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

Reading 21

Introduction to Fixed Income Portfolio Management

FinQuiz.com

FinQuiz.com
CFA Level III Item-set - Question
Study Session 10
June 2018

Copyright © 2010-2018. FinQuiz.com. All rights reserved. Copying, reproduction or
redistribution of this material is strictly prohibited.

FinQuiz.com © 2018 - All rights reserved.


Reading 21

Introduction to Fixed Income Portfolio Management

FinQuiz.com

FinQuiz Item-set ID: 134521
Questions 1(134522) through 6(134527) relate to Reading 21

Tina Summers Case Scenario
Tina Summers is the fund manager for Topa, a global fund comprising domestic and foreign
bonds. The benchmark for the fund is a global bond index. Summers manages the fund with the
objective of earning a periodic return of at least 25 basis points in excess of the benchmark. The
fund’s investors are taxable institutions.

As a starting point, Summers computes the 12-month expected return for Topa using data
collected in Exhibit 1. The data incorporates income earned on the reinvestment of coupons.
Exhibit 1
Notional value of fund’s investments
Average annual coupon
Current average bond price
Expected average bond price (in 12 months)
Modified duration
Modified convexity
Expected currency gains
Expected average yield and yield spread change

$25 million
$3.20
$97.85
$99.00
2.60
1.30
1.95%
1.80%

Next, Summers compares the composition and weighted average duration of Topa relative to its
benchmark index for the purposes of performance evaluation. Exhibit 2 summarizes the results
of her analysis.
Exhibit 2
Securities
Treasuries
Corporate bonds
Floating-coupon bonds
Emerging market bonds

Domestic high-yield bonds
Total
Duration

Fund

Benchmark
Index

25%
30
15
8
22
100
2.60

28%
32
10
3
27
100
2.58

Topa is currently unleveraged and Summers is contemplating leveraging the fund to further
increase returns. Exhibit 3 summarizes a proposed leveraging strategy.

FinQuiz.com © 2018 - All rights reserved.

Reading 21

Introduction to Fixed Income Portfolio Management

FinQuiz.com

Exhibit 3
Amount borrowed
Current value of Topa’s equity
Return on invested funds
Cost of borrowing

$15 million
$25 million
7.80%
6.30%

Summers attempts to explain the over allocation in floating-coupon bonds relative to the
benchmark index noting that the asset class has a duration of – 1 and a correlation of – 0.30 with
the rest of the portfolio.
A year later Summers decides to reduce Topa’s corporate bond holdings and invest the proceeds
in emerging market bonds which have a higher expected return. Summers is comparing two bond
issues in the fund for potential liquidation (Exhibit 4).
Exhibit 4
Current market value
Capital gains/losses
Coupon rate
Investment view
Time to maturity

Income tax rate
Capital gains tax rate

Issue A
$850,000
$42,000
5.00%
Overvalued
8 years

Issue B
$850,000
- $42,000
5.00%
Undervalued
8 years

40%
37%

The Bascille Corporation’s pension fund’s portfolio is partially invested in Topa. The plan’s
chief investment officer (CIO) holds a meeting with Summers to discuss his plans for
implementing an immunization approach with an emphasis on duration matching for the policy
portfolio. He shares his understanding of the approach with Summers as follows:
Statement 1: “Duration-matching seeks to minimize cash flow shortfall risk by matching the
duration and present value of the liability stream.”
Statement 2: “Duration-matching approach cannot accommodate bonds with embedded options,
so we will need to liquidate Bascille’s portfolio holdings of any such bonds.”

FinQuiz Question ID: 134522

1. Using the data in Exhibit 1, the fund’s expected return is closest to:
A. 3.79%.
B. 3.83%.
C. 13.19%.

FinQuiz.com © 2018 - All rights reserved.


Reading 21

Introduction to Fixed Income Portfolio Management

FinQuiz.com

FinQuiz Question ID: 134523

2. Using the data in Exhibit 2, which investment mandate has Summers employed for managing
Topa?
A. Pure indexing
B. Enhanced indexing
C. Active management
FinQuiz Question ID: 134524

3. Using the data in Exhibit 3, will the use of leverage increase Topa’s returns?
A. No.
B. Yes, Topa’s return will increase to 8.70%.
C. Yes, Topa’s return will increase to 10.30%.
FinQuiz Question ID: 134525

4. Which of the following reasons least likely supports the over allocation of the Topa fund to
floating-coupon bonds?
A. Diversification of risk
B. Stabilize cash flow stream
C. Inflation hedging potential
FinQuiz Question ID: 134526

5. Considering the fund investors, which issue should Summers consider for liquidation?
A. Issue 1
B. Issue 2
C. Neither of the two issues; the liquidation of issues will trigger capital gains taxes which
should be avoided.
FinQuiz Question ID: 134527

6. Considering the CIO’s discussion concerning duration-matching, he is most likely correct
regarding:
A. Statement 1 only.
B. Statement 2 only.
C. both of the statements.

FinQuiz.com © 2018 - All rights reserved.