CFA level 3 CFA level 3 volume III applications of economic analysis and asset allocation finquiz item set answers, study session 12, reading 22

Reading 22

Liability-Driven and Index-Based Strategies

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

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Reading 22

Liability-Driven and Index-Based Strategies

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FinQuiz Level III 2018 – Item-sets Solution
Reading 22: Liability-Driven and Index-Based Strategies
1. Question ID: 134577
Correct Answer: C
C is correct. The residential mortgage loan is an example of a Type IV asset to Lake’s lender because
the prepayment option may result in coupon interest and principal being received earlier than
expected increasing the uncertainty for the mortgage lender. In addition, the potential for default
exists and affects the projected amount of cash flow at each date. Type IV liabilities/assets have an

uncertain timing and amount.
2. Question ID: 134578
Correct Answer: C
C is correct. Strong’s instructions to Mendes regarding immunizing Lake’s liability are inappropriate
because she has failed to consider the fact that the duration measure changes with the passage of time
and shifts in yield curve.
A is incorrect. A sufficient, but not necessary, condition for immunization is that yield curve shifts are
parallel. However, the immunization conditions can even prevail in the event of non-parallel yield
curve shifts.
B is incorrect. Mortgage loans are an example of a Type IV liability and therefore effective duration
should be used to measure interest rate sensitivity.
Strong has appropriately instructed Mendes to match the effective durations and market value of the
asset and liability portfolios.
3. Question ID: 134579
Correct Answer: B
B is correct. To immunize a multi-liability portfolio 1) the BPV of the asset portfolio should closely
match that of the liability portfolio and 2) the asset portfolio should have a higher dispersion (which
can be implied as higher convexity).
The BPVs of all three asset portfolios closely match the liabilities portfolio. To immunize multiple
liabilities using duration matching, the convexity of the asset portfolio should be higher. Portfolio A
and C are ruled out on these grounds which makes Portfolio B the most optimal choice.

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Reading 22

Liability-Driven and Index-Based Strategies

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4. Question ID: 134580
Correct Answer: B
B is correct. A laddered portfolio such as Portfolio C is optimal for liquidity management because as
time passes there will always be a bond that is close to redemption. With a greater range of bonds of
varying maturities, the final coupon and principal of bonds can be deployed for consumption or
reinvested in a long-term bond at the back of the ladder.
A is incorrect. Structural risk arises from the design of the asset portfolio. The more dispersed a
portfolio’s cash flows are, the higher is the structural risk. In this respect, Portfolio C has the highest
cash flow dispersion and has the highest structural risk while Portfolio A has the lowest amount of
structural risk.
5. Question ID: 134581
Correct Answer: A
A is correct. One of the drawbacks of immunizing multiple Type I liabilities such as those of
Wholesome Foods’ with assets of higher quality (A-rated versus AAA-rated, respectively), is that the
exposure to spread risk increases. The risk is that the respective spreads on the asset and liability
portfolios do not move in unison with a shift in the benchmark bond yield curve.
6. Question ID: 134582
Correct Answer: B
Strong will prefer the purchase of the receiver swaption over the other two derivatives contracts when
the swap rate exceeds 5.50%. In this scenario, the swaption collar will generate a loss to Wholesome
Foods because the payer swaption will be in the money for the counterparty (and will require a
payment to the counterparty) while the receiver swaption will be out of the money. The receive-fixed
swap will also be unfavorable because it incurs a loss while the purchased receiver swaption will help
mitigate the loss which is generated on the two overlay strategies.

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