-based bond market index?
ᅚ A) The duration of a typical broad-based bond market index and the liabilities of a
pension fund are not similar.
ᅞ B) This indexing strategy may produce tracking error risk.
ᅞ C) The manager might outperform the index.
Explanation
The pension fund manager should define the benchmark in terms of the pension liabilities that must be satisfied. Most broadbased bond market indexes have shorter durations. If the pension fund manager decides to use a bond index, then he should
chose one that matches the duration of the pension plan.

Question #29 of 73
Which of the following CORRECTLY describes cash flow matching for a single liability? Cash flow matching involves:

ᅞ A) selecting a bond with the same duration as the liability.

Question ID: 466039


ᅞ B) selecting a bond with a present value equal to the present value of the liability and with the
same maturity.

ᅚ C) selecting a bond whose cash flows coincide exactly with the payments of the liability.
Explanation
Cash flow matching is matching up the cash flows from a bond to fund a liability stream so that the asset value of the bond is
zero after the last liability is paid.

Question #30 of 73

Question ID: 466025

Which of the following is NOT a key consideration in implementing a contingent immunization strategy?

ᅞ A) Identifying a suitable and immunizable safety net.
ᅚ B) Decide in advance about the frequency the portfolio will be rebalanced.
ᅞ C) Establishing well defined immunized initial and ongoing available target returns.
Explanation
The frequency of rebalancing is determined (among other things) by the level of the safety net. So the rebalancing frequency is not
exogenous to interest rate movements.

Questions #31-36 of 73
Fixed Income Asset Management, Incorporated, (FIAM) has traditionally managed fixed income portfolios for pension and
endowment funds employing immunization and cash matching strategies. Recently, FIAM has accepted the responsibility for
managing funds for which indexed and enhanced indexed strategies are appropriate. Ms. Debra C. Truxell, CFA, a senior
manager at FIAM, has been promoted to Vice President for Index Bond Fund Management to lead the company in this new
direction. To staff this effort, Truxell had to recruit several new employees. Since most of the newly hired employees had little
experience with indexing strategies, Truxell thought it would be prudent to conduct a series of in-house training seminars.
Cara Moore, an expert in bond indexing strategies, presented the first seminar. She opened the session with a discussion of
the risk characteristics that distinguish bond management styles. She stated the key risk factor that distinguishes indexing from
active management is that indexing takes no position on duration, but may differ in terms of sector, yield expectations, and
quality differences. The differences depend upon how far the portfolio falls along the indexing versus active management
continuum.
Moore's associate, James Higgins, noted that "lower costs, diversification, and stable performance are all advantages of
indexing a portfolio to a large, well-diversified bond index." He also said, "Simple replication of a bond index such as the
Lehman Brothers Aggregate Bond Index is known as pure bond indexing. I recommend pure bond indexing for most passively
managed portfolios because it is the most efficient means of reducing tracking error and is the easiest indexing strategy to
implement in most circumstances." Truxell supported his statement by saying, "The greatest cost benefit of indexing lies in
pure bond indexing."
During the second seminar, lead by Pilar Newman, the topic of matching based on various risk factors was addressed. One
participant asked "Is it sufficient to match the duration of the indexed portfolio to the duration of the bond index to control for
the primary risks of the bond index?" Newman replied, "Yes, that is precisely how portfolio managers protect against nonparallel shifts in the yield curve." A second participant asked if modified duration is the appropriate measure of interest rate risk

and Newman's partner Martin George replied, "While modified duration accurately measures interest rate risk for bullet bonds,
it does not accurately measure interest rate risk for bonds with embedded options." Newman added that matching the sector,
coupon, and maturity weights of the callable sectors of a bond index results in a better matching of the convexity of the index,
which is desirable.
Nicholas Morgan, a long-time FIAM employee, is interested in implementing call exposure positioning. He understands that
when bonds move from being priced to call to being priced to maturity, returns can be enhanced by increasing the portfolio's
relative exposure to call risk. He notes "bonds that are priced to maturity tend to underperform when rates fall and bonds that
are priced to call tend to underperform when rates rise." Morgan tells Truxell's staff that they need to factor this in when
implementing a call exposure enhancement strategy.

Question #31 of 73

Question ID: 465993

Regarding bond indexing:
ᅞ A) Moore is incorrect regarding the primary factor that distinguishes indexing
from active management; Truxell is incorrect regarding the cost savings from
pure bond indexing.
ᅚ B) Moore is correct regarding the primary factor that distinguishes indexing from active
management; Truxell is incorrect regarding the cost savings from pure bond indexing.
ᅞ C) Moore is correct regarding the primary factor that distinguishes indexing from active
management; Truxell is correct regarding the cost savings from pure bond indexing.
Explanation
Moore is correct. A full-blown active management strategy takes an aggressive approach to risk factor mismatches, including
duration. Enhanced indexing maintains the same duration as the index. It is not until one moves up the risk spectrum into
active strategies that a position regarding duration is taken.
Truxell is incorrect in her assessment of the cost savings from pure bond indexing. Full replication is extremely costly. In
general, it is more difficult to fully replicate a bond index than a stock index. (Study Session 9, LOS 20.b)

Question #32 of 73

Question ID: 465994

Regarding the statements made by Higgins about bond indexing, he is:
ᅞ A) incorrect both with respect to the advantages of indexing and in his
conclusions regarding pure bond indexing.
ᅞ B) correct both with respect to the advantages of indexing and in his conclusions
regarding pure bond indexing.
ᅚ C) correct with respect to the advantages of indexing but incorrect in his conclusions
regarding pure bond indexing.
Explanation
Higgins is correct regarding the advantages of indexing. Diversification, lower costs, and stable performance relative to a nonindexed portfolio are all advantages of indexing. However, pure bond indexing is expensive and difficult to implement in a
fixed-income portfolio due to the illiquidity of many of the bonds in the index. Therefore, Higgins is incorrect in the conclusions
he draws regarding pure bond indexing (or full replication). (Study Session 9, LOS 20.b)


Question #33 of 73

Question ID: 465995

Truxell's most likely reply to Newman's answer to the question regarding duration matching would be:
ᅚ A) "Matching the primary risk factors of the index such as duration, cash flow,
sectors, quality, and callability is the most effective method".
ᅞ B) "As a matter of fact this type of matching is the best way to assure that the tracking
error attributable to a yield shift is minimized."
ᅞ C) "It is not sufficient. Sector cell weighting is the recommended strategy to control for
primary risk factors."
Explanation
To match the primary risk factors of an index managers commonly match several factors such as duration, cash flow, sectors,

quality , and callability of the bonds in the index. Duration alone only protects against small parallel shifts in the yield curve.
(Study Session 9, LOS 20.d)

Question #34 of 73

Question ID: 465996

Frederick Jackson, a recent college graduate and CFA candidate, asked Truxell if she felt that return enhancements could be
realized through sector exposure. Truxell accurately replied,"Yes, as a matter of fact, it is possible to increase the yield of the
portfolio without a proportionate increase in risk by:
ᅞ A) overweighting 1-5 year Treasuries and underweighting 1-5 year corporates."
ᅚ B) underweighting 1-5 year Treasuries and overweighting 1-5 year corporates."
ᅞ C) underweighting long-term Treasuries and overweighting long-term corporates."
Explanation
Short term (less than 5 years) corporate bonds have the most favorable yield spread per unit of duration risk. Overweighting
these issues and underweighting short duration Treasuries is known as enhanced indexing by small risk factor mismatches.
(Study Session 9, LOS 20.d)

Question #35 of 73

Question ID: 465997

With respect to comments made about duration:
ᅞ A) George is correct; Newman is incorrect regarding matching the convexity of the
index.
ᅞ B) George is incorrect; Newman is correct regarding matching the convexity of the index.
ᅚ C) George is correct; Newman is also correct regarding matching the convexity of the
index.
Explanation
George is correct, modified duration does not effectively measure the interest rate risk of bonds with embedded options - we

must use effective duration for that task. Newman is also correct regarding her statement about convexity. Matching the
sector, coupon, and maturity weights of the callable sectors results in a better match of the convexity of the index. (Study
Session 9, LOS 20.d)

Question #36 of 73

Question ID: 465998


Regarding callable bonds, Morgan is:
ᅞ A) incorrect in assuming that returns may be enhanced when a callable bond that
is priced to call is replaced with a callable bond that is priced to maturity. He
also does not understand the relationship between interest movements and the
performance of callable bonds.
ᅞ B) correct in assuming that returns may be enhanced when a callable bond that is priced
to call is replaced with a callable bond that is priced to maturity, and he understands
the relationship between interest rate movements and the performance of callable
bonds, which will allow him to profit from rate changes.
ᅚ C) correct in assuming that returns may be enhanced when a callable bond that is priced
to call is replaced with a callable bond that is priced to maturity, however, he does not
understand the relationship between interest movements and the performance of
callable bonds.
Explanation
Morgan is correct in assuming that returns can be enhanced by increasing a portfolio's relative exposure to call risk when a
callable bond that is priced to call is replaced with a callable bond that is priced to maturity. Usually callable bonds cannot be
called for 5 to 10 years after being issued and the issuer of the callable bond will pay the investor an annual spread premium
compared to a straight bond. However, he is backwards when it comes to over and underperformance of callable bonds when
interest rates change. Bonds that are priced to call underperform when rates decline and as rates increase they outperform
non-callables. The reason is that callable bonds "cap out" when rates fall and don't fall as much as noncallable bonds when
rates rise due to negative convexity. (Study Session 9, LOS 21.e)

Question #37 of 73

Question ID: 465986

Which of the following is a difference between pure bond index matching and enhanced indexing that allows for minor risk factor
mismatches? Enhanced indexing that allows for minor risk factor mismatches:

ᅚ A) allows larger mismatches between the index and portfolio return.
ᅞ B) is essentially an active management strategy.
ᅞ C) allows only smaller mismatches between the index and portfolio return.
Explanation
Enhanced indexing with minor risk factor mismatches means that the portfolio will have the same duration as the index, but will have
differential exposures from the index due to sector, quality, term structure, etc... mismatches. These differential positions will allow larger
return mismatches between the portfolio and the index than that generated by the pure bond index matching approach.

Question #38 of 73

Question ID: 466017

Which of the following is a relative measure of the interest rate sensitivity of a portfolio compared to an underlying index?
ᅚ A) Spread duration.
ᅞ B) Value at risk.


ᅞ C) Portfolio duration.
Explanation
Spread duration is a relative measure of the interest rate sensitivity of a portfolio compared to an underlying index. The other
choices are both absolute measures.

Question #39 of 73

Question ID: 472684

Which of the following would least likely be used as a bond benchmark?
ᅞ A) Sampling for passive bond managers.
ᅞ B) Customized benchmarks for active managers.
ᅚ C) Full replication.
Explanation
Full replication is unusual because most bond indexes hold some illiquid securities making full replication difficult and
expensive. Alternatives include sampling the index to represent the benchmark for passive managers and the creation of a
custom benchmark for active managers.

Question #40 of 73

Question ID: 466036

Which of the following refers to the risk that floating rate assets may have an upper bound on the interest rate whereby a
maximum rate of interest on the asset is achieved?
ᅞ A) Call risk.
ᅞ B) Interest rate risk.
ᅚ C) Cap risk.
Explanation
Cap risk is the risk that the interest rate is capped (has a maximum) and that interest income from the asset is then capped.

Question #41 of 73

Question ID: 472686

Which of the following lead to difficulty in using a bond index as a benchmark?

ᅞ A) Identifying which bonds are in an index.
ᅚ B) Heterogeneity in the global bond market.
ᅞ C) The relatively small size of the overall global bond market compared to the global
equity market.
Explanation
Both governments and corporations issue bonds with different maturities, seniorities, and other characteristics leading to a
heterogeneous global bond market. This is compared to the homogeneous global equity market with equities usually being


issued as only 1 type of stock. The overall size of the global bond market is considered to be almost twice the size of the
global equity market. Bond indices are considered to be unambiguous, measurable, and specified in advance but not
investable, appropriate, reflective of current investment opinions, or accountable.

Question #42 of 73

Question ID: 466023

A portfolio manager has decided to pursue a contingent immunization strategy over a four-year time horizon. He just
purchased at par $26 million worth of 6% semiannual coupon, 8-year bonds. Current rates of return for immunized strategies
are 6% and the portfolio manager is willing to accept a return of 5%. Given that the required terminal value is $31,678,475,
and if the immunized rates rise to 7% immediately, which of the following is most accurate? The dollar safety margin is:

ᅞ A) positive ($6,158,602) and the portfolio manager can continue with contingent
immunization.
ᅞ B) negative (-$1,423,980) and the portfolio manager must switch to immunization.
ᅚ C) positive ($370,765) and the portfolio manager can continue with contingent
immunization.
Explanation
We are given the required terminal value of $31,678,475.
Next, we calculate the current value of the bond portfolio: PMT = ($26,000,000)(0.03) = $780,000; N = 16; I/Y = 7/2 = 3.5%;

and FV = $26,000,000; CPT → PV = $24,427,765.
Next, compute the present value of the required terminal value at the new interest rate: FV = $31,678,475; PMT = 0; N = 8; I/Y
= 7/2 = 3.5%; CPT → PV = $24,057,000.
Alternatively $31,678,475 / (1.035)8 = $24,057,000
The dollar safety margin is positive ($24,427,765 − $24,057,000 = $370,765) and the manager can continue to employ
contingent immunization.

Question #43 of 73

Question ID: 466002

Why should total return analysis be used to assess the potential performance of a trade before the trade is implemented? Because total
return analysis:

ᅞ A) can be used to assess the likelihood of a certain outcome which will affect the potential
performance of a trading strategy.

ᅚ B) allows to quantify the potential performance of any trading strategy.
ᅞ C) identifies the range of possible outcomes and therefore provides the manager with a feel for
the risk associated with a trade.

Explanation
Total return analysis can be used with scenario analysis to assess the potential performance and risk associated with the wide variety of
bond investment strategies. Total return analysis may be used to determine the potential performance, and scenario analysis may be
used to ascertain how the performance will vary under different sets of assumptions.


Question #44 of 73

Question ID: 466043

The manager of a bond fund is assessing several choices in attempting to immunize a portfolio. To meet a predetermined
liability, the manager needs a five percent return. Which of the choices below would be the best in pursuit of that goal? An
immunized strategy with a target return equal to:
ᅚ A) 5.6% with a 95% confidence interval at +/- 50 basis points.
ᅞ B) 6.0% with a 95% confidence interval at +/- 100 basis points.
ᅞ C) 5.2% with a 95% confidence interval at +/- 20 basis points.
Explanation
Of the three portfolios, the portfolio with a 5.6% target return and a +/-50 basis point confidence interval has the best chance
of achieving the needed return. The chance of not meeting the 5% return is LESS THAN (1-95%)/2 = 2.5% because, the 95%
interval does not include the target 5%. The portfolios with the 6% target return and 5.2% would have exactly a 2.5%
probability of not achieving the goal.

Question #45 of 73

Question ID: 466037

Which of the following refers to the differences in interest rate sensitivity of the firm's assets relative to its liabilities?
ᅞ A) Tracking error risk.
ᅚ B) Interest rate risk.
ᅞ C) Cap risk.
Explanation
Interest rate risk refers to differences in the interest rate sensitivity of the firm's assets versus its liabilities.

Question #46 of 73

Question ID: 466038

Which of the following risks associated with managing a bond portfolio is least accurate?
ᅞ A) Price risk and reinvestment risk are the two components that comprise interest

rate risk.
ᅚ B) Contingent claim risk is the risk that interest rates could increase, resulting in the cost
of the firm's liabilities exceeding the return on its fixed-rate assets.
ᅞ C) Combination matching for multiple liabilities is the same as horizon matching.
Explanation
Contingent claim risk (a.k.a. call risk or prepayment risk) is the risk that interest rates could decrease with the bonds in the
portfolio being called resulting in reinvesting the principal at reduced rates of return. To adjust for this potential, rather than
simply comparing the portfolio duration to that of the liability, the manager must consider the convexity of the bonds. Cap risk
is the risk that interest rates could increase, resulting in the cost of the firm's liabilities exceeding the return on its floating rate
assets if those assets contain caps.


Question #47 of 73

Question ID: 466027

A portfolio manager has decided to pursue a contingent immunization strategy over a three-year time horizon. She just
purchased at par $84 million worth of 9.2% semi-annual coupon, 10-year bonds. Current rates of return for immunized
strategies are 9.2% and the portfolio manager is willing to accept a return of 8.5%. Given that the required terminal value is
$107,829,022, and if interest rates rise to 11% immediately, which of the following is most accurate? The dollar safety margin
is:
ᅞ A) positive ($1,486,948) and the manager can continue with contingent
immunization.
ᅞ B) negative (-$3,237,038) and the manager can continue with contingent immunization.
ᅚ C) negative (-$3,237,038) and the manager must switch to immunization.
Explanation
We are given the required terminal value of $107,829,022. Next, we calculate the current value of the bond portfolio: PMT=($84,000,000)
(.046)=$3,864,000, N=20, I/Y=11/2=5.5%, and FV=$84,000,000, CPT → PV=$74,965,511.
Next, compute the present value of the required terminal value at the new interest rate: FV=$107,829,022, PMT=0, N=6, I/Y=11/2=5.5%,
CPT → PV=$78,202,549.

Alternatively ($107,829,022) / (1.055)6 = $78,202,548
The dollar safety margin is negative ($74,965,511 − $78,202,549 = -3,237,038) and the manager can no longer employ contingent
immunization.
Therefore, a switch to immunization is necessary.

Question #48 of 73

Question ID: 472685

Which of the following is a solution to the bums problem in a bond index?
ᅞ A) Weight the bond in the index according to the issue's size.
ᅞ B) Use a market capitalized weighted index.
ᅚ C) Limit the weight of certain bonds in the index.
Explanation
The bums refer to bonds in a market capitalized index from issuers (corporations or governments) that have borrowed heavily
thus they make up a larger proportion of the index. The bums are subject to a higher probability of default thus lowering the
return and increasing the risk of the index also resulting in inefficient portfolios for investors tracking the index. Solutions to the
bums problem are to use an equally weighted index or to limit the amount of bonds from issuers who have borrowed heavily.

Question #49 of 73

Question ID: 465980

Which of the following is a difference between the investment objective for a liability based benchmark and an index based benchmark? If
a bond index is chosen as a benchmark the:


ᅞ A) objective will be less risk averse.
ᅞ B) bond index has to be outperformed on a risk-adjusted basis.
ᅚ C) objective is primarily return oriented.

Explanation
A passive bond portfolio manager's objective is to get as close to the index return as possible by mimicking the bonds in the index and
matching their duration with the understanding that due to management expenses their return will be slightly less than the index. An active
bond portfolio manager would attempt to at least meet the index return and outperform it. Outperforming an index on a risk adjusted basis
implies using a risk adjusted measurement such as the Sharpe ratio to compare the manager's performance to the index which is not
normally done when comparing the manager's performance to an index. In a liabilities based benchmark the portfolio manager's objective
is to at least match the value of the liabilities when they come due.

Question #50 of 73

Question ID: 472687

Because bonds are not traded on an exchange, some bond issues are limited in size, and bond investors tend to hold onto
their bonds long term, this most likely leads to:
ᅞ A) the manager not being able to be accountable for what's in the index.
ᅞ B) indices that are not reflective of the manager's current investment opinion.
ᅚ C) illiquidity thus bond indices are not investable.
Explanation
Because there is no single exchange that bonds trade on, the size of some bond issues is limited, and investors tend to hold
onto their bonds longer term, bond indices are illiquid and not investable. Many times the bond indexes contain securities the
manager is not familiar with thus the index would not be reflective of the manager's current investment opinion nor could the
manager agree to be accountable for what's in the index.

Question #51 of 73

Question ID: 465989

Fixed-income investors whose objective is to generate sufficient cash to satisfy their liabilities specify the benchmark:
ᅞ A) as a bond index.
ᅞ B) as either a bond index or in terms of its liability structure.

ᅚ C) in terms of its liability structure.
Explanation
Fixed-income investors whose objective is to generate sufficient cash to satisfy the liabilities specify the benchmark in terms of
its liability structure.

Question #52 of 73

Question ID: 466022

If interest rates rise sufficiently such that the dollar safety margin is negative in a contingent immunization strategy, which of


the following statements is least accurate?
ᅞ A) The portfolio manager can no longer use contingent immunization.
ᅚ B) Contingent immunization is still a viable alternative.
ᅞ C) A switch to immunization is necessary.
Explanation
If the dollar safety margin is negative, the present value of liabilities exceeds the present value of assets and the portfolio
manager can no longer use contingent immunization. Equivalently, the portfolio manager must switch to immunization.

Question #53 of 73

Question ID: 465991

What is the investment objective for a pension sponsor who has a defined benefits based liability structure? The main objective is to:

ᅞ A) outperform a bond index.
ᅚ B) match the amount and timing of the liability.
ᅞ C) minimize prepayment risk.
Explanation

Although the other answers are worthwhile activities in pension fund management, matching the liability structure should be the primary
objective for the pension sponsor.

Question #54 of 73

Question ID: 466035

Which of the following is the best definition of cap risk? Cap risk is the risk:

ᅞ A) that a floating rate note has an embedded cap.
ᅞ B) associated with the issuer of a floating rate note with an embedded cap.
ᅚ C) that the funding rate used to purchase a floating rate note exceeds the note's cap rate.
Explanation
Cap risk is the risk that the cost of the firm's interest rate-sensitive liabilities exceeds the return on its capped assets in an environment of
rising interst rates. Cap risk is a particular concern to investors who borrow at a floating rate.

Question #55 of 73

Question ID: 465984

Which of the following bond management styles results in a portfolio that most closely resembles the return performance of a
bond index?
ᅚ A) Enhanced indexing/ matching primary risk factors.
ᅞ B) Enhanced indexing/minor risk factor mismatches.
ᅞ C) Active management/full blown active.


Explanation
Enhanced indexing/matching primary risk factors does not try to fully replicate the index, as the pure bond approach does.
This style uses a large sample of bonds to represent the risk factors present in the index, and, as a result, more closely

resembles the index than the others listed.

Question #56 of 73

Question ID: 466045

Which of the following statements concerning the process of cash flow matching for funding multiple liabilities is CORRECT?
Find bonds with:
ᅚ A) maturity dates equal to the maturity dates of each liability payment.
ᅞ B) an average duration equal to the average duration of the liabilities.
ᅞ C) durations equal to the durations of each liability.
Explanation
The process is to find bonds with maturity dates equal to the maturity dates of each liability payment.

Question #57 of 73

Question ID: 465985

Which of the following is a difference between enhanced indexing by matching primary risk factors and enhanced indexing that allows
minor risk factor mismatches? Enhanced indexing by matching primary risk factors:

ᅚ A) allows smaller mismatches between the index and portfolio return.
ᅞ B) is essentially an active management strategy.
ᅞ C) allows larger mismatches between the index and portfolio return.
Explanation
Matching by primary risk factors means that the portfolio will be exposed to the same broad market moving movements as the index.
Enhanced indexing with minor risk factor mismatches means that the portfolio will have the same duration as the index, but will have
differential movements from the index due to sector, quality, term structure, etc... mismatches. Hence, the matching by primary risk
factors will tend to yield smaller differences between index and portfolio returns.

Question #58 of 73

Question ID: 466020

Which of the following best describes the difference between spread duration and portfolio duration? Spread duration allows the manager
to measure the sensitivity of portfolio value from changes in:

ᅞ A) the price of the underlying securities.
ᅞ B) both convexity and yield changes.
ᅚ C) yield levels relative to a benchmark yield.
Explanation


With duration a parallel shift in the yield curve could be caused by a change in inflation expectations which causes the yields
on all bonds, including treasuries, to increase/decrease the same amount. In spread duration, the shift is in the spread only,
indicating an overall increase in risk aversion (risk premium) for all bonds in a given class.

Question #59 of 73

Question ID: 465982

Which of the following bond portfolio investment strategies has active management and is aggressive with large mismatches in
all risk factors, including duration?
ᅞ A) Pure bond index matching.
ᅞ B) Active management/larger risk factor mismatches.
ᅚ C) Active management/full-blown active.
Explanation
Active management/full blown active is the most actively managed type of bond portfolio and also has the highest potential
returns and tracking error. On the opposite end of relative management activity is pure bond indexing which attempts to 100%
replicate the index, resulting in the lowest tracking error of the alternative enhancement strategies.

Question #60 of 73

Question ID: 465990

Which of the following most accurately describes the relationship between an investor's investment objectives and the benchmark chosen
for performance evaluation? An investor with a:

ᅞ A) bond index as a benchmark has as an investment objective to outperform the bond
index.

ᅚ B) liability as a benchmark has an investment strategy to match the timing and amount of the
payments corresponding to the liability.

ᅞ C) liability as a benchmark has an investment objective that is to earn a higher return than the
cost of borrowing.

Explanation
The purpose of using the liability structure as a benchmark is to ensure meeting the liability payment streams, both in timing and amount.

Question #61 of 73

Question ID: 466013

A commercial bank takes in short-term deposits and the uses those funds to make longer term loans. As such, the duration of
the bank's assets tends to be longer than the duration of the bank's liabilities. What will happen when interest rates rise? The
bank's:
ᅞ A) liabilities will decrease in value by more than the bank's assets causing the
bank's equity (surplus) to increase.
ᅚ B) assets will decrease in value by more than the bank's liabilities causing the bank's

equity (surplus) to decrease.


ᅞ C) assets will increase in value by more than the bank's liabilities causing the bank's
equity (surplus) to decrease.
Explanation
As interest rates rise, the long-duration assets will decrease in value by more than the short-duration liabilities. As assets
decrease in value by more than liabilities, the bank's equity (surplus) must decline (A=L+E).

Question #62 of 73

Question ID: 466003

Why should scenario analysis be used to assess the potential performance of a trade before the trade is implemented? Because scenario
analysis:

ᅚ A) identifies the range of possible outcomes and therefore provides the manager with a
feel for the risk associated with a trade.

ᅞ B) involves measuring the reactions of market participants under a variety of different scenarios
which the manager needs to know before he makes a trade.

ᅞ C) consists of evaluating the worst-case scenario which enables an investor to know his highest
potential loss of a trade.

Explanation
Total return analysis can be used with scenario analysis to assess the potential performance and risk associated with the wide variety of
bond investment strategies. Total return analysis may be used to determine the potential performance, and scenario analysis may be
used to ascertain how the performance will vary under different sets of assumptions.

Question #63 of 73

Question ID: 466040

Which strategy for funding multiple liabilities uses a process for selecting bonds that have cash flows that correspond to those
of the liability stream?
ᅞ A) Combination matching.
ᅞ B) Multiple liability immunization.
ᅚ C) Cash flow matching.
Explanation
The cash flow matching strategy for funding multiple liabilities uses a process for selecting bonds that have cash flows that
correspond to those of the liability stream.

Question #64 of 73

Question ID: 466000

In aligning the risk exposures of a bond portfolio to those of a benchmark bond index, the purpose of matching key rate
durations is:
ᅞ A) to make adjustments for convexity.


ᅞ B) to better match cash flows.
ᅚ C) to hedge twists of the yield curve.
Explanation
Matching total duration will not necessarily hedge against changes in shape of the yield curve. Matching the durations of a few
key rates along the yield curve will better hedge the fund against twists of the yield curve.

Question #65 of 73

Question ID: 465999

Bruce Turner, CFA, is composing a fund to track a benchmark bond index. He decides to use enhanced indexing by matching
primary risk factors. This method aligns the risk exposures of the portfolio by investing in:
ᅞ A) all the bonds in the index in the same proportion as the index and using
derivatives to enhance the returns.
ᅚ B) a sample of bonds to match the primary index risk factors with the goal of minimizing
construction and maintenance costs.
ᅞ C) all the bonds in the index in the same proportion as the index and using leverage to
enhance returns.
Explanation
Choosing a sample of bonds to match the primary risk factors is called enhanced indexing by matching primary risk factors.
The goal is to match the risk factors while lowering construction and maintenance costs. The manager can also be selective
when choosing the sample and try to select bonds that are the most undervalued.

Question #66 of 73

Question ID: 466021

Two portfolios have the same portfolio duration but one of them has a higher nominal spread duration. How does the higher spread
duration affect the portfolio characteristics? The higher spread duration portfolio will have:

ᅚ A) the same exposure to small parallel shifts in the Treasury curve but will have a higher
exposure to changes in the yield difference between non-Treasury and Treasury bonds.

ᅞ B) the same exposure to small parallel shifts in the Treasury curve but will have a higher
exposure to changes in the yield difference between long and short-term Treasury securities.

ᅞ C) a higher exposure to small parallel shifts in the Treasury curve and a higher exposure to
changes in the yield difference between non-Treasury and Treasury bonds.

Explanation
Nominal spread is the spread between the nominal yield on a non-Treasury bond and a Treasury of the same maturity.

Question #67 of 73

Question ID: 466024

A portfolio manager has decided to pursue a contingent immunization strategy over a three-year time horizon. He just