CFA level 3 CFA level 3 volume III applications of economic analysis and asset allocation finquiz item set answers, study session 12, reading 21

Reading 21

Introduction to Fixed Income Portfolio Management

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CFA Level III Item-set - Solution
Study Session 10
June 2018

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Reading 21

Introduction to Fixed Income Portfolio Management

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FinQuiz Level III 2018 – Item-sets Solution
Reading 21: Introduction to Fixed Income Portfolio Management
1. Question ID: 134522
Correct Answer: B
Return component
Formula
Yield income
+ Rolldown return

Annual coupon/current bond price
𝐵𝑜𝑛𝑑𝑝𝑟𝑖𝑐𝑒+,- − 𝐵𝑜𝑛𝑑𝑝𝑟𝑖𝑐𝑒/01.
𝐵𝑜𝑛𝑑𝑝𝑟𝑖𝑐𝑒/01

Calculation
$3.20/$97.85 = 3.27%
($99.00 – $97.85)/$97.85
= 1.18%

= Rolldown yield
+E(change in price based
on Summers’ yield and
yield spread view)
+E(currency gains)

[−𝑀𝐷 × ∆𝑌𝑖𝑒𝑙𝑑 +
;

: × 𝐶𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦 × ∆𝑌𝑖𝑒𝑙𝑑< B]
<

4.45%
[- 2.60 × 1.80] + [1/2 ×
1.30 × 1.802] = - 2.574%

Given
1.95%

=Total expected return

3.826%
2. Question ID: 134523
Correct Answer: B
B is correct. Summers is using the enhanced indexing approach to manage Topa as her objective is to
earn an active return of 25 bps, a modest return objective. Furthermore, the portfolio weights deviate
slightly from the benchmark index while duration is nearly matched to that of the index.
3. Question ID: 134524
Correct Answer: B
B is correct.
All $ figures are in millions.
To determine the impact of leverage on fund returns, total portfolio returns will need to be calculated
as follows:

rP = rI +

VB
(rI - rB ) = 0.078 + $15 (0.078 - 0.063) = 0.087
VE
$25

Topa’s returns will increase from 7.80% to 8.70%.

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Reading 21

Introduction to Fixed Income Portfolio Management

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4. Question ID: 134525
Correct Answer: B
B is correct. Unlike fixed-coupon bonds, floating-coupon bonds do not generate a pre-determined
cash flow stream which is known at the time the bond is issued. On each reset date, the reference rate
is reset to the inflation rate prevailing in the market. Therefore, the coupon rate is not known in
advance.
A is incorrect. Floating-coupon bonds have a low (and negative) correlation with the rest of the
portfolio and thus their addition to Topa will generate diversification benefits by reducing the overall
risk of the fund.
C is incorrect. Floating-coupon bonds provide a hedge against inflation because the reference rate
should adjust for inflation.
5. Question ID: 134526
Correct Answer: B
B is correct. Given that fund investors are taxable, Summers should seek to minimize taxes when
liquidating corporate bonds by deferring capital gains and realizing capital losses early to offset
current or future capital gains. Summers should therefore seek to liquidate Issue B because of its
embedded capital loss which will result in a lower net realized capital gain being distributed to
investors.
6. Question ID: 134527
Correct Answer: A
A is correct. Statement 1 is correct. Duration matching seeks to match the duration of the assets
portfolio with the liabilities portfolio as well as the present value of both these portfolios. The idea is
that changes in the bond portfolio’s market value closely match the change in the liability portfolio
and any shortfall in cash flows is covered by the asset portfolio.
B is incorrect. Statement 2 is incorrect. In general, immunization approaches can accommodate bonds
with embedded options to the extent that a bond’s duration is replaced by its effective duration.

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