2019 CFA level 3 qbank reading 22 introduction to fixed income portfolio management answers

Question #1 of 13
Credit risk is a major source of concern for repo agreements. Protection against borrower
default can be mitigated by the safety of the underlying security that is used as collateral and
the "haircut" that requires additional capital over the principal borrowed amount.
Which of the following statements regarding the hair cut is most accurate?

A) The size of the haircut increases as the volatility of the underlying asset increases.
B) The size of the haircut is not related to the underlying asset’s volatility.

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C) Average credit spreads determine the haircut, not volatility.
Explanation

(Study Session 11, Module 22.3, LOS 22.e)

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Question #2 of 13

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Haircuts for highly rated government securities are typically around 1% to 2% and will be
higher for more risky securities. As the underlying security increases in volatility, the haircut
percentage generally increases to provide further credit protection against the possibility of
default by the borrower.


Tara Harris is the lead portfolio manager for the Quantas Bond Fund and needs to raise
$8,000,000 to meet expected withdrawals this quarter. Quantas Bond Fund's investors
primarily consist of medical professionals that are taxed at the top tax bracket in the U.S. Harris
is considering selling two bonds this quarter to meet the expected redemptions.
Selected data for the two bonds:

Bank Bond

Current Market Value

$8,000,000

$8,000,000

Capital gain/loss

$200,000

-$400,000

Coupon Rate

3.50%

4.00%

Maturity

12 years

12 years

Investment committee
analysis

Undervalued

Overvalued

39%

Capital Gains tax rate

15%

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Top U.S. Income tax rate

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Telecomm Bond

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Based on the above information, the optimal tax loss harvesting strategy is:

A) Sell $6,000,000 of the Telecomm Bond and $2,000,000 of the Bank Bond.
B) Sell $8,000,000 of the Telecomm Bond.
C) Sell $8,000,000 of the Bank Bond.

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Explanation

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The optimal strategy is to sell $8,000,000 of the Bank Bond and realize a $400,000 loss for tax
considerations. The loss can be used to o set current or future capital gains for tax
purposes.

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(Study Session 11, Module 22.3, LOS 22.f)
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Question #3 of 13
Jake Tyler is new to investing and has learned that correlation among assets is important in
determining diversi cation bene ts. However, Jake also begins to wonder if asset class volatility
is also important in understanding portfolio risk.
The most correct statement regarding bond volatility by Tyler is:

A) Bonds are generally less volatile than equities.
B) Bonds are generally more volatile than equities.


C) Bonds have the same volatility as equities.
Explanation
Volatility of the asset class is also important in determining portfolio risk and bonds generally
have less volatility than equities.
(Study Session 11, Module 22.1, LOS 22.a)
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Question #4 of 13
The bond type that provides the best in ation hedge and protects against in ation for both the

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coupon payments and the principal received at maturity are:

A) xed – coupon bonds.
B) in ation linked bonds.

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C) oating-coupon bonds.
Explanation

In ation Linked Bonds (see chart below)

Coupon

Protected

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In ation linked bonds

not protected not protected

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Fixed-coupon bonds

Par

Floating-coupon bonds Protected

Protected
not protected

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(Study Session 11, Module 22.1, LOS 22.a)
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Question #5 of 13
Which of the following are common xed-income derivatives that are traded on exchanges?

A) Bond futures and options on futures.
B) Interest rate swaps and bond futures.
C) Interest rate swaps and credit default swaps.
Explanation


A common alternative to investing directly in bonds is to use xed-income derivatives. Bond
futures and options on futures are traded on exchanges, while interest rate swaps and credit
default swaps trade over the counter (OTC). Since the nancial crisis, many OTC securities are

starting to have similar features compared to exchange traded products (i.e. initial margin,
daily cash settlement, etc.).
(Study Session 11, Module 22.1, LOS 22.c)
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Question #6 of 13

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Which of the following statements listing the typical liquidity of xed income sub-sectors from

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highest to lowest is most accurate?

A) Sovereigns, corporate bonds with shorter maturity, corporate bonds with longer
maturity.

B) Corporate bonds with shorter maturity, corporate bonds with longer maturity,

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Sovereigns.

C) Corporate bonds with shorter maturity, Sovereigns, corporate bonds with longer
maturity.

Explanation

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Bond market liquidity is not constant among xed income sub-sectors. Sovereign
government bonds are generally more liquid than corporate bonds and bonds with longer
maturities are generally less liquid than shorter-maturity bonds since many purchasers of
long-term bonds intend to hold them until maturity, i.e. they stop trading after a while.

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(Study Session 11, Module 22.1, LOS 22.c)
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Question #7 of 13
Which of the following liability-based strategies provides the lowest expected return and
requires the lowest risk and complexity in its design?

A) Horizon matching.
B) Contingent immunization.
C) Cash ow matching.
Explanation

Cash ow matching

Comparison of Liability-Based Strategies
Initial funding
required (PVA)

Risk and
complexity

Expected realized
return if successful

(3)

Lowest (1)

Lowest (1)

Horizon
matching

(2)

(2)

(2)

Duration
matching

Lowest (1)

(3)

(3)

Contingent
immunization

Highest (4)*

Highest (4)

Highest (4)

(Study Session 11, Module 22.1, LOS 22.b)
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Question #8 of 13

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*This re ects the requirement to initially overfund with a surplus

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Cash ow
matching


Tami Taylor works for a large multinational corporation based in Texas that recently purchased
Euro 5,000,000 of Greek bonds from a large shipping conglomerate. Taylor has been called to
tomorrow's Board meeting to discuss the investment.
Selected Data on the Greek Bond Portfolio:

Euro
5.00

Average bond coupon payment (per Euro 100 par)

Euro
5.50

Coupon frequency

Annual

Current average bond price

Euro
94.12

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Notional principal of the shipping conglomerate bonds (in
millions)

Euro
94.74

Average bond convexity

0.25

Average bond modi ed duration

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Expected average bond price in one year (assuming unchanged
yield curve)

5.00

0.50%

Expected credit loss

0.20%

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Expected average yield and yield spread change

Expected currency losses (Euro depreciation versus $)

0.25%

Assuming no reinvestment income the calculated expected return of the Euro bond portfolio
next year is closest to:

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A) 4.25%.

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B) 3.75%.

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C) 3.55%.

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Explanation


Total expected return = Rolling yield + E(Change in price based on investor's yield and yield
spread view) – E(Credit losses)+ E(Currency gains or losses)
Rolling yield = Yield income + Rolldown return

Return
Component
Yield
income

Formula
Annual coupon payment/Current bond price

= Rolling
yield

(Bond priceEnd−of−horizon period −Bond priceBeginning−of−horizon period  )
Bond priceBeginning−of−horizon period

Yield income + Rolldown return

Given

+

E(Currency
gains or
losses)

Given

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= Total
expected
return

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E(Credit
losses)

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+ E(Change
in price
based on

investor's
[MD ì Yield] + [ẵ ì Convexity × (ΔYield)2 ]
yield and
yield spread
view)

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+ Rolldown
return

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The portfolio's yield income (current yield) is 5.84%. The portfolio has average coupon
payments of Euro 5.50 on Euro 100 Notional and currently trades at Euro 94.12. The current
yield (yield income) is Euro 5.50 / Euro 94.12 = 5.84%
Assuming we are at the end of year one and we had an unchanged yield curve, the rolldown
return is (Euro 94.74 – Euro 94.12) / Euro 94.12 = .66%.
The rolling yield (yield income + rolldown return) is 5.84% + .66% = 6.5%
The expected change in price based on Tami's expectation of yield spreads is -0.5%. The bond
portfolio has a modi ed duration of 5.0 and a convexity of .25. The expected change in bond
price is: (-5 × .005) + (.5 × .25 x .0052) = -.025 = -2.5%
Tami expects .2% credit loss in her Euro bond portfolio.
Tami expects the Euro to depreciate by .25% over the next year versus the U.S. dollar
resulting in a .25% loss to the portfolio.
The total expected return, combing the components is:
+ 5.84% Yield Income


+ 0.66% Rolldown return

- 2.50% Expected change in price based on Tami's view on yield spreads
- 0.20% Expected credit losses in Euro bonds
- 0.25% Expected depreciation of Euro versus USD
= 3.55%
(Study Session 11, Module 22.2, LOS 22.d)
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Question #9 of 13

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Leslie currently has 40% of her overall portfolio invested in a diversi ed xed-coupon bond

portfolio with an average duration of 8 years. The remainder of her portfolio is evenly spread
across both large and small cap stocks that are balanced globally across many sectors and
countries, primarily through diversi ed ETFs. Leslie primarily wants to reduce the overall risk of

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her portfolio and also keep up with in ation until she retires in 16 years.

Leslie is a professional photographer and has a limited understanding of the nancial markets.
During a recent meeting with her nancial advisor, Leslie was informed of some changes she

should consider making to her portfolio. Her advisor identi ed that the correlation coe cient
of Leslie's current bond portfolio with her equity holdings is - .05. Also, the correlation

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coe cient between her equity holdings and an ETF consisting of in ation-linked bonds is .23.

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Finally, the approximate correlation coe cient between Leslie's current xed income portfolio
and the proposed in ation-linked ETF is relatively high at .55.

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Her advisor recommends that Leslie should diversify her current xed-coupon bond holdings
by adding in ation- linked bonds to her portfolio.

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The following action Leslie would take considering her primary goal is to reduce her portfolio
risk and also keep up with in ation until she retires is most likely:

A) ignore the recommendation since her portfolio is already properly diversi ed.
B) reduce her current bond holdings by 25% and purchase small cap emerging market
stocks with the proceeds.
C) rebalance 25% of her xed Income holdings into in ation-linked bonds.
Explanation

Rebalancing 25% of her xed income holdings into in ation-linked bonds to an already
diversi ed portfolio of bonds and stocks generally results in superior risk-adjusted real
portfolio returns. Leslie can also lower the overall risk of her portfolio by adding in ation
linked bonds to her portfolio. The correlation between nominal xed–coupon bonds and
in ation-linked bonds is .55, which is less than 1.0. Adding the in ation-linked bonds helps to
meet Leslie's requirement to keep up with in ation.
Increasing the percentage of the portfolio in emerging markets stocks will not reduce the
overall portfolio risk as Leslie has requested.
Based on Leslie's primary goal, she should follow her advisor's advice and add in ation-linked
bonds to her portfolio.
(Study Session 11, Module 22.1, LOS 22.a)
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Question #10 of 13

Jim is a new associate in operations at a mid-sized xed income consulting rm. Jim is trying to

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learn the bene ts of cash ow matching versus duration matching and reaches out to some of
his friends on Wall Street for assistance in understanding the key features of liability-based

mandates.

Jim's friend Je tells Jim that the key features of cash ow matching include: making no yield

rebalancing is not required.

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curve assumptions, matching the bond portfolio's cash ows to existing liabilities and frequent

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Jim also called his friend Ted who tells Jim the bene ts of cash ow matching include:
accommodating multiple yield curve assumptions, frequent rebalancing and the ability to

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handle increased complexity, so many advanced traders like this strategy overall.
Which of Jim's friend's explanation of cash ow matching is most accurate?

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A) Ted’s statement.

B) Neither Je nor Ted statements are correct.
C) Je ’s statement.
Explanation
Je 's statement is the most accurate. Cash ow matching makes no yield curve assumptions',
rebalancing is not required, and bond portfolios are created to match cash ows with

liabilities.
(Study Session 11, Module 22.1, LOS 22.b)
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Question #11 of 13
Amanda Smith is a new member of a large pension fund and her team is focused on xed
income investing. Amanda has been researching in ation-linked bond volatility and how this
volatility compares to the volatility found with conventional bonds and equities. After
concluding her analysis, Amanda is most likely to nd:

A) In ation-linked bonds generally are more volatile than conventional bonds but less
volatile than equities.
B) In ation-linked bonds have the same volatility as conventional bonds but less
volatility than equities.
C) In ation-linked bonds generally have lower return volatility than conventional

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bonds and equities.

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Explanation

In ation-linked bonds are linked to real interest rates, not nominal rates and real rates are
generally not as volatile as conventional bonds or equities.
(Study Session 11, Module 22.1, LOS 22.a)

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Question #12 of 13

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The following is selected data on Omega Fixed-Income Mutual Fund

$105.00

Average Modi ed duration

8.50

Average Annual Coupon

$1.50

PV of assets (millions)

$120.00

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Current average bond price

Value of Portfolio's equity (millions) $62.25
Value of borrowed funds (millions)

$30.26

Borrowing rate

1.75%

Return on Invested Funds

4.25%

The leveraged portfolio return for the Omega Fixed Income Mutual Fund is closest to:

A) 9.43%.
B) 5.75%.
C) 5.47%.


Explanation
Return on the leveraged portfolio =
Return on invested funds + (value of borrowed funds / value of portfolio's equity) x

(return on invested funds – borrowing rate)
= 4.25% + ($30.26 million / $62.25 million) x (4.25% - 1.75%) = 5.47%
(Study Session 11, Module 22.3, LOS 22.e)
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Question #13 of 13

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Je Timura is currently the lead portfolio manager for an International xed income portfolio.
Timura has an upcoming meeting on December 20th with his largest client, Tucker Powell, to
discuss the rm's outlook for the upcoming year. At the meeting, Timura tells Powell that he

expects the yield curve to continue to remain unchanged for the next 16 months. Assuming the

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forecast is correct, which of the following statements is most likely correct?

A) The current yield (yield income) of an international global portfolio is an incomplete
measure of the portfolio’s expected return.

B) Since Timura is expecting a stable yield curve, yield income is a good estimate of
the bond portfolio’s expected return for next year.

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C) The best estimate of the bond’s return is the portfolio’s yield income plus its

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Explanation

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rolldown return minus its expected credit losses.

Yield income (current yield) is an incomplete measure of a bond portfolio's expected return.

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Decomposing expected xed-income returns allows an investor to di erentiate among
several important return components. At the most general level, expected returns (denoted
as E(R) below) can be decomposed (approximately) in the following manner:

E(R) ≈ Yield income
+ Rolldown return
+ E(Change in price based on
investor's views of yields and yield
spreads)
− E(Credit losses)
+ E(Currency gains or losses)
(Study Session 11, Module 22.2, LOS 22.d)

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