weaverbirdllm/famma · Datasets at Hugging Face

500

english_224_2_r1

nan

Do Orion’s policies on asset valuation most likely comply with GIPS standards

[ "A. Yes", "B. No, because valuations should be based on fair value", "C. No, because settlement date accounting should be used for all transactions" ]

Not supported with pagination yet

screenshot

B

Solution: B. GIPS standards require the use of fair value for portfolio valuations

hard

multiple-choice

portfolio management

english

224

2

0

Not supported with pagination yet

release_basic

501

english_224_3_r1

nan

Orion’s private equity disclosure least likely meets GIPS standards with respect to the

[ "A. Use of multiples", "B. Timing of valuations", "C. Construction of composites" ]

Not supported with pagination yet

screenshot

C

Solution: C. GIPS standards require the separation of composites by strategy as well as vintage year

hard

multiple-choice

portfolio management

english

224

3

0

Not supported with pagination yet

release_basic

502

english_224_4_r1

nan

Does Lee’s proposed hierarchy of private equity valuation methodologies in Exhibit 1 most likely meet GIPS standards

[ "A. Yes", "B. No, the correct order of methodologies is 2, 3, 1", "C. No, the correct order of methodologies is 3, 2, 1" ]

Not supported with pagination yet

screenshot

B

Solution: B. According to GIPS standards, the correct order of valuation methodologies is: 1. Objective, observable quoted market prices for similar investments in active markets. (#2) 2. Quoted prices for identical or similar investments in markets that are not active. (#2) 3. Market-based inputs other than quoted prices that are observable for the investment. (#3) 4. Subjective, unobservable inputs. (#1)

hard

multiple-choice

portfolio management

english

224

4

0

Not supported with pagination yet

release_basic

503

english_224_5_r1

nan

Lee is most likely correct with regard to which category of investments being subject to the real estate provisions of the GIPS standards

[ "A. Category 1", "B. Category 3", "C. Category 2" ]

Not supported with pagination yet

screenshot

B

Solution: B. B is correct. The GIPS standards specify the types of investments that are not considered real estate, such as publicly traded REITs and private debt investments, both commercial and residential. A is incorrect because REITs are not subject to GIPs real estate provisions. C is incorrect because commercial real estate loans are not subject to GIPs real estate provisions.

hard

multiple-choice

portfolio management

english

224

5

0

Not supported with pagination yet

release_basic

504

english_224_6_r1

nan

Which of the comments made by Lee is not consistent with GIPS verification standards

[ "A. Comment 1", "B. Comment 2", "C. Comment 3" ]

Not supported with pagination yet

screenshot

C

Solution: C. GIPS standards require that the firm being verified, and not the verification firm (i.e., Stowe), maintain the data and information necessary for the calculations.

hard

multiple-choice

portfolio management

english

224

6

0

Not supported with pagination yet

release_basic

505

english_225_1_r1

Laura Davidson is a financial advisory partner with Emerald Private Bank (Emerald). Emerald is based in Dublin, Ireland, and manages money on behalf of high-net-worth individual investors, foundations, and endowments. Davidson works in Emerald's private wealth group (PWG). This group is tasked with meeting clients, developing financial plans, and implementing recommendations from Emerald's investment committee. The PWG meets weekly to review new client relationships and to discuss the most appropriate approach for working with each client. Emerald believes there are significant benefits to incorporating behavioral finance as part of their client assessment process and has recently made changes to this effect. During preparation for the weekly PWG meeting, Davidson reviews the financial holdings of three new clients along with their risk assessment questionnaires. Her observations are summarized in Exhibit 1. <image_1> During the meeting, fellow adviser Liam Roche makes the following observation based on the information in Exhibit 1: "Mr. Donnelly should respond favorably to education focused on how the investment program affects financial security, retirement planning, and future generations. However, Ms. Connor and Mr. O'Driscoll will respond better to education on portfolio metrics, such as the Sharpe Ratio." Amanda Kelly is an investment strategist and a member of Emerald's investment committee. Kelly sits in on the PWG meeting to provide an update on the firm's investment themes and positioning. Emerald has developed a multi-factor macro model to forecast such variables as GDP growth and interest rate movements. At the meeting, Kelly provides detailed information about the macro model, including many statistics on how the factors have performed using both in-sample and out-of-sample backtesting. The model appears to have had a good track record of predicting changes in the macro environment over time. As part of her investment update, Kelly notes that the macro model predicts that interest rates in Europe are going to revert to their historical averages over the next three years and that this move will start within the next six to nine months. Davidson asks Kelly if recent unprecedented monetary policy actions by the Bank of England and European Central Bank have affected the reliability of the model. Kelly responds that because the macro model incorporates more than 100 different variables, central bank policies are accurately accounted for. Later that day, Kelly attends Emerald's weekly investment committee meeting. Kelly brings up Davidson's concerns regarding how central bank activity may affect the accuracy of their macro model. Emerald's chief investment officer (CIO), who chairs the meeting, dismisses Davidson's concerns as uninformed. The rest of the committee members agree. The CIO then suggests updating their stock selection model to incorporate a price momentum factor. Kelly states that she is concerned that momentum will not be effective across all sectors. The CIO counters that because several behavioral biases support the persistence of price momentum, they would be foolish not to incorporate this factor. After a brief discussion, the other committee members agree with the CIO and momentum is added to the stock selection model. Following the meeting, Kelly is frustrated and writes an email to the CIO with suggestions she believes will improve the dynamics of the investment committee in the future. Her recommendations include the following: 1. Spending more time analyzing prior committee decisions. 2. Structuring the committee to ensure a higher level of common skills and experiences. 3. Requesting stated opinions from members prior to any formal committee discussion.

Roche's observation regarding client education is least likely accurate for which client

[ "A. Kyra Conner", "B. Alan O'Driscoll", "C. Michael Donnelly" ]

Not supported with pagination yet

screenshot

A

Solution: A. Both Conner and Donnelly are exhibiting emotional biases. When advising emotionally biased investors, advisers should focus on explaining how the investment program being created affects such issues as financial security, retirement, or future generations rather than focusing on quantitative details. The recommendation for Conner would be more suited for a cognitively biased investor. O'Driscoll is a cognitively biased investor (friendly follower). As such, focusing on such metrics as the Sharpe Ratio would be appropriate for this client.

hard

multiple-choice

portfolio management

english

225

1

0

Not supported with pagination yet

release_basic

506

english_225_2_r1

nan

Which behavioral investor type most likely describes Michael Donnelly

[ "A. Independent individualist", "B. Active accumulator", "C. Friendly follower" ]

Not supported with pagination yet

screenshot

B

Solution: B. Donnelly is entrepreneurial and created his own wealth. He lacks spending controls, does not believe in the benefits of portfolio diversification, has a high-risk tolerance, and prefers high-risk investments recommended by friends. These are all attributes of an active accumulator

hard

multiple-choice

portfolio management

english

225

2

0

Not supported with pagination yet

release_basic

507

english_225_3_r1

nan

In Kelly's response to Davidson, she is most likely exhibiting

[ "A. illusion of control bias", "B. gambler's fallacy", "C. self-attribution bias" ]

Not supported with pagination yet

screenshot

A

Solution: A. The illusion of control bias can be encouraged by complex models. The illusion of control can lead to analysts being overly confident when forecasting complex patterns, such as future interest rate movements.

hard

multiple-choice

portfolio management

english

225

3

0

Not supported with pagination yet

release_basic

508

english_225_4_r1

nan

Which of the following biases least likely provides behavioral support for the factor being added to the stock selection model

[ "A. Framing", "B. Availability", "C. Hindsight" ]

Not supported with pagination yet

screenshot

A

Solution: A. Framing bias is a type of cognitive error in which a person answers a question differently based on the way in which it is asked. This behavior is unlikely to explain the persistence of momentum. Regret is a type of hindsight bias that can result in investors purchasing securities after a significant run-up in price because of a fear of not participating. This bias could explain momentum. With availability bias, also referred to as the recency effect, the tendency to recall recent events more vividly can result in investors extrapolating recent price gains into the future. This bias could also explain momentum.

hard

multiple-choice

portfolio management

english

225

4

0

Not supported with pagination yet

release_basic

509

english_225_5_r1

nan

Which of Kelly's recommendations is least likely to be effective

[ "A. Recommendation 1", "B. Recommendation 2", "C. Recommendation 3" ]

Not supported with pagination yet

screenshot

B

Solution: B. It is recommended that investment committees be composed of people with differing skills and experiences, not similar as Kelly has suggested. Decision makers are most likely to learn to control harmful behavioral biases when they have repeated attempts at decision making and there is good quality feedback on prior outcomes. The investment committee chair should actively encourage alternative opinions so that all perspectives are covered. Asking for individual views prior to discussion can help mitigate the impact of group thinking

hard

multiple-choice

portfolio management

english

225

5

0

Not supported with pagination yet

release_basic

510

english_226_1_r1

Brian O’Reilly is a capital markets consultant for the Tennessee Teachers’ Retirement System (TTRS). O’Reilly is meeting with the TTRS board to present his capital market expectations for the next year. Board member Arnold Brown asks O’Reilly about the use of high-frequency (daily) data in developing capital market expectations. O’Reilly answers: “Sometimes it is necessary to use daily data to obtain a data series of the desired length. High-frequency data are more sensitive to asynchronism across variables and, as a result, tend to produce higher correlation estimates.” Board member Harold Melson noted he recently read an article on psychological traps related to making accurate and unbiased forecasts. He asks O’Reilly to inform the board about the anchoring trap and the confirming evidence trap. O’Reilly offers the following explanation: “The anchoring trap is the tendency for forecasts to be overly influenced by the memory of catastrophic or dramatic past events that are anchored in a person’s memory. The confirming evidence trap is the bias that leads individuals to give greater weight to information that supports a preferred viewpoint than to evidence that contradicts it.” The board asks O’Reilly about using a multifactor model to estimate asset returns and covariances among asset returns. O’Reilly presented the factor covariance matrix for global equity and global bonds shown in Exhibit 1 and market factor sensitivities and residual risk shown in Exhibit 2. <image_1> <image_2> Finally, the board asks about forecasting expected returns for major markets given that price earnings ratios are not constant over time and that many companies are repurchasing shares instead of increasing cash dividends. O’Reilly responds that the Grinold-Kroner model accounts for those factors and then makes the following forecasts for the European equity market: • Dividend yield will be 1.95% • Shares outstanding will decline 1.00% • Long-term inflation rate will be 1.75% per year • An expansion rate for P/E multiples of 0.15% per year • Long-term corporate real earnings growth at 3.5% per year

With respect to his answer to Brown’s question, O’Reilly most likely is

[ "A. Correct", "B. Incorrect, because high-frequency data are less sensitive to asynchronism", "C. Incorrect, because high-frequency data tend to produce lower correlation estimates" ]

Not supported with pagination yet

table

C

Solution: C. O’Reilly’s answer is incorrect with respect to correlation estimates. High-frequency data are more sensitive to asynchronism across variables and, as a result, tend to produce lower correlation estimates.

easy

multiple-choice

equity

english

226

1

0

Not supported with pagination yet

release_basic

511

english_226_2_r1

nan

Is O’Reilly’s explanation of the anchoring trap most likely correct

[ "A. Yes", "B. No, because the anchoring trap is the tendency to temper forecasts so that they do not appear extreme", "C. No, because the anchoring trap is the tendency for the mind to give a disproportionate weight to the first information it receives on a topic" ]

Not supported with pagination yet

table

C

Solution: C. O’Reilly’s explanation of the anchoring trap is incorrect. The anchoring trap is the tendency of the mind to give disproportionate weight to the first information it receives on a topic. Initial impressions, estimates, or data anchor subsequent thoughts and judgments.

easy

multiple-choice

equity

english

226

2

0

Not supported with pagination yet

release_basic

512

english_226_3_r1

nan

Given the data in Exhibits 1 and 2, the covariance between Market 1 and Market 2 is closest to

[ "A. 0.0017", "B. 0.0225", "C. 0.0243" ]

Not supported with pagination yet

table

C

Solution: C. The covariance between Market 1 and Market 2 is calculated as follows: M12 = (1.20 × 0.90 × 0.0225) + (0 × 0 × 0.0025) + [(1.20 × 0) + (0 × 0.90)] × 0.0022 = 0.0243.

hard

multiple-choice

equity

english

226

3

1

Not supported with pagination yet

release_basic

513

english_226_4_r1

nan

Given O’Reilly’s forecasts for the European market, the expected long-term equity return using the Grinold-Kroner model is closest to

[ "A. 6.35%", "B. 7.35%", "C. 8.35%" ]

Not supported with pagination yet

table

C

Solution: C. According to the Grinold-Kroner model, the expected long-term developed market equity return is equal to the sum of the: 1) expected income return (dividend yield minus the percentage change in the number of shares outstanding), 2) expected nominal earnings growth return (long-term inflation rate plus long-term corporate earnings growth rate), and 3) repricing return (expansion rate for P/E multiples). In this case: E (Re) = [1.95 – (–1.0)] + [1.75 + 3.50] + 0.15 = 2.95 + 5.25 + 0.15 = 8.35%

hard

multiple-choice

equity

english

226

4

1

Not supported with pagination yet

release_basic

514

english_227_1_r1

Olli Nava is a junior economist for Globofunds Asset Management, a large investment management company. She has been asked to produce capital market expectations for asset classes in several different markets relevant to the Diversified Absolute Return Strategies Fund (DARS), the company’s largest fund. Nava is aware that long-term GDP trend forecasting is considered the starting point to form capital market expectations at Globofunds, but she is unsure why this is the case. She asks a colleague, Jedd Wiggins to explain why long-term trend GDP growth is considered so important when forecasting asset class returns. Wiggins makes the following two statements. • Statement 1: There is both theoretical and empirical support for the case that the average level of real government bond yields is causally linked to the trend rate of growth in the economy. • Statement 2: Over the long run, the total return of an equity market is causally linked to the growth rate of GDP. To make a forecast of trend GDP growth in the domestic economy, Nava collates the following Globofunds data displayed in Figure 1. <image_1> Nava has the view that increased levels of globalization will lead to the current account playing a larger role in growth rate of economies. She considers the macroeconomic linkages between the three main economies which the fund is exposed to. Macroeconomic data relating to these economies is displayed in Figure 2. <image_2> Nava also considers the movement in foreign exchange to be a key determinant of the medium-term performance of DARS. She considers the macroeconomic policy of the three main developing markets which the fund is exposed to and collates the data as shown in Figure 3. <image_3> Nava attempts to forecast the likely foreign exchange rate movements that will affect the fund. She notes that the largest foreign currency exposure is in Country X. The current spot rate of the domestic currency of the fund (DOM) versus the foreign currency of Country X (FOR) is DOM/FOR = 1.3020. Data related to the expected returns in the domestic and foreign markets is displayed below in Figure 4. <image_4> Nava also considers purchasing power parity as a tool for long-term foreign exchange rate forecasting. She notes that expected inflation in the domestic country is higher than the expected inflation in Country X.

How many of the statements made by Wiggins are accurate

[ "A. Zero", "B. One", "C. Two" ]

Not supported with pagination yet

table

B

Solution: B Statement 1 is correct. There is theoretical and empirical evidence that average long-term government bond yields are directly linked to the trend rate of growth in an economy. Statement 2 is incorrect. Over the long run, the capital gains component of equity returns is directly linked to GDP. However, this does not apply to the income component of returns (i.e., the dividend yield). Hence, it is not true to say that the total return (capital gains plus income) is linked to GDP growth.

hard

multiple-choice

economics

english

227

1

0

Not supported with pagination yet

release_basic

515

english_227_2_r1

nan

Based on the data in Figure 1, the projected long-term domestic market equity return is closest to

[ "A. 4.5%", "B. 5.0%", "C. 7.5%" ]

Not supported with pagination yet

table

C

Solution: C. Real GDP growth = labor input growth + labor productivity growth = 0.8% + 1.2% = 2.0% Nominal GDP growth = real GDP growth + inflation = 2.0% + 2.5% =4.5% Long-term capital gains in equity markets = %Δ nominal GDP + %Δ profits/GDP + %Δ PE = 4.5% + 0% + 0% = 4.5% Long-term total domestic market equity return = capital gains + dividend yield = 4.5% + 3.0% = 7.5%

hard

multiple-choice

economics

english

227

2

1

Not supported with pagination yet

release_basic

516

english_227_3_r1

nan

Based on the information in Figure 3, the market that is least likely to be able to pursue an independent monetary policy is developing

[ "A. Market A", "B. Market B", "C. Market C" ]

Not supported with pagination yet

table

B

Solution: B. A country cannot simultaneously have unrestricted capital flows, a fixed exchange rate, and an independent monetary policy because changes in monetary policy (e.g., interest rates) will likely cause capital flows, which will impact on the currency exchange rate. Hence, developing Market B is least likely to be able to follow an independent monetary policy.

hard

multiple-choice

economics

english

227

3

0

Not supported with pagination yet

release_basic

517

english_227_4_r1

nan

Based in the data in Figure 4, the forecast one year DOM/FOR foreign exchange rate, based on capital flows using the Dornbusch overshooting, is closest to

[ "A. 1.2825", "B. 1.2889", "C. 1.3215" ]

Not supported with pagination yet

table

A

Solution: A. The Dornbusch overshooting mechanism states that immediate capital flows will strengthen the currencies of countries with high expected returns to the point where the high return currency will be expected to depreciate going forward by the return differential. This is captured by the relation: E(%ΔSVAR/FIX) = E(RVAR) – E(RFIX), where: E(RVAR) = expected return in the variable currency market E(RFIX) = expected return in the fixed currency market The quote of DOM/FOR has the domestic currency as variable and the foreign currency of Country X as fixed. The expected return of the domestic market is given by the sum of the domestic returns and premiums. This is equal to 0.75% + 0.00% + 1.10% + 3.00% + 0.00% = 4.85%. The expected return of the market in Country X is given by the sum of the Country X returns and premiums. This is equal to 1.25% + 0.50% + 0.60% + 4.00% + 0.00% = 6.35%. Hence under the Dornbusch overshooting model: E(%ΔSDOM/FOR) = 4.85% – 6.35% = –1.50% Hence, the forecast foreign exchange rate in one year = (1 – 0.015) × spot DOM/FOR = (1 – 0.015) × 1.3020 = 1.2825. Note that the higher expected return currency of Country X is expected to weaken going forward.

hard

multiple-choice

economics

english

227

4

1

Not supported with pagination yet

release_basic

518

english_227_5_r1

nan

Based on purchasing power parity, Nava should forecast that, relative to the current spot rate, the DOM/FOR exchange rate is forecast to

[ "A. fall", "B. rise", "C. remain unchanged" ]

Not supported with pagination yet

table

B

Solution: B. Purchasing power parity states that high inflation currencies are expected to weaken. If the domestic country inflation is expected to be higher than inflation in Country X, then the domestic currency is expected to weaken. This means the DOM/FOR quote will rise as there will be more DOM units per FOR units.

hard

multiple-choice

economics

english

227

5

0

Not supported with pagination yet

release_basic

519

english_228_1_r1

Earl Warren is an investment strategist who develops capital market expectations for an investment firm that invests across asset classes and global markets. Warren’s approach to economic forecasting utilizes a structural model in conjunction with a diffusion index to determine the current phase of a country’s business cycle. Warren also determines whether any adjustments need to be made to his initial estimates of the respective aggregate economic growth trends based on historical rates of growth for Countries A and B (both developed markets) and Country C (a developing market). Exhibit 1 summarizes Warren’s predictions: <image_1> Warren then discusses various risks of investing in emerging market equities and states that “We try to identify the forces that will likely exert the most powerful influences and assess their relative strength before investing in that market.” The following economic indicators of India from CEIC database to explain the impact of various factors on exchange rates: <image_2> After the discussion, Warren makes a professional explanation of the impact of monetary and fiscal policies on the yield curve. With regard to their combining impact on the yield curve and the economic environment, he made the following statements: Statement 1: If monetary policy is expansionary and fiscal policy is restrictive, the yield curve is moderately steep and the economic implications are less clear. Statement 2: If both monetary and fiscal policies are expansionary, the yield curve is steep and the economy will likely expand. Statement 3: If monetary policy is restrictive and fiscal policy is expansionary, the yield curve is moderately inverted and the economic implications are less clear. Warren is considering adding three new securities to his internationally focused fixed income portfolio. He has gathered the following information: <image_3> Warren seeks to establish expectations for rate of return for properties in the industrial sector over the next year. He has obtained the following information: <image_4>

Warren is most likely to make significant adjustments to her estimate of the future growth trend for which of the following countries

[ "A. Country B only", "B. Country C only", "C. Countries B and C" ]

Not supported with pagination yet

table

B

Solution: B. Country C is a developing market. Less-developed markets are likely to be undergoing more rapid structural changes, which may require the analyst to make more significant adjustments relative to past trends.

easy

multiple-choice

economics

english

228

1

0

Not supported with pagination yet

release_basic

520

english_228_2_r1

nan

Based on Exhibit 1, what capital market effect is Country C most likely to experience in the short-term

[ "A. Unemployment starts to fall but the output gap remains negative", "B. Monetary policy becomes restrictive", "C. The output gap is large" ]

Not supported with pagination yet

table

B

Solution: B. Warren’s model predicts that Country C’s business cycle is currently in the late upswing phase. In the late expansion phase, interest rates are typically rising as monetary policy becomes more restrictive.

easy

multiple-choice

economics

english

228

2

0

Not supported with pagination yet

release_basic

521

english_228_3_r1

nan

What is the likely short-term impact of capital flows on the exchange rate? The exchange rate 𝑆 𝑑/𝑓(INR is the domestic currency) will mos likely

[ "A. rise", "B. fall", "C. remain unchanged" ]

Not supported with pagination yet

table

A

Solution: A. The exchange rate Sd/f (INR is the domestic currency) will most likely rise because the Indian currency versus the foreign currency will depreciate. Both the decrease in short-term rates and the likely decrease in the equity premium are likely to induce short-term capital outflows. This should put significant pressure on the Indian currency to depreciate (i.e., the Sd/f exchange rate will rise if INR is defined as the domestic currency). The initial impact may be offset to some extent by inflows of government bonds as investors push yields down in anticipation of increasing demand, but as bonds are repriced, it will reinforce the downward pressure on the exchange rate.

easy

multiple-choice

economics

english

228

3

0

Not supported with pagination yet

release_basic

522

english_228_4_r1

nan

Which of Warren’s statements with respect to the impact of monetary and fiscal policies on the yield curve is least likely correct

[ "A. Statement 1", "B. Statement 2", "C. Statement 3" ]

Not supported with pagination yet

table

C

Solution: C. If monetary policy is restrictive and fiscal policy is expansionary, the yield curve is flat and the economic implications are less clear.

hard

multiple-choice

economics

english

228

4

0

Not supported with pagination yet

release_basic

523

english_228_5_r1

nan

Based on the Exhibit 3, using the risk premium approach to calculate the expected return of 10-year BBB rated corporate bond

[ "A. 2.5%", "B. 3.5%", "C. 5.0%" ]

Not supported with pagination yet

table

C

Solution: C. The expected return of 10-year BBB rated corporate bond at issue is 2.5%+1%+0.85%+0.65%=5.0%.

hard

multiple-choice

economics

english

228

5

0

Not supported with pagination yet

release_basic

524

english_228_6_r1

nan

Based on the Exhibit 4, estimate the expected return from the industrial sector properties

[ "A. 4.6%", "B. 7.1%", "C. 10.36%" ]

Not supported with pagination yet

table

C

Solution: C. The expected change in the cap rate is 4.45%−4.6% 4.6% = −3.26%; E(R) = Cap Rate + NOI growth rate − %ΔCap Rate = 4.6% + 2.5%− (−3.26%) = 10.36%.

hard

multiple-choice

economics

english

228

6

1

Not supported with pagination yet

release_basic

525

english_229_1_r1

Eunice Fox is head of Strategic Asset Allocation at Windsong Wealth Management, Inc. (WWM). WWM’s clients include pension funds, foundations, sovereign funds, high-net-worth individuals, and family trusts. Fox is in the process of hiring an asset allocation analyst and has just completed interviewing two candidates, Ambrose Kelly and Catherine Trainor, for the position. The interviews were directed around the case study of Jane Lennon, a fictitious client, described in Exhibit 1. <image_1> Fox reviews her interview notes. Fox told the candidates to assume that Lennon would use sub-portfolios to achieve her aspirational goals and asked them to identify which of the sub-portfolios is in the best position to tolerate the greatest risk exposure. In reviewing Lennon’s risk tolerance, Fox pointed out that Lennon’s prior investment experience clearly indicates some behavioral biases that would influence her reaction to any asset allocation proposals. Fox reminded the candidates that in addition to high-net-worth individuals, the firm’s client base also includes various institutional investors. The candidates made the following statements: Trainor: A goals-based approach to asset allocation is appropriate for individual investors, but institutions need to focus either on the asset or liability side of the balance sheet, depending on the nature of their business. Kelly: A typical objective of some institutions is to maximize their Sharpe ratio for an acceptable level of volatility, and they rely on the law of large numbers to assist them in modeling their liabilities. Other institutions behave much like individuals by segmenting general account assets into sub-portfolios associated with specific lines of business with their individual return objectives. Fox mentioned to the candidates that when dealing with strategic asset allocation, investors often had difficulty understanding the relevant characteristics of asset classes. They responded: Kelly: I like to stress to clients that asset classes should have high within-group correlations but low correlations with other classes. In addition, because investors need to rebalance to a strategic asset allocation, asset classes need to have both sufficient liquidity and low transaction costs. Trainor: It is important that asset classes should be diversifying. I always look for low pairwise correlations with other asset classes. Other general comments were noted about asset classes, but Fox could not recall their sources: • Emerging market equities should not be considered a separate asset class from global equities. • Asset classes differ from strategies in offering a non-skill-based ex ante expected return premium. • Asset classes should be defined in such a way that there is no overlap in sources of risk.

Based on the information in Exhibit 1, Lennon’s economic net worth (in $ millions) is closest to

[ "A. 4.75", "B. 5.75", "C. 1.25" ]

Not supported with pagination yet

table

B

Solution: B. B is correct.

easy

multiple-choice

portfolio management

english

229

1

0

Not supported with pagination yet

release_basic

526

english_229_2_r1

nan

Which of the sub-portfolios dedicated to Lennon’s aspirational goals is in the best position to tolerate the greatest risk exposure? The one dedicated to

[ "A. Everett’s education", "B. Marshall’s trust", "C. University endowment" ]

Not supported with pagination yet

table

A

Solution: A. A is correct. Both of the funds planned for the trust and university endowment represent an imminent need (immediate for the trust and within two years for the endowment). The funding needed for education, however, extends over the longest time horizon, possibly as long as 8 to 10 years. Thus, its sub-portfolio would be in the best position to take on the greatest risk.

hard

multiple-choice

portfolio management

english

229

2

0

Not supported with pagination yet

release_basic

527

english_229_3_r1

nan

The behavioral bias that Lennon’s past investment experience illustrates is best described as

[ "A. self-control bias", "B. mental accounting bias", "C. loss-aversion bias" ]

Not supported with pagination yet

table

C

Solution: C. C is correct. The behavioral bias illustrated in Lennon’s past investment experience was loss-aversion bias: Losses are perceived as more painful than the satisfaction of equivalent gains, and assets that have incurred losses but have little chance of recovery are retained because the pain of recognizing the loss is too great. Given the risk of having to give back gains already realized, winning investments are often sold early, resulting in self-imposed limited upside potential.

easy

multiple-choice

portfolio management

english

229

3

0

Not supported with pagination yet

release_basic

528

english_229_4_r1

nan

The most appropriate statement in regards to approaches to asset allocation by institutions is made by

[ "A. Kelly, regarding their goals-based allocations", "B. Trainor", "C. Kelly, regarding the Sharpe ratio and modeling of liabilities" ]

Not supported with pagination yet

table

A

Solution: A. A is correct. Kelly’s second comment regarding institutions’ goals-based allocations is correct. Some institutions (e.g., insurance companies) segment their general account assets into sub-portfolios associated with specific lines of business or blocks of liabilities, with each sub-portfolio having its own return objective.

easy

multiple-choice

portfolio management

english

229

4

0

Not supported with pagination yet

release_basic

529

english_229_5_r1

nan

In the candidates’ responses to Fox regarding the relevant characteristics of asset classes, the statement that is least accurate is

[ "A. Kelly’s regarding correlations", "B. Trainor’s", "C. Kelly’s regarding rebalancing" ]

Not supported with pagination yet

table

B

Solution: B. B is correct. Although Trainor is correct that asset classes should be diversifying, low pairwise correlations with other asset classes is not sufficient. An asset class may be highly correlated with some linear combination of the other asset classes even when pairwise correlations are not high. Both of Kelly’s comments are correct: Asset classes should have high within-group correlations but low correlations with other classes. If liquidity and transaction costs are unfavorable for an investment of a size meaningful for an investor, an asset class may not be a suitable investment for that investor.

hard

multiple-choice

portfolio management

english

229

5

0

Not supported with pagination yet

release_basic

530

english_229_6_r1

nan

In the general comments about asset classes that Fox noted, the most accurate comment is the one regarding

[ "A. the overlap of sources of risk", "B. emerging markets", "C. the return premiums from asset classes" ]

Not supported with pagination yet

table

C

Solution: C. C is correct. Asset classes should have a return premium based on an underlying market risk factor (e.g., beta) and not any underlying skill of the investor. Strategies, on the other hand, involve combinations of asset classes with the objective of earning a return based on investment skill.

hard

multiple-choice

portfolio management

english

229

6

0

Not supported with pagination yet

release_basic

531

english_230_1_r1

The Azur fund is a sovereign wealth fund valued at USD792 billion located in the country of Azurbikan. Azurbikan is a member of OPEC petroleum exporting countries with the main funding source of the fund being oil exports. Noir Rashwan, is the managing director ofthe fund and is currently meeting with the board of directors of the fund, consisting of representatives from various goverment departments, business leaders, and other stakeholders. Her agenda is to discuss concerns regarding low oil prices and how that affects the country's wealth in its concentrated position in oil, a proposed change to the fund's strategic asset allocation to increase the overall return of the fund in response to the low price of oil, and divestiture of some real estate assets to capture gains. Rashwan first presents the current and proposed asset allocations shown below. <image_1> She explains to the board of directors that since the fund has low liquidity needs the proposed strategic asset allocation will allow the skilled submanagers to add value through active management of the non-traditional assets. In 2008, many of the fund's foreign investments that were purchased at the peak of the real estate market lost substantial amounts of value. Some of those real estate values have since rebounded and are currently above the purchase price. Rashwan proposes to sell the fund's USD 100 million stake in a hotel located in the United States in South Beach Miami. Zein Minkara, president of a major pharmaceutical company, states, "We should sell now to lock in the gains, avoiding the substantial and painfullosses that many of our real estate holdings experienced during the last global recession." The hotel property value has a pre-tax standard deviation of 13% and would be subject to a 20% capital gains tax. Regarding the low price of oil, Jamal Zayat, Sultan of Azurbikan, states, "Since we're part of OPEC, a consortium of oil exporting nations, we should agree to restrict the world supply of oil, thus propping up its price as we've been able to do in the past." Siham Atallah, chairman of the central bank of Azurbikan, discusses changes in the economic environment of oil production putting downward pressure on oil prices. These changes include reduced demand in gasoline through greater fuel-efficient cars, weak economies of Europe and developing countries, and the development of new technologies allowing countries to extract oil and natural gas from areas that were once unprofitable. Atallah ends with a summary of short-term capital market expectations: • “Overall global GDP is expected to grow at a moderate pace, • the yield curve is expected to flatten with shor-term rates increasing while long-term rates remain steady, • yield spreads are exceedingly high, and • global real estate values are showing signs of overvaluation in some markets."

Which of the following statements regarding the proposed change in strategic asset allocation for the Azur fund is least accurate

[ "A. Due to the large size of the fund, it may not be possible to find enough alternative investments to meet the proposed strategic asset allocation.", "B. The percent allocated to alternative investments is acceptable given the low liquidity needs, long time horizon, and desire for increased return.", "C. The proposed asset allocation is too heavily weighted towards non-traditional assets with not enough exposure towards more traditional bond and equity investments" ]

Not supported with pagination yet

table

C

Solution: C. For institutional investors like a large sovereign wealth fund with a long-time horizon and little liquidity needs, a portfolio comprised largely of non-traditional investments where manager skill and an illiquidity premium can be earned is acceptable. The problem large institutional investors may run into is not enough alternative investments available to invest in, like hedge funds, to meet their target asset allocation

easy

multiple-choice

portfolio management

english

230

1

0

Not supported with pagination yet

release_basic

532

english_230_2_r1

nan

The behavioral bias displayed by Minkara, the president of the pharmaceutical company, is most likely described as

[ "A. recency bias", "B. loss aversion", "C. mental accounting" ]

Not supported with pagination yet

table

A

Solution: A. Minkara is displaying recency bias (also referred to as representative bias) when investors attach more importance to more recent data. In this case, he is placing more emphasis on the recent run up in real estate prices and equating that with similar events that led to the last global recession. Loss aversion is when the utility given up from a loss is greater than the utility derived from achieving a gain on an investment. In loss aversion, the investors sell winners too soon and hold onto losers too long in hope of gaining back some of their losses. Mental accounting is when assets (or liabilities) are separated into different buckets based on subjective criteria. There is no evidence of mental accounting in this situation.

hard

multiple-choice

portfolio management

english

230

2

0

Not supported with pagination yet

release_basic

533

english_230_3_r1

nan

The after-tax standard deviation on the sale of the USD 100 million stake in the hotel is closest to

[ "A. 10.4%", "B. 13.6%", "C. 16.3%" ]

Not supported with pagination yet

table

A

Solution: A. The after-tax standard deviation = pre-tax standard deviation (1 - t) = 13% (1- 0.2)= 10.4%. After-tax risk and return can signifìcantly impact the efficient frontier; therefore, the post-tax standard deviation should be used as an input into the asset allocation process.

hard

multiple-choice

portfolio management

english

230

3

1

Not supported with pagination yet

release_basic

534

english_230_4_r1

nan

After implementing the new strategic asset allocation, the pre-tax rebalancing range for real estate is now 5% to 15%. The after-tax rebalancing range for the sovereign wealth fund's allocation to real estate is closest to

[ "A. 7.25% to 12.75%", "B. 5.00% to 15.00%", "C. 3.75% to 16.25%" ]

Not supported with pagination yet

table

C

Solution: C. Pre-tax allowable deviation is 15% - 10% = 5% or 10% - 5% = 5%. Post-tax deviation = 5% / (1 - t) = 5% / (1 -0.2) = 6.25% for a range of 3.75% to 16.25%

hard

multiple-choice

portfolio management

english

230

4

1

Not supported with pagination yet

release_basic

535

english_230_5_r1

nan

The statements made by the Sultan regarding reducing the supply of oil reflect which behavioral bias

[ "A. Framing", "B. Home bias", "C. Illusion of control" ]

Not supported with pagination yet

table

C

Solution: C. He is exhibiting illusion of control in that he believes OPEC can control the world supply of oil. Changes in the economic environment can lead to major changes for optimization of asset allocation as changes in oil and gas production have significantly changed over the last decades. Home bias has to do with a preference to invest in securities listed on the exchanges of your home country. Framing bias has to do with answering a question differendy depending upon how it is asked.

hard

multiple-choice

portfolio management

english

230

5

0

Not supported with pagination yet

release_basic

536

english_230_6_r1

nan

Based on the short-term capital market expectations, which of the following tactical asset allocations would least likely be implemented

[ "A. Increase high yield bonds and reduce real estate", "B. Decrease long-term bonds and reduce real estate", "C. Increase equities and increase corporate bonds" ]

Not supported with pagination yet

table

B

Solution: B. Since long-term rates are not projected to increase, there would be no need to decrease the allocation to long-term bonds. The increase in short-term rates will make cash instruments like money market funds more attractive; high yield spreads mean corporate bond prices are undervalued, allowing for opportunities to invest in investment grade and high yield bonds.

hard

multiple-choice

portfolio management

english

230

6

0

Not supported with pagination yet

release_basic

537

english_231_1_r1

Angelica Mukasa was recently hired as the CFO of Channel, a leading property and casualty insurer based in a developed European country. Channel is financially strong, and the industry outlook is stable. Channel’s profitability is high, primarily driven by robust underwriting results and favorable investment returns on its large reserve of assets. Channel’s investment group is focused on matching premium reserve assets to projected policyholder claims, investing excess assets for growth. The reserve currently has sufficient surplus to support its liabilities. Regulators impose a maximum limit of 10% of total reserve assets (which include matched and excess assets) on non-publicly traded securities. Mukasa’s new assistant, Samiah Pai, presents three possible allocation options for total reserve assets, as shown in Exhibit 1. <image_1> Mukasa also serves as a trustee of Channel’s defined-benefit pension plan. The plan is legally distinct from Channel’s assets. The company has made contributions sufficient to maintain a fully funded status. It is a tax-exempt fund and must hold 20% of its assets in domestic government bonds to maintain its tax-exempt status. The plan’s key objective is to meet current and future pension obligations. The plan’s current allocation is 60% global equities, 20% domestic government bonds, 15% domestic corporate bonds, and 5% cash. Mukasa is considering adding a new asset class to Channel’s pension fund to improve expected returns. Pai compiles data for three possible new asset classes (Exhibit 2). <image_2> Several years later, Channel’s pension plan has grown to over EUR 5 billion in assets. During that time, the fund’s allocation to illiquid assets (which includes direct real estate, private equity and infrastructure) increased to 30%. Channel maintains its leading position in the insurance industry and its balance sheet remains healthy. However, given heightened competition and increasingly soft pricing conditions, Channel staff members are researching possible cost saving strategies for management consideration. While viewed as an unlikely choice by Mukasa, reducing Channel’s cash contributions to its pension plan is among them. The plan is currently 90% funded. Pai reviews key benefits and constraints of large institutional investors in asset allocation that may be relevant to Channel’s pension plan. He makes the following statements. Statement 1: A substantial allocation to illiquid assets may be inappropriate for Channel’s pension plan if there is a significant probability of Channel lowering its contributions to the plan. Statement 2: Large institutional investors, such as Channel’s pension plan, will likely benefit from deploying active equity strategies, due to manager access, liquidity, and trading cost advantages. Statement 3: Channel’s pension fund may rebalance portfolio weights from the strategic allocation to exploit perceived opportunities based on its latest five-year capital market expectations.

Which allocation in Exhibit 1 is most appropriate for Channel’s insurance reserve assets

[ "A. Allocation 1", "B. Allocation 2", "C. Allocation 3" ]

Not supported with pagination yet

table

A

Solution: A. P&C insurers such as Channel are primarily focused on matching assets to the projected, probabilistic cash flows of the risks they are underwriting. Therefore, fixed-income assets are likely the largest component of their asset base. An allocation to higher risk assets, such as equity, is likely much smaller. Thus, Allocation 1 is more appropriate than either Allocation 2 or 3. In addition, the regulation limits non-publicly traded securities such as real estate and private equity, to 10%, which would eliminate Allocation 2 from consideration. Allocation 3 is less appropriate than Allocation 1, given the small allocation to fixed ncome and relatively large allocations to equity and cash

hard

multiple-choice

alternative investments

english

231

1

0

Not supported with pagination yet

release_basic

538

english_231_2_r1

nan

Which approach is least relevant to a strategic allocation for Channel’s pension plan

[ "A. Shortfall risk", "B. Heuristic approach", "C. Surplus optimization" ]

Not supported with pagination yet

table

B

Solution: B. A heuristic approach is least relevant. Heuristics refers to rules that provide a reasonable but not necessarily optimal solution. Some investors may skip the various optimization techniques and simply adopt an asset allocation mix (such as the “120 minus your age” rule or a 60/40 stock/bond mix). Shortfall risk is a liability-relative approach focused on the risk of having insufficient assets to pay obligations when due. Surplus optimization is a liability-relative allocation approach that involves applying mean-variance optimization (MVO) to an efficient frontier based on the volatility of the surplus (known as surplus volatility or surplus risk) as the measure of risk.

hard

multiple-choice

alternative investments

english

231

2

0

Not supported with pagination yet

release_basic

539

english_231_3_r1

nan

Which asset class in Exhibit 2 is most likely to be considered for inclusion by Channel’s pension plan

[ "A. Global real estate (REITs)", "B. Emerging markets equities", "C. Global high-yield corporate bonds" ]

Not supported with pagination yet

table

A

Solution: A. Global real estate is most likely to be considered for inclusion by Channel’s pension plan for any of the following reasons: • Asset classes should be mutually exclusive for the purpose of asset allocation. Overlapping asset classes will reduce the effectiveness of asset allocation in controlling risk. Thus, given the plan’s current investment in global equities, emerging markets equities should be excluded from consideration. In addition, we assume that the plan’s current allocation to domestic corporate bonds includes both investment grade and high yields. While the high yield allocation is not explicitly defined, global high-yield corporate bonds are likely to overlap somewhat and should be excluded from consideration. • Asset classes should be diversifying. A new asset class should not have extremely high expected correlations (over 0.95) with existing asset classes. Otherwise, the new asset class will be effectively redundant in a portfolio because it will duplicate risk exposures already present. None of the possible asset classes presented in the example have high expected correlations with the current portfolio. • The asset classes as a group should make up a preponderance of world investable wealth. Selecting an asset allocation from a group of asset classes satisfying this criterion should increase expected return for a given level of risk (Sharpe ratio). Based on global real estate’s Sharpe ratio (relatively high) and its correlation to the existing portfolio (reasonably low), while the existing portfolio’s Sharpe ratio is not provided, we can make a reasonable assumption that adding this asset class will likely improve the portfolio’s expected return. Note that global real estate is the only asset class left after the two other asset classes were eliminated based on mutual exclusivity. Other remaining criteria to help specify asset classes include: Assets within an asset class should be relatively homogeneous. Asset classes selected for investment should have the capacity to absorb a meaningful proportion of an investor’s portfolio without seriously affecting the portfolio’s liquidity.

hard

multiple-choice

alternative investments

english

231

3

0

Not supported with pagination yet

release_basic

540

english_231_4_r1

nan

Which of Pai’s statements is most appropriate for the pension plan, given Channel’s current market circumstances

[ "A. Statement 1", "B. Statement 2", "C. Statement 3" ]

Not supported with pagination yet

table

A

Solution: A. The change to the expected cash contributions to the pension fund, if adopted, would materially affect the fund’s asset allocation strategy. The odds of that happening, however, appear low at present according to Mukasa. At this point, this indicates a need for the pension plan to increase sensitivity to liquidity concerns but is not necessarily cause for immediate revisions to the current allocation. Large institutional investors, including Channel’s pension plan, may benefit from operational efficiencies and other competitive advantages (such as scale, expertise and resources). However, scale may also impose obstacles related to the liquidity conditions and trading costs of the underlying assets. A very large size might make it difficult to deploy capital effectively in certain active equity strategies—for example, to benefit from opportunistic investments in niche markets or from skilled investment managers who have a small set of unique ideas or concentrated bets. Therefore, Statement 2 is not necessarily correct. Statement 3 is mixing portfolio rebalancing (to a strategic asset allocation) and tactical asset allocation (relative to strategic asset allocation). Rebalancing is the discipline of adjusting portfolio weights to more closely align with the strategic asset allocation. Changes in asset prices may cause the portfolio asset mix to deviate from strategic target weights even in the absence of changing investor circumstances, a revised economic outlook, or tactical asset allocation views. In contrast, tactical asset allocation (TAA) involves short-term tilts away from the strategic asset allocation (SAA) in order to exploit perceived opportunities in financial market conditions (e.g., temporary asset mispricing).These short-term bets are expected to increase risk-adjusted return. SAA is developed based on long-term economic forecasts and capital market expectations (long-term expected asset class returns).

hard

multiple-choice

alternative investments

english

231

4

0

Not supported with pagination yet

release_basic

541

english_232_1_r1

Preston Remington is the managing partner of Remington Wealth Partners. The firm manages high-net-worth private client investment portfolios using various asset allocation strategies. Analyst Hannah Montgomery assists Remington. Remington and Montgomery’s first meeting of the day are with a new client, Spencer Shipman, who recently won $900,000 in the lottery. Shipman wants to fund a comfortable retirement. Earning a return on his investment portfolio that outpaces inflation over the long term is critical to him. He plans to withdraw $54,000 from the lottery winnings investment portfolio in one year to help fund the purchase of a vacation home and states that it is important that he be able to withdraw the $54,000 without reducing the initial $900,000 principal. Montgomery suggests they use a risk-adjusted expected return approach in selecting one of the portfolios provided in Exhibit 1. <image_1> Remington and Montgomery discuss the importance of strategic asset allocation with Shipman. Remington states that the firm’s practice is to establish targeted asset allocations and a corridor around the target. Movements of the asset allocations outside the corridor trigger a rebalancing of the portfolio. Remington explains that for a given asset class, the higher the transaction costs and the higher the correlation with the rest of the portfolio, the wider the rebalancing corridor. Montgomery adds that the higher the volatility of the rest of the portfolio, excluding the asset class being considered, the wider the corridor. Remington and Montgomery next meet with client Katherine Winfield. The firm had established Winfield’s current asset allocation on the basis of reverse optimization using the investable global market portfolio weights with further adjustments to reflect Winfield’s views on expected returns. Remington and Montgomery discuss with Winfield some alternative asset allocation models that she may wish to consider, including resampled mean–variance optimization (resampling). Remington explains that resampling combines mean–variance optimization (MVO) with Monte Carlo simulation, leading to more diversified asset allocations. Montgomery comments that resampling, like other asset allocation models, is subject to criticisms, including that risker asset allocations tend to be under-diversified and the asset allocations inherit the estimation errors in the original inputs. Montgomery inquires whether asset allocation models based on heuristics or other techniques might be of interest to Winfield and makes the following comments: 1. The 60/40 stock/bond heuristic optimizes the growth benefits of equity and the risk reduction benefits of bonds. 2. The Norway model is a variation of the endowment model that actively invests in publicly traded securities while giving consideration to environmental, social, and governance issues. 3. The 1/N heuristic allocates assets equally across asset classes with regular rebalancing without regard to return, volatility, or correlation.

Which of the portfolios provided in Exhibit 1 has the highest probability of enabling Shipman to meet his goal for the vacation home

[ "A. Portfolio 1", "B. Portfolio 2", "C. Portfolio 3" ]

Not supported with pagination yet

table

B

Solution: B. Portfolio 2 has the highest probability of enabling Shipman to meet his goal for the vacation home. All three of the portfolios’ expected returns over the next year exceed the 6.0% (see calculations below) required return threshold to avoid reducing the portfolio. However, on a risk-adjusted basis, Portfolio 2 (probability ratio of 0.231) has a higher probability of meeting and surpassing the threshold than either Portfolio 1 (probability ratio of 0.175) or Portfolio 3 (probability ratio of 0.225). Step 1: Calculate the required return threshold: 54,000 ÷ 900,000 = 0.06 = 6.0%. Step 2: To decide which allocation is best for Shipman, calculate the probability ratio: [E(RP) – RL] ÷ σP, where RP = The return for the portfolio RL = The required return threshold σP = The standard deviation of the portfolio Portfolio 1: (10.50% – 6.0%) ÷ 20.0% = 4.50% ÷ 20.0% = 0.225. Portfolio 2: (9.00% – 6.0%) ÷ 13.0% = 3.00% ÷ 13.0% = 0.231. (Highest) Portfolio 3: (7.75% – 6.0%) ÷ 10.0% = 1.75% ÷ 10.0% = 0.175.

hard

multiple-choice

portfolio management

english

232

1

0

Not supported with pagination yet

release_basic

542

english_232_2_r1

nan

When discussing asset allocation corridors with Shipman, which of Remington’s and Montgomery’s statements is the least accurate? The one regarding:

[ "A. volatility", "B. correlation", "C. transaction costs" ]

Not supported with pagination yet

table

A

Solution: A. The statement regarding volatility is the least accurate. The higher the volatility of the rest of the portfolio, excluding the asset class being considered, the more likely a large divergence from the strategic asset allocation becomes, which should point to a narrower optimal corridor, all else being equal. B is incorrect because the higher the correlation of an asset class with the rest of the portfolio, the wider the optimal corridor. When asset classes move in sync, further divergence from target weights is less likely. C is incorrect because the higher the transaction costs, the wider the optimal corridor. High transaction costs set a high hurdle for rebalancing benefits to overcome.

hard

multiple-choice

portfolio management

english

232

2

0

Not supported with pagination yet

release_basic

543

english_232_3_r1

nan

The model on which Winfield’s current asset allocation is based is best characterized as

[ "A. mean–variance optimization", "B. Black–Litterman", "C. reverse optimization" ]

Not supported with pagination yet

table

B

Solution: B. Winfield’s current asset allocation is most likely based on the Black–Litterman model. Black– Litterman starts with the excess returns produced from reverse optimization, which commonly uses the observed market-capitalization value of the assets or asset classes of the global opportunity set. It then alters the reverse-optimized expected returns that reflect an investor’s own distinctive views yet still behaves well in an optimizer.

hard

multiple-choice

portfolio management

english

232

3

0

Not supported with pagination yet

release_basic

544

english_232_4_r1

nan

In Remington and Montgomery’s discussion with Winfield on resampling, Montgomery’s comment is most likely

[ "A. correct", "B. incorrect regarding estimation errors", "C. incorrect regarding diversification of asset allocations" ]

Not supported with pagination yet

table

C

Solution: C. Montgomery’s comment about the criticisms of resampling is incorrect regarding diversification of asset allocations. Risker asset allocations are over-diversified, not under-diversified. The comment is correct with regard to estimation errors because the asset allocations do inherit the estimation errors in the original inputs.

hard

multiple-choice

portfolio management

english

232

4

0

Not supported with pagination yet

release_basic

545

english_232_5_r1

nan

In describing heuristics and other modeling techniques, Montgomery is most accurate with respect to

[ "A. Comment 1", "B. Comment 2", "C. Comment 3" ]

Not supported with pagination yet

table

C

Solution: C. The 1/N rule asset allocation heuristic involves equally weighting allocations to assets; 1/N of wealth is allocated to each of N assets available for investment at each rebalancing date. All assets are treated as indistinguishable in terms of mean returns, volatility, and correlations

hard

multiple-choice

portfolio management

english

232

5

0

Not supported with pagination yet

release_basic

546

english_233_1_r1

Teddy Brealer is the president of Vitting University (VU). VU just successfully completed a fundraising campaign of $300 million that significantly increased the funds in the endowment (Exhibit 1). <image_1> At a meeting with VU’s board of regents, Brealer proposes that the endowment should fund a new capital improvements project for the university that will cost $210.3 million. Brealer acknowledges that it is a large amount that will require another fundraising campaign in the future, but he states that he has already found a wealthy alumnus, Roger Clement, who is willing to donate $50 million if the project is undertaken. Jennifer Wong, a board member, asks: “If we undertake the project with Clement’s donation but without a new fundraising campaign, how much will the endowment be underfunded?” Other board members agree that the answer to this question should be considered before making a decision. Consequently, the board decides to discuss Brealer’s proposal further at a future meeting. The board moves on to a discussion about the investment of the endowment with the recently raised funds. Ronald Black, an investment adviser to the board, suggests the following: · The asset allocation choice should have a heavy emphasis on fixed-income securities with cash distributions. This type of allocation will offset the future cash disbursements necessary to cover costs at the university in excess of tuition revenue. · The weightings within the portfolio should be able to deviate within 5% of the target portfolio weights to take advantage of short-term market opportunities for additional return. Brealer suggests bringing Black’s portfolio allocation ideas to the University Planning and Priorities Committee (UPPC). The UPPC is composed of six tenured faculty members and three final-year students. Three of the faculty members are from the arts area, and three are from the sciences area. Faculty appointments to the committee are for two-year, non-renewable terms. Brealer states that the UPPC desires to have the endowment invested in a socially responsible manner, which will require developing a new investment policy statement (IPS). The UPPC intends to draft the new IPS and present it to the board for approval. Upon receiving board approval, the UPPC will direct a financial advisory team and the investment managers to implement the asset allocation indicated in the IPS. Progress reports and governance audits will be provided to the board upon request. The board is agreeable to this plan and assigns Black to be part of the advisory team after the IPS is drafted and approved. Black states that the UPPC should also consider such issues as the cost associated with rebalancing the portfolio and that the future distribution of asset returns may not be fully characterized by the expected return and volatility. Black further states that his preferred method for dealing with these additional allocation issues is the use of Monte Carlo simulation.

Which asset allocation approach best describes the asset allocation choice suggested by Black to the board

[ "A. Mean–variance optimization", "B. Black-Litterman", "C. Liability-relative" ]

Not supported with pagination yet

table

C

Solution: C. Investment in fixed-income securities specifically to generate cash distributions to offset the cash disbursements necessary for maintaining university costs in excess of tuition revenue is a liability-relative approach. A is incorrect because a mean–variance approach is an asset-only approach that does not consider liabilities. B is incorrect because the Black-Litterman model is an asset-only approach that does not consider liabilities.

easy

multiple-choice

portfolio management

english

233

1

0

Not supported with pagination yet

release_basic

547

english_233_2_r1

nan

Black’s suggestion to the board in regard to the asset weightings in the endowment portfolio is best described as allowing for an asset allocation that is

[ "A. dynamic", "B. tactical", "C. indexed" ]

Not supported with pagination yet

table

B

Solution: B. The ability to deviate from target portfolio weightings for short-term market opportunities is an example of tactical asset allocation, which is an active strategy. Dynamic asset allocation is a long-term active strategy, and indexing is a passive strategy

easy

multiple-choice

portfolio management

english

233

2

0

Not supported with pagination yet

release_basic

548

english_233_3_r1

nan

The process for creating and implementing the investment policy statement (IPS) by the University Planning and Priorities Committee (UPPC) most likely follows best governance practices in regard to

[ "A. transparency of decision rights for approving a proposed asset allocation", "B. expertise for developing the asset allocation", "C. governance audit reporting" ]

Not supported with pagination yet

table

A

Solution: A. The UPPC must seek the board of regents’ approval for any asset allocation the committee proposes to implement. Consequently, the decision rights in regard to the asset allocation process are very transparent, which is consistent with best governance practices. Governance audits being on an “as requested” basis instead of being periodic is inconsistent with best governance practices. The committee members’ short terms (two years for faculty and one year for students because they are final-year students) and apparent lack of financial expertise are also inconsistent with best governance practices.

easy

multiple-choice

portfolio management

english

233

3

0

Not supported with pagination yet

release_basic

549

english_233_4_r1

nan

When addressing the University Planning and Priorities Committee, Black’s preferred approach for dealing with the additional allocation issues is most likely

[ "A. correct", "B. incorrect because it is unable to address rebalancing costs", "C. incorrect because it is unable to address distributions that are dependent on parameters other than expected return and volatility" ]

Not supported with pagination yet

table

A

Solution: A. Black’s preferred approach for dealing with the additional asset allocation issues is the use of Monte Carlo simulation. Monte Carlo simulation can accommodate many future possible scenarios, such as portfolio rebalancing costs and non-normal distributions (i.e., distributions that require more than expected return and volatility as parameters).

hard

multiple-choice

portfolio management

english

233

4

0

Not supported with pagination yet

release_basic

550

english_234_1_r1

Olivinia is an oil-rich state in the country of Puerto Rinaldo, which uses the US dollar as its official currency of exchange. In 1981, the state’s legislature created the Olivinia Heritage Fund (OHF) to collect a portion of the state’s non-renewable resource revenue and invest it on behalf of future generations. James Lafferty, the managing director of the fund, is one of the keynote speakers at the Global Wealth Creation Conference. He begins his presentation with a brief overview of OHF’s history (Exhibit 1). <image_1> Exhibit 1 An overview of the olivinia heritage fund Phase 1 (1981–1991) • The fund was given an initial allocation of $1 billion by the state. The fund was to receive 10% of all state revenues arising from taxes on oil and gas production and extraction. The fund was given a 20-year accumulation period over which no distributions were allowed and the fund was forecasted to grow to $10 billion. Income earned following the accumulation period was to be used to provide for public works and other public infrastructure within the state. Investments were restricted to cash and investment-grade bonds. Phase 2 (1991–2001) • By 1991, after being in existence for 10 years, the fund value had grown to $2.2 billion. At this time, transfers of state revenues from taxes on oil-related resources was halted and the government began to use income generated by the fund for direct economic development and social investment purposes. In addition to cash and investment-grade bonds, the investment mandate for the fund was expanded to include investments in private and public companies, real estate, and infrastructure investments. Management of cash and bond investments was performed in-house. For the higher-risk component of the portfolio, the fund hired external managers in an effort to increase return and correspondingly lower the incidence of negative performance. These managers were hired or retained if they had outperformed other active managers in their sectors in at least the prior two years. The fund value at the end of this period was $6 billion. Phase 3 (2001–2014) • Strong reform legislation related to the original intent of the fund was introduced in 2001. It reinstated transfers of oil-related taxes to the fund, increasing them to 35% of oil- and gas-related state revenues. In addition, the fund was mandated to have 50% in public equities through passive index funds and 10% in cash and investment-grade bonds. The remainder was to be divided equally between high-yield bonds, real estate, private equity, and hedge funds and would continue to be managed externally. All investments were to be made outside the country to avoid overheating the national economy. Investments managed by individual external managers was limited to approximately $75 million. A two-thirds majority in both the upper and lower legislative bodies was required to change any future legislation related to the fund. By the end of this phase, the fund was worth $28 billion. Phase 4 (2014–Present) • The fund’s management felt that the significant decline in oil prices since mid-2014 and lowered production levels were likely to persist through several business cycles, requiring a change in strategy to maintain the long-term objectives of the funds. They sought government approval for lower withdrawals from the fund, higher equity exposure, and the flexibility to vary asset class policy weights by as much ±5% for each asset class from the static weights that had previously existed. The government reaffirmed its commitment to the fund given in Phase 3, and legislative approval was received for these changes, including the ability to increase public equity exposure to 65% and reduce investment-grade bond exposure to as little as 7.5%. Of the remaining authorized assets, no one asset class could have a weight in excess of 10%. Lafferty states that ever since the fund was given the authority to vary asset class policy weights from their strategic levels, it has actively engaged in tactical asset allocation (TAA) using a variety of proprietary short-term forecasting tools that have been developed in-house. He provides the data in Exhibits 2 and 3 to illustrate the results of one such shift in the fund’s asset allocation following a signal from its TAA model. <image_2> <image_3> Lafferty concludes the morning portion of his presentation at the conference by comparing the relative performance of the three portfolios (from Exhibit 2) utilizing a graph (Exhibit 3) of the efficient frontier derived from the asset classes used by the fund.

During Phase 1, the most significant constraint on OHF’s asset allocation choices was the result of

[ "A. liquidity needs", "B. asset size", "C. regulation" ]

Not supported with pagination yet

chart

C

Solution: C. During Phase 1, OHF was restricted to investing in only cash and high-grade debt instruments.

easy

multiple-choice

portfolio management

english

234

1

0

Not supported with pagination yet

release_basic

551

english_234_2_r1

nan

In Phase 3, the most likely change in the constraints facing OHF’s ability to undertake asset allocation arose from an increased need for

[ "A. governance resources", "B. Liquidity", "C. risk reduction" ]

Not supported with pagination yet

chart

A

Solution: A. In Phase 3, 40% of assets were to be invested in high-yield bonds, real estate, private equity, and hedge funds, which were to be managed externally. Each external manager was limited to approximately $75 million of the fund’s assets. As indicated in the table below, the number of external managers required grew from about 30 to almost 150 by the end of the period. This would have placed substantial demands on the governance resources of the fund to allow for identification of suitable managers and to monitor their performance.

easy

multiple-choice

portfolio management

english

234

2

0

Not supported with pagination yet

release_basic

552

english_234_3_r1

nan

Based on Exhibit 2, compared with the strategic asset allocation, the incremental return added to the fund through tactical asset allocation was closest to

[ "A. 0.39%", "B. 0.53%", "C. 0.13%" ]

Not supported with pagination yet

chart

B

Solution: B. By underweighting investment-grade bonds and real estate and overweighting public equity and high-yield bonds, the TAA strategy added 0.53% to the return of the fund, as shown below. <ans_image_1> <ans_image_2>

hard

multiple-choice

portfolio management

english

234

3

1

Not supported with pagination yet

release_basic

553

english_234_4_r1

nan

The most appropriate conclusion that can be drawn from Exhibit 3 is that

[ "A. management’s risk–return objectives may not have been achieved with the TAA portfolio", "B. the current portfolio is a corner portfolio", "C. the Sharpe ratios for the policy portfolio and the TAA portfolio are the same" ]

Not supported with pagination yet

chart

A

Solution: A. The Sharpe ratio is the slope of the line drawn from the risk-free rate to a particular portfolio. The two portfolios of interest are the policy portfolio and the TAA portfolio because both are indicated as being efficient. The diagram to the right indicates that the policy portfolio/risk-free combination has a higher slope than the TAA/risk-free combination. Even though the TAA portfolio has a higher return than the policy portfolio, the additional return requires too much additional risk. In addition, the TAA portfolio may exceed management’s risk tolerance. <ans_image_3>

medium

multiple-choice

portfolio management

english

234

4

0

Not supported with pagination yet

release_basic

554

english_235_1_r1

Joenia Dantas is a financial risk manager for Alimentos Serra (AS), a Brazilian manufacturer and exporter of soybean-based food products. AS is a privately held corporation, wholly owned by Cesar Serra. Recently, AS took out a R25,000,000, four-year, floating-rate bank loan requiring semi-annual payments of interest based on SELIC (Banco Central do Brasil’s overnight lending rate) plus a spread of 4.50 percent and repayment of principal at maturity. Serra believes that interest rates will rise in the near future and worries that AS will be unable to absorb the higher loan costs associated with an increase in rates. Dantas tells him that she will convert the loan to a 10.80 percent fixed rate by entering into the pay-fixed side of a four-year, R25,000,000 notional principal interest rate swap with semi-annual payments that exchanges SELIC for a fixed rate of 10.80 percent. She explains that the swap will act as a hedge for the loan, reducing the company’s net cash flow risk and net market value risk. Discussions with Dantas about using interest rate swaps to reduce risk cause Serra to think about the fixed income portion of his personal investment portfolio, which includes R12.0 million in bonds that have a modified duration of 5.50 years. Serra’s beliefs about rising interest rates make him want to reduce the bond portfolio’s modified duration to 2.00 years using interest rate swaps. In order to determine the correct swap position, he needs to learn how to calculate the modified duration of a swap. He asks Dantas how to do this. She explains it to him, using the example described in Exhibit 1. <image_1> Serra decides to use a swap that has a modified duration of -2.40 years for the pay-fixed side to reduce his bond portfolio’s duration to the desired level. Dantas knows that AS currently needs to borrow an additional R30,000,000 for 5 years to fund its growth. Brazilian credit markets have tightened and it would cost 17.70 percent per year to borrow this amount locally, but AS can obtain a yen-denominated loan at a fixed rate of 9.50 percent. This would expose it to substantial currency risk. A 5-year currency swap is available in which AS would pay interest in real to the counterparty at 12.20 percent and receive interest in yen from the counterparty at 7.10 percent. The current exchange rate is ¥40/R. In addition to the current needs, in six months AS will enter into a four-year, quarterly payment, R50,000,000 loan to fund local projects. Dantas expects to borrow these funds at a floating rate and convert the loan to fixed using an interest rate swap. She explains to Serra that AS can commit to a fixed rate of 14.3 percent for the future loan by buying a payer swaption today with an exercise rate of 14.3 percent for a four-year swap with quarterly payments and a notional principal amount of R50,000,000.

Dantas’ explanation of her plan to convert the four-year loan from floating to fixed is most likely

[ "A. correct", "B. incorrect, because the fixed loan rate will be 15.30%", "C. incorrect, because the swap should be entered to pay SELIC" ]

Not supported with pagination yet

table

B

Solution: B. Converting a floating-rate loan to a fixed-rate loan requires entering into a plain-vanilla (fixed-for-floating) interest rate swap on the pay-fixed side. The swap should have the same maturity, the same payment frequency, and the same floating interest rate index as the loan and its notional principal should be equal to principal balance of the loan. The borrower will pay the fixed rate on the swap (here 10.80%) and receive the index (SELIC) from the swap counterparty. The borrower will pay the index (SELIC) plus any spread (4.50%) to the lender. The net, fixed interest rate on the swapped loan is the fixed rate on the swap plus any spread over index on the loan or 10.80% + 4.50% = 15.30% in this situation.

hard

multiple-choice

derivatives

english

235

1

0

Not supported with pagination yet

release_basic

555

english_235_2_r1

nan

Dantas’ characterization of the interest rate swap as a hedge for the bank loan is most likely

[ "A. correct", "B. incorrect, because the swap increases the cash flow risk of AS", "C. incorrect, because the swap increases the market value risk of AS" ]

Not supported with pagination yet

table

C

Solution: C. The original loan is floating rate. A floating rate loan has very low duration and therefore little market value risk. It might, as Serra suggests, pose a cash flow risk if the firm is not able to handle the increase in loan payments associated with an increase in market interest rates. Using an interest rate swap to convert the loan from a floating rate to a fixed rate reduces the cash flow risk. However, the resulting fixed rate loan has a much higher duration, and its market value will therefore fluctuate much more drastically as market interest rates change

hard

multiple-choice

derivatives

english

235

2

0

Not supported with pagination yet

release_basic

556

english_235_3_r1

nan

The duration of the interest rate swap described in Exhibit 1 is closest to

[ "A. -2.41 years", "B. -2.66 years", "C. -2.91 years" ]

Not supported with pagination yet

table

B

Solution: B. The duration of the pay-fixed position in an interest rate swap is equal to the duration of a floating rate bond with the same payment frequency minus the duration of a fixed rate bond with coupon rate equal to the fixed rate and maturity equal to the swap maturity. The duration of the floating rate bond is, on average, half of the time interval between payments (in this case, half of 0.5 years or 0.25 years.) The duration of the fixed rate bond is given as 2.91 years. 0.25 years-2.91 years = -2.66 years.

hard

multiple-choice

derivatives

english

235

3

1

Not supported with pagination yet

release_basic

557

english_235_4_r1

nan

In order to reduce the duration of his bond portfolio to the desired level, Serra will enter into a pay-fixed swap position with a notional principal closest to

[ "A. R17.5 million", "B. R27.5 million", "C. R42.0 million" ]

Not supported with pagination yet

table

A

Solution: A. <ans_image_1>

hard

multiple-choice

derivatives

english

235

4

1

Not supported with pagination yet

release_basic

558

english_235_5_r1

nan

If AS enters into the yen-real currency swap with a notional principal of ¥1.2 billion (R40.0 million), net yen interest expense for each year is closest to

[ "A. ¥28.80 million", "B. ¥85.20 million", "C. ¥114.00 million" ]

Not supported with pagination yet

table

A

Solution: A. If AS borrows in yen, it will borrow ¥1.2 billion (=R30,000,000 × ¥40/R). In order to hedge this, it will enter into a currency swap with a notional principal of ¥1.2 billion/R30,000,000. It will receive 7.10% in yen from the swap and pay 9.50% in yen on the loan, for a net payment of 2.40% (on ¥1.2 billion) or ¥28.80 million.

hard

multiple-choice

derivatives

english

235

5

1

Not supported with pagination yet

release_basic

559

english_236_1_r1

Omega Analytics provides risk management consulting for institutional and individual clients. Rachel Osborne, is an investment advisor for Omega who works with the firm’s larger accounts. She is considering derivative strategies for several clients. • HMM Foundation owns 30,000 shares of Nasdaq 100 Index Tracking Stock (Symbol: QQQQ), which has a current price of $30 per share. Osborne believes there is substantial risk of downside price movement in the index over the next six months. She recommends HMM use a six-month collar for the entire position of 30,000 shares as protection against the QQQQ price falling below $27. Exhibit 1 illustrates current QQQQ puts and calls expiring in 6 months. <image_1> HMM would hold the collar strategy until expiration of the put and call options. • Bob Valentine believes the prices of large capitalization stocks will rise slightly and he wants to profit from this movement using a bull spread strategy. Osborne recommends Valentine use Dow Jones Industrial Average (DJX) options expiring in two months. The current price of DJX is $91. Exhibit 2 illustrates current option information for two DJX call options expiring in two months. Valentine decides to use 100 contracts per position. Each contract is equal to 100 shares. <image_2>

If the HHM Foundation enters into the collar recommended by Osborne and the market value of QQQQ is $33 at the expiration of the options, the profit from the position would be closest to

[ "A. $85,500", "B. $90,000", "C. $94,500" ]

Not supported with pagination yet

table

A

Solution: A. The profit per collar = ST + max(0, X1-ST)-max(0, ST-X2)-S0-(p0-c0), where: S0, ST = price of underlying at time 0 and time T X1 = exercise price of put, X2 = exercise price of call; p0 = price of put at time 0; c0 = price of call at time 0 Profit = 33+0-0-30-0.15 = 2.85 Total profit = $2.85x30,000 = $85,500

hard

multiple-choice

derivatives

english

236

1

Not supported with pagination yet

release_basic

560

english_236_2_r1

nan

If the HHM Foundation enters into the collar recommended by Osborne, the maximum potential profit from the position at expiration of the options is closest to

[ "A. $145,500", "B. $150,000", "C. $154,500" ]

Not supported with pagination yet

table

A

Solution: A. The maximum profit on the collar occurs when the short call expires at the money, i.e., QQQQ = $35. Max profit per collar = ST + max (0, X1-ST)-max (0, ST-X2)-S0-(p0-c0) Max profit per collar = 35+0-0-30-.15 = $4.85 Total max profit = 4.85×30,000 = $145,500

hard

multiple-choice

derivatives

english

236

2

1

Not supported with pagination yet

release_basic

561

english_236_3_r1

nan

At expiration of the DJX call options, the maximum potential profit from the bull spread strategy recommended for Valentine is closest to

[ "A. $6,000", "B. $26,000", "C. $60,000" ]

Not supported with pagination yet

table

B

Solution: B. A bull spread combines a long call at a lower exercise price (X1 = 88) and a short call at a higher exercise price (X2 = 94). The cost of X1 is c1 = $4.40 and the cost of X2 is c2 = +$1.00. The maximum profit per contract = (X2 – X1 – c1 + c2) × 100 = ($94 – $88 – $4.40 + $1.00) × 100 = 2.60 × 100 = $260; the maximum profit for 100 contracts is $260 × 100 = $26,000.

hard

multiple-choice

derivatives

english

236

3

1

Not supported with pagination yet

release_basic

562

english_236_4_r1

nan

The delta of Valentine’s bull spread just before contract expiration, if the price of DJX is $93, will most likely be in the range of

[ "A. 0.00 to 0.20", "B. 0.40 to 0.60", "C. 0.80 to 1.00" ]

Not supported with pagination yet

table

C

Solution: C. If the price of DJX= $93, then the long call (exercise price = $88) will be in the money and its delta would be close to 1.0. The short call (exercise price = $94) will be out of the money and (very close to expiration) its delta would be close to 0.0. The overall delta is then very close to 1.0.

hard

multiple-choice

derivatives

english

236

4

1

Not supported with pagination yet

release_basic

563

english_237_1_r1

Garrison Investments is a money management firm focusing on endowment management for small colleges and universities. Over the past 20 years, the firm has primarily invested in U.S. securities with small allocations to high quality long-term foreign government bonds. Garrison’s largest account, Point University, has a market value of $800 million and an asset allocation as detailed in Figure 1. <image_1> Garrison recently convinced the board of trustees at Point University that the endowment should allocate a portion of the portfolio to European equities. The board has agreed to the plan but wants the allocation to international equities to be a short-term tactical move. Managers at Garrison have put together the following proposal for the reallocation: To minimize trading costs while gaining exposure to international equities, the portfolio can use futures contracts on the domestic 12-month mid-cap equity index and on the 12-month European equity index. This strategy will temporarily exchange $80 million of U.S. mid-cap exposure for European equity index exposure. Relevant data on the futures contracts are provided in Figure 2. <image_2> Three months after proposing the international diversification plan, Garrison was able to persuade Point University to make a direct short-term investment in Haikuza International (HI), a Japanese electronics firm. Analysts at Garrison have regressed the historical returns of the HI stock with changes in value of the yen. When the HI returns are measured in U.S. dollars, the regression slope coefficient is +0.80. The managers at Garrison are discussing other factors that may be considered if they continue to diversify into foreign markets. The following statements are made: Statement 1: The minimum variance hedge ratio is riskier than a simple direct one-for-one hedge ratio because it depends on the correlation between asset and currency returns. • Statement 2: An alternative to selling the yen forward to implement the HI currency hedge would be to buy calls on the USD. This would protect the portfolio from currency risk while still retaining potential currency upside. Unfortunately, it will have a higher initial cost.

With regard to Garrison’s proposal to generate temporary exposure to European equities in the Point University portfolio, determine the appropriate position in the mid-cap equity index futures.

[ "A. Buy 417 contracts", "B. Sell 298 contracts", "C. Sell 417 contracts" ]

Not supported with pagination yet

table

C

Solution: C. In order to adjust the allocation of an existing equity portfolio, two futures contracts are needed. The first contract should have an underlying equal (or highly similar) to the existing equity exposure to be reduced. This contract is sold to reduce a portion of the existing portfolio to a zero beta, effectively canceling the exposure to that equity sector. The se cond futures contract should have an underlying equal to the desired equity exposure. This contract is purchased to provide the desired equity exposure. The number of contracts to use is calculated using the following formula: <ans_image_1>

easy

multiple-choice

equity

english

237

1

Not supported with pagination yet

release_basic

564

english_237_2_r1

nan

Garrison’s analysis to determine a hedge ratio for the HI exposure is best described as producing a

[ "A. cross hedge", "B. transaction hedge", "C. minimum variance hedge" ]

Not supported with pagination yet

table

C

Solution: C. Regressing the foreign market return measured in the investor’s domestic currency versus the foreign currency value produces a minimum variance hedge ratio, and the intent is to minimize the volatility of the return to the domestic investor. It jointly minimizes the volatility of the foreign market and currency. It would be a form of a cross hedge because the hedged item (RDC) is not the same thing as the hedging vehicle (the foreign currency), but that is a vague answer and much less specific than correctly describing it as a MVH. (All MVHs are cross hedges, but most cross hedges are not MVHs.) A transaction exposure generally refers to hedging a known in or out flow of a foreign currency. There are elements of that here, but it is a much less specific answer and so is not acceptable.

hard

multiple-choice

equity

english

237

2

0

Not supported with pagination yet

release_basic

565

english_237_3_r1

nan

Which of the following is the correct short position in yen the managers at Garrison will execute to implement a minimum variance hedge for a JPY 200,000,000 currency exposure

[ "A. 40 million", "B. 160 million", "C. 240 million" ]

Not supported with pagination yet

table

B

Solution: B. The slope coefficient for a regression of the foreign asset returns measured in the investor’s domestic currency (USD) is the MVHR. JPY 200,000,000 × 0.8 = JPY 160,000,000.

hard

multiple-choice

equity

english

237

3

1

Not supported with pagination yet

release_basic

566

english_237_4_r1

nan

Which of the statements regarding diversifying into foreign markets is most accurate

[ "A. Statement 1", "B. Statement 2", "C. Both statements" ]

Not supported with pagination yet

table

C

Solution: C. The MVHR is based on regressing historical returns and its future performance is therefore less predictable and riskier. The relationship (correlation) can change. Buying calls on the USD is equivalent to buying puts on the yen and the statement correctly describes the consequences of a protective put on the yen: downside protection, full upside participation, but an initial option premium expense.

hard

multiple-choice

equity

english

237

4

0

Not supported with pagination yet

release_basic

567

english_238_1_r1

Declan Kaufman is an investment manager working at New Wave Advisers, an investment firm specializing in providing innovative derivatives solutions to institutional investors and sophisticated individuals. Ariadne Burch is corporate treasurer of a large European retailer, looking to expand operations into the United States. She is exploring ways of borrowing USD, which is required for the expansion, and has presented Kaufman with the following information: • The rate on USD loan direct from a U.S. bank is the USD reference rate +100 bps. • The rate on EUR loan direct from European bank is the EUR reference rate +70 bps. • The EUR-USD cross-currency basis swap is quoted at –20 bps. Burch would like to know what the effective cost of borrowing USD would be if this were conducted through a cross-currency basis swap rather than directly borrowing USD. Another client of Kaufman, Beatrice Rutledge, has asked Kaufman for advice on derivatives based on volatility. Rutledge is aware that volatility is a key input when pricing options; however, she is not familiar with other derivatives used to trade volatility. Kaufman prepares a short presentation on variance swaps. He bases his presentation on data displayed below in Figure 1. <image_1> During Kaufman’s presentation, Rutledge asks Kaufman how the payoff of a variance swap is likely to behave. Kaufman replies with the following comments: • Comment 1: The sensitivity of the value of a variance swap to changes in implied volatility falls over the life of the swap. • Comment 2: The payoff of a variance swap is convex with respect to changes in volatility.

If Burch’s firm raises USD financing through a cross currency basis swap, the cost of borrowing verses a direct USD loan would be

[ "A. 20 bps lower", "B. 10 bps lower", "C. 20 bps higher" ]

Not supported with pagination yet

table

B

Soluton: B. If Burc h’s firm borrows directly in USD, her firm will pay the USD reference rate +100bps. If Burch’s firm uses the cross currency basis swap to borrow USD the firm will: • Borrow EUR directly at EUR reference rate +70bps. • Swap the Euros for USD under the swap, and in doing so agreeing to pay the USD reference rate, and receive the EUR reference rate minus 20bps since the basis is 20bps. The net interest paid would, therefore, be: (EUR reference rate + 70bps) + USD reference rate (EUR reference rate 20bps) = US D reference rate + 90bps The advantage of borrowing USD through the swap market versus directly is therefore 10 bps (i.e., the difference between the cost of direct borrowing [USD reference rate + 100bps] and the cost of borrowing USD through the swap [USD reference rate + 90bps]).

hard

multiple-choice

derivatives

english

238

1

Not supported with pagination yet

release_basic

568

english_238_2_r1

nan

Using the data in Figure 1, the approximate gain or loss for a 1% change in volatility, under the variance swap, is closest to

[ "A. $14.", "B. $263", "C. $10,000" ]

Not supported with pagination yet

table

C

Solution: C. The approximate gain or loss for a 1% change in volatility for a variance swap is the swap’s vega notional. The vega notional is related to variance notional through the formula: <ans_image_1>

hard

multiple-choice

derivatives

english

238

2

1

Not supported with pagination yet

release_basic

569

english_238_3_r1

nan

Using the data in Figure 1, the payoff to the variance buyer, from the variance swap, at the end of its life is closest to

[ "A. $526", "B. $21,000", "C. $800,000" ]

Not supported with pagination yet

table

B

Solution: B. Payoff to variance buyer = variance notional × (realized variance – variance strike) = 263 × (212 –192) = $21,040

hard

multiple-choice

derivatives

english

238

3

1

Not supported with pagination yet

release_basic

570

english_238_4_r1

nan

How many of Kaufman’s comments regarding the payoff behavior of a variance swap are most accurate

[ "A. Zero", "B. One", "C. Two" ]

Not supported with pagination yet

table

C

Solution: C. Both comments are accurate comments. The value of a variance swap becomes less dependent on implied volatility and more dependent on realized volatility as time passes. The payoff of variance swaps is convex in relation to volatility due to the nonlinear (squared) nature of variance in relation to volatility.

hard

multiple-choice

derivatives

english

238

4

0

Not supported with pagination yet

release_basic

571

english_239_1_r1

Gari Dimeola is an investment advisor specializing in derivatives strategies in equity, fixed income, and currency markets. Dimeola is approached by his client, Ryan Karunathilike, for advice regarding option strategies. Karunathilike is a U.K. domiciled client who wants to hedge a short position in Euros (EUR) over the coming month. The current spot EUR/GBP exchange rate is 1.1523. Dimeola advises Karunathilike that he has three strategies using derivatives on the EUR/GBP exchange rate available to him, which are displayed in Figure 1. <image_1> Karunathilike asks Dimeola to review his existing options strategies. He presents the signs of the Greek exposures of his strategies as displayed in Figure 2. <image_2> Karunathilike has identified a stock, GHS Corp., which historically has had options exhibiting a volatility skew. The options of GHS currently exhibit a volatility smile, and Karunathilike believes that within the next days implied volatility will revert back to a more usual profile. Karunathilike asks Dimeola to design an options strategy to allow him to profit from this view.

How many of the strategies in Figure 1 meet the objective of Karunathilike

[ "A. Zero", "B. Two", "C. All three" ]

Not supported with pagination yet

table

C

Solution: C. The U.K. investor is short EUR, so they will lose on this position when the Euro strengthens against GBP. When the EUR strengthens against GBP the EUR/GBP rate will fall since it will cost less EUR to b uy GBP (recall that the curriculum presents currency quotes as variable or fixed). Hence, Strategy 1 and Strategy 3 would be adequate hedges. Conversely, when the EUR strengthens against GBP the GBP/EUR rate will rise meaning that Strategy 2 is also an effective hedge.

hard

multiple-choice

derivatives

english

239

1

0

Not supported with pagination yet

release_basic

572

english_239_2_r1

nan

Which of Karunathilike’s options strategies in Figure 2 is most likely a short straddle position

[ "A. Strategy A", "B. Strategy B", "C. Strategy C" ]

Not supported with pagination yet

table

C

Solution: C. A short straddle position is created by selling a call and a put with the same underlying details. The short straddle will have a delta that is close to zero when the options are at the money, but will have negative gamma since it is a short option position. Short options also have a positive theta and negative vega as found in Strategy C.

hard

multiple-choice

derivatives

english

239

2

0

Not supported with pagination yet

release_basic

573

english_239_3_r1

nan

Based on the Greek exposures displayed in Figure 2, Strategy B is most likely a

[ "A. short straddle", "B. short put", "C. bull spread" ]

Not supported with pagination yet

table

B

Solution: B. A short put will have a positive delta since it loses value as the underlying asset price falls, and a negative gamma since it is a short option position. It also has positive theta since short options profit as time decay reduces the value of the option. It will also have negative vega since an increase in volatility will increase the value of the put and causes losses to the short put position

hard

multiple-choice

derivatives

english

239

3

0

Not supported with pagination yet

release_basic

574

english_239_4_r1

nan

The most appropriate options strategy, given Karunathilike’s view on the implied volatility profile of GHS Corp, is to sell

[ "A. out-the-money calls and buy out-the-money puts", "B. out-the-money puts and buy in-the-money puts", "C. at-the-money calls and buy at-the-money puts" ]

Not supported with pagination yet

table

A

Solution: A. A volatility smile occurs when both out-the money (OTM) puts and OTM calls have higher implied volatility than at-the-money (ATM) options. A volatility smirk occurs when OTM puts have higher implied volatility but OTM calls have lower implied volatility. Since options prices decline as implied volatility falls, Karunathilike should sell OTM calls and buy OTM puts to profit from his view.

hard

multiple-choice

derivatives

english

239

4

0

Not supported with pagination yet

release_basic

575

english_240_1_r1

A US bond portfolio manager Tony Kalman wants to hedge a long position in a 10-year Treasury bond against a potential rise in domestic interest rates. Besides, he observes that the VIX term structure is upward sloping. In particular, the VIX is at 19.60, the front-month futures contract trades at 21.50, and the second-month futures contract trades at 23.00. Assuming the shape of the VIX term structure will remain constant over the next three-month period, he decides to implement a trade that would profit from the VIX carry roll down. In his spare time, Kalman also operates a subscription website through which he offers financial advice on currency issues to retail investors. One morning he receives three subscriber e-mails seeking guidance. <image_1>

Regarding his view on domestic interest rates, Kalman would most likely

[ "A. sell fixed-income (bond) futures", "B. enter a receive-fixed 10-year interest rate swap", "C. sell a strip of 90-day Eurodollar futures contracts" ]

Not supported with pagination yet

table

A

Solution: A. The portfolio manager would most likely use a longer-dated fixed-income (bond) futures contract to hedge his interest rate risk exposure. The choice of the hedging instrument, in fact, will depend on the maturity of the bond being hedged. Interest rate futures, like 90-day Eurodollar futures, have a limited number of maturities and can be used to hedge short-term bonds. The mark-to-market value of a receive-fixed 10-year interest rate swap will become negative if interest rates rises, and thus the swap cannot be used as a hedge in this case.

easy

multiple-choice

derivatives

english

240

1

0

Not supported with pagination yet

release_basic

576

english_240_2_r1

nan

Based on his view about VIX term structure, Kalman will most likely purchase the

[ "A. VIX and sell the VIX second-month futures", "B. VIX and sell the VIX front-month futures", "C. VIX front-month futures and sell the VIX second-month futures" ]

Not supported with pagination yet

table

C

Solution: C. VIX futures converge to the spot VIX as expiration approaches, and the two must be equal at expiration. When the VIX futures curve is in contango and assuming volatility remains stable, the VIX futures will get “pulled” closer to the spot VIX, and they will decrease in price as they approach expiration. Traders calculate the difference between the front-month VIX futures price and the VIX as 0.90, and the spread between the front-month and the second-month futures is 1.50. Assuming that the spread declines linearly until settlement, the trader would realize roll-down gains as the spread decreases from 1.50 to 0.90 as the front-month futures approaches its expiration. At expiration, VIX futures are equal to the VIX, and the spread with the old second-month (and now the front-month) futures contract will be 0.90. Finally, since one cannot directly invest in the VIX, trades focusing on the VIX term structure must be implemented using either VIX futures or VIX options, so Answers A and B are not feasible.

easy

multiple-choice

derivatives

english

240

2

0

Not supported with pagination yet

release_basic

577

english_240_3_r1

nan

For Subscriber 1, the most significant factor to consider would be

[ "A. margin requirements", "B. transaction costs of using futures contracts", "C. different quoting conventions for future contracts" ]

Not supported with pagination yet

table

A

Solution: A. Exchange-traded futures contract not only have initial margin requirements, they also have daily mark-to-market and, as a result, can be subject to daily margin calls. Market participants must have sufficient liquidity to meet margin calls, or have their positions involuntarily liquidated by their brokers. Note that the risk of daily margin calls is not a feature of most forwards contracts; nor is initial margin. (However, this is changing among the largest institutional players in FX markets as many forward contracts now come with what are known as Collateral Support Annexes—CSAs—in which margin can be posted. Posting additional margin would typically not be a daily event, however, except in the case of extreme market moves.)

hard

multiple-choice

derivatives

english

240

3

0

Not supported with pagination yet

release_basic

578

english_240_4_r1

nan

For Subscriber 2, and assuming all of the choices relate to the KRW/USD exchange rate, the best way to implement the trading strategy would be to

[ "A. write a straddle", "B. buy a put option", "C. use a long NDF position" ]

Not supported with pagination yet

table

C

Solution: C. Based on predicted export trends, Subscriber 2 most likely expects the KRW/USD rate to increase (i.e., the won—the price currency—to depreciate relative to the USD). This would require a long forward position in a forward contract, but as a country with capital controls, a NDF would be used instead. (Note: While forward contracts offered by banks are generally an institutional product, not retail, the retail version of a non-deliverable forward contract is known as a “contract for differences” (CFD) and is available at several retail FX brokers.)

medium

multiple-choice

derivatives

english

240

4

0

Not supported with pagination yet

release_basic

579

english_240_5_r1

nan

Based on Subscriber 3’s correlation forecast, the expected domestic-currency return (measured in EUR terms) and expected domestic-currency return risk will most likely

[ "A. increase and decrease", "B. decrease and remain unchanged", "C. remain unchanged and increase" ]

Not supported with pagination yet

table

C

Solution: C. <ans_image_1>

medium

multiple-choice

derivatives

english

240

5

0

Not supported with pagination yet

release_basic

580

english_241_1_r1

The Flagstone College endowment fund recently received a significant donation and has decided to allocate the new funds to fixed income. Flagstone selected Allied Advisors to manage the fixed income portfolio and is currently evaluating Allied’s recommendations on structuring the portfolio. Greg Thorne, fixed income portfolio manager with Allied Advisors, is meeting with the endowment fund’s trustees. Jerome Moir, a trustee, makes the following statements: Statement 1: “We want to use portfolio returns to fund as many scholarships as possible; the endowment fund has no specific liabilities to meet.” Statement 2: “The endowment fund’s investment policy statement indicates a medium term time horizon and seeks to avoid capital losses.” Thorne responds: “Irrespective of whether you have specific liabilities to meet, a bond market index must be selected that will serve as a benchmark.” Thorne then presents the trustees with four benchmarks that could be used to evaluate the performance of a fixed income portfolio. The characteristics of the benchmarks are outlined in Exhibit 1. <image_1> Moir asks Thorne to present the historical performance of one of Allied’s portfolios relative to the benchmark index. Thorne’s comparison is shown in Exhibit 2. <image_2> Moir also is interested in the risks that Allied takes in spread sectors. He asks for additional information on the amount of spread risk in Allied’s portfolio relative to the benchmark. Thorne responds with the information shown in Exhibit 3. <image_3> Moir then asks Thorne for his interest rate forecast for the coming year. Thorne responds, “At Allied we expect long rates to underperform short rates causing a twist in the yield curve.”

Is Thorne’s statement regarding the selection of a bond market index as a benchmark most likely correct

[ "A. Yes", "B. No, because if the portfolio has a liability to meet, then the liability becomes the benchmark", "C. No, because the selection of a bond market index is only required if a full-blown active management strategy is followed" ]

Not supported with pagination yet

table

B

Solution: B. Thorne’s statement is incorrect because if Flagstone had specific liabilities to match, then the liability itself becomes the benchmark.

hard

multiple-choice

fixed income

english

241

1

0

Not supported with pagination yet

release_basic

581

english_241_2_r1

nan

Based on Statement 2 made by Moir and the information presented in Exhibit 1, the most appropriate benchmark for Flagstone’s endowment fund is the

[ "A. Barclays Aggregate", "B. Barclays U.S. High Yield", "C. Barclays 1-3 year Government/Corporate" ]

Not supported with pagination yet

table

A

Solution: A. The Barclays Aggregate index represents a diversified portfolio of sectors and has medium-term duration which should generate reasonable returns with moderate price sensitivity as interest rates fluctuate. Statement 2 clearly indicates that the Flagstone endowment fund has a medium term horizon and generally seeks to avoid capital losses.

hard

multiple-choice

fixed income

english

241

2

0

Not supported with pagination yet

release_basic

582

english_241_3_r1

nan

The strategy of the portfolio whose returns and risk characteristics are presented in Exhibits 2 and 3 is best described as

[ "A. enhanced indexing by minor risk factor mismatches", "B. active management by larger risk factor mismatches", "C. enhanced indexing by matching primary risk factors" ]

Not supported with pagination yet

table

A

Solution: A. The Barclays Aggregate index represents a diversified portfolio of sectors and has medium-term duration which should generate reasonable returns with moderate price sensitivity as interest rates fluctuate. Statement 2 clearly indicates that the Flagstone endowment fund has a medium term horizon and generally seeks to avoid capital losses.

hard

multiple-choice

fixed income

english

241

3

0

Not supported with pagination yet

release_basic

583

english_241_4_r1

nan

Given the information in Exhibit 3, a mismatch of risk exposures between the portfolio and the benchmark should most likely be attributed to the

[ "A. mortgage sector", "B. corporate sector", "C. asset backed sector" ]

Not supported with pagination yet

table

B

Solution: B. The portfolio’s spread duration (2.87) is greater than that of the benchmark (2.31) resulting in a mismatch of risk exposures. The difference is primarily because of the larger contribution to spread duration of corporate bonds in the portfolio (1.96) compared to the benchmark (1.38) despite having the similar nominal representation (22.5% and 23.0%, respectively).

hard

multiple-choice

fixed income

english

241

4

0

Not supported with pagination yet

release_basic

584

english_241_5_r1

nan

Given Thorne’s interest rate forecast, which method for managing interest rate risk relative to the benchmark will be most effective

[ "A. Key rate duration", "B. Effective duration", "C. Convexity adjustment" ]

Not supported with pagination yet

table

A

Solution: A. Matching key rate durations will reduce tracking error resulting from a non-parallel shift, such as a twist in the yield curve.

hard

multiple-choice

fixed income

english

241

5

0

Not supported with pagination yet

release_basic

585

english_242_1_r1

Robert Waterman, and Sophia Chen, are portfolio managers of a U.S-based investment firm, Simon Fraser Analytics. Waterman and Chen are thinking investing in U.S. and U.K bonds. They consider all kinds of yield curve and other strategies. Exhibit 1 shows the data they collected from the liquid government bonds on U.S and U.K market. <image_1> Also both of them are interested in: 1. Riding the yield curve over next year 2. Long or short call and/or put options on U.K. government bonds through purchasing convexity 3. Carrying out a carry trade between U.S and U.K 3-year duration bonds. Waterman and Chen consider to buy a bond issued by a Norwegian BeeBalm Manufacture firm. Exhibit 2 shows their expectation. <image_2> According to their market expectation, they decide to hedge the NOK currency risk with a one-year forward contract after investing in the BeeBalm bond. However, they find that market has become inactive resulting in high transaction costs. There is a more active forward market for the Swedish currency (SEK), so they determine to construct a cross hedge by selling the SEK forward to buy the USD. Lastly, Waterman and Chen think about to purchase a BB-rated U.S. corporate bond with a duration of 3.5 and a yield of 3.7%. While they do not agree on the best way to measure the credit spread, they both agree its credit will improve and spread will narrow down. • Waterman says we can use Exhibit 1 to calculate the G-spread of the U.S. bond as being 3.64% • Chen says the I-spread is superior because it is based on swap fixed rates and these have less credit risk. • Chen also admit that G-spread has an advantage because it is the return we can expect to earn if we hedge interest rate risk.

Based on the data presented, it is more likely correct to say a “riding the yield curve” strategy

[ "A. Assumes the level of the yield curve will change", "B. Would be more profitable in the U.K than in the U.S", "C. Cannot work in the U.S. yield curve environment" ]

Not supported with pagination yet

table

B

Solution: B. The riding the yield curve strategy is based on assuming the yield curve is upward sloping and will not change in shape. Therefore, buy the bond at the end of the steeper segment of the curve and hold it. As it shortens in maturity (duration), it will trade at a now lower yield and there will be a price again. The U.K. curve is steeper and more suited to the strategy. The decline in rates from holding a U.K. bond will be larger, and therefore, the price again will be larger. Of course, the yield is also better.

hard

multiple-choice

fixed income

english

242

1

0

Not supported with pagination yet

release_basic

586

english_242_2_r1

nan

Buying convexity will most likely

[ "A. involve increasing the portfolio’s yield", "B. require selling calls but not puts", "C. require buying both calls and puts" ]

Not supported with pagination yet

table

C

Solution: C. Buying convexity means increasing portfolio convexity. Higher convexity is a benefit if there are large changes in interest rates, but the “cost” is a lower yield. Increasing portfolio convexity can be done by reducing exposure to callable and MBS (both have embedded short call positions), buying putable bonds, or most effectively by buying calls and/or puts on bonds. While it is not a requirement to buy both options, that certainly works and is the only choice that is true.

hard

multiple-choice

fixed income

english

242

2

0

Not supported with pagination yet

release_basic

587

english_242_3_r1

nan

Based on the data presented, it is most correct to say the carry trade

[ "A. Involves borrowing in the U.S. and investing in the U.K", "B. Does best when interest rate parity correctly predicts the change in value of currencies", "C. Would perform better if U.S. rates decrease and U.K. interest rates increase" ]

Not supported with pagination yet

table

A

Solution: A. The carry trade refers to borrowing at lower rates to invest at higher rates. In this case, it was specified to use three-year duration instruments, so borrow at 1% U.S. rates and invest at 2% U.K. rates. An increase in U.K. rates would hurt the value of the bonds purchased and having borrowed in the United States at 3-year duration, the decline in U.S. rates increases the value of that liability, which is also a loss to the investor. The carry trade will not work if IRP predicts changes in currency value. The United Kingdom has the higher interest rate, so its currency will trade at a forward discount. If the U.K. currency (GBP) declines it will take more GBP to buy the USD required to pay back the U.S. borrowing. The cross currency carry trade actually depends in part on the observation that the higher interest rate (GBP) currency usually appreciates in value, Forward premiums and discounts are not valid predictors of change in currency value.

hard

multiple-choice

fixed income

english

242

3

0

Not supported with pagination yet

release_basic

588

english_242_4_r1

nan

Based on the data in Exhibit 2, should the BeeBalm Manufacture bond be hedged against currency risk and what is the hedged return

[ "A. No, the hedge return is 4.70%", "B. No, the hedge return is 6.60%", "C. Yes, the hedge return is 6.60%" ]

Not supported with pagination yet

table

A

Solution: A. The unhedged return on the foreign bond is the return on the bond plus the expected change in The NOK: 7.00 0.40 = 6.60 Hedging the currency requires selling the NOK forward and buying the USD. That makes the return on the hedged currency the initial forward premium or discount, which is approxim ated at lose the NOK and gain the USD short term rate: 0.5 - 2.80= 2.30 The hedged return is the return on the bond plus the forward discount for the NOK: 7.00 - 2.30=4.70 The currency unhedged return is superior. Therefore, do not hedge the currency risk.

hard

multiple-choice

fixed income

english

242

4

0

Not supported with pagination yet

release_basic

589

english_242_5_r1

nan

In order for the cross hedge of selling the SEK forward to work, the correlation of

[ "A. SEK and NOK must be high, approaching +1", "B. SEK and USD must be high, approaching +1", "C. Both the SEK and NOK must be highly correlated to the USD, approaching +1" ]

Not supported with pagination yet

table

A

Solution: A The U.S.-based firm would normally sell the foreign currency (NOK) and buy the USD to hedge the currency risk. An alternative is to sell another currency that is highly correlated to the NOK, a form of cross hedge (sometimes called a proxy hedge). The idea is that if the NOK declines versus the USD, the SEK will also decline for a gain on the short SEK contracts that offsets the loss on NOK. There must be high correlation and a predictable relationship of the SEK and NOK for this to work. Higher correlation to the USD has nothing to do directly with the cross hedge of the currency risk. Note that if the USD and the other currencies are highly correlated, it suggests they change in similar fashion to each other; in other words, the exchange rate will be relatively stable and change in currency value will be a less significant factor in the return earned from investing in the foreign bond.

hard

multiple-choice

fixed income

english

242

5

0

Not supported with pagination yet

release_basic

590

english_242_6_r1

nan

Regarding their statements concerning the spread for the BB-rated U.S. corporate bond, the most correct statement is

[ "A. Waterman’s comment on G-spread", "B. Chen’s comment on I-spread", "C. Chen’s comment on G-spread" ]

Not supported with pagination yet

table

C

Solution: C. G spread is the yield of the bond minus the interpolated yield of a comparable duration governmen t bond. Letting w be the weight to the 3.0 duration U. S. government bond, the interpolated yield for a 3.5 year duration U.S. government bond is found as follows: 3.5= w3.0+ (1 w) 4.1 3.5= 3.0w+4.1 4.1w 0.6=1.1w W=55% and the weight in the 4.1 duration bond is 45% Interpolated yield of a comparable duration U.S. government bond: 0. 55(1.00) + 0.45(1.10) = 1. 05% And G spread is: 3.70 1. 05 = 2. 65% Furthermore, this G spread is the expected return if you invest in and hedge the interest rate risk of the corporate bond by shorting a 55/45 weighted combination of the two government bonds that duration matches the corporate bond. While SFR are similar to government bond yields, SFR do reflect some credit risk. SFR are not less credit risky than government bonds.

hard

multiple-choice

fixed income

english

242

6

0

Not supported with pagination yet

release_basic

591

english_243_1_r1

Samuel Morse, is a senior analyst in the Balance Sheet Strategy Division of Bayside Insurance. Morse has been asked to contrast the merits of cash flow matching and duration matching. Bayside presently uses both strategies, but given the recent increase in volatility in US interest rates over the last month, Bayside’s management wants to better prepare for future opportunities. Morse also considers the use of derivatives to manage interest rate risk. This would be a new strategy for Bayside. Morse determines the number of bond futures needed to immunize the overall interest rate risk exposure of the company. The basis point value (BPV) for the asset portfolio is 48,000, while the liability portfolio has a BPV of 22,000. To facilitate her analysis, Morse compiles the additional information related to bond futures shown in Exhibit 1. <image_1> Morse intends to construct sample portfolio structures by shifting the allocations between three tenors of bullet government bonds: 2-year, 10-year and 30-year US Treasury securities. The allocations in the sample portfolios are shown in Exhibit 2. The expected return estimates for the 2- and 30-year bonds, which are shown in Exhibit 3. <image_2> <image_3> Morse interviews Horace Mann to assist him in evaluating fixed-income funds and securities for the bank’s fixed-income offerings. Morse shows his the following financial data of three funds presented in Exhibit 4 and asks him to review each fund. Mann assumes that there is no reinvestment income and the yield curve remains unchanged in the preliminary review of each fund. Morse interviews Horace Mann to assist him in evaluating fixed-income funds and securities for the bank’s fixed-income offerings. Morse shows his the following financial data of three funds presented in Exhibit 4 and asks him to review each fund. Mann assumes that there is no reinvestment income and the yield curve remains unchanged in the preliminary review of each fund. <image_4> Morse recommends Treasuries from the existing portfolio that he believes are overvalued and will generate capital gains. Mann asks Morse why he chose only overvalued bonds with capital gains and did not include any bonds with capital losses. Morse responds with two statements. Statement 1 Taxable investors should prioritize selling overvalued bonds and always sell them before selling bonds that are viewed as fairly valued or undervalued. Statement 2 Taxable investors should never intentionally realize capital lo sses.

Which immunization strategy is most likely to be more negatively impacted by non- parallel shifts in the yield curve

[ "A. Cash flow matching", "B. Duration matching", "C. The strategies will perform the same" ]

Not supported with pagination yet

table

B

Solution: B. A duration matching strategy is more likely than a cash flow matching strategy to be negatively impacted by non-parallel shifts in the yield curve. With cash flow matching, assets are selected to mirror the timing of payments in the liability portfolio. In a duration matching strategy, the potential for greater dispersion of the maturities may lead to unexpected risk exposures as interest rates change over time.

easy

multiple-choice

derivatives

english

243

1

0

Not supported with pagination yet

release_basic

592

english_243_2_r1

nan

The number of five-year T-note futures contracts required to be sold in order to rebalance the immunizing portfolio is closest to

[ "A. 329 contracts", "B. 464 contracts", "C. 501 contracts" ]

Not supported with pagination yet

table

B

Solution: B. With derivative overlay strategies, in order to calculate the number of contracts needed, the futures BPV must be adjusted to reflect the conversion factor: Futures BPV = Note BPV / Conversion Factor 44.8/0.8=56 Number of contracts = (Asset BPV–Liability BPV) / Futures BPV (48,000-22,000)/56=464.286

hard

multiple-choice

derivatives

english

243

2

1

Not supported with pagination yet

release_basic

593

english_243_3_r1

nan

Which portfolio is most likely to benefit from a flattening yield curve environment

[ "A. Portfolio 1", "B. Portfolio 2", "C. Portfolio 3" ]

Not supported with pagination yet

table

A

Solution: A. Portfolio 1 is most likely to benefit from a flattening yield curve, as it is constructed using a barbell approach, with higher allocations at the short and long ends of the yield curve.

easy

multiple-choice

derivatives

english

243

3

0

Not supported with pagination yet

release_basic

594

english_243_4_r1

nan

Given the expected prices over the next year, which bond has the higher expected total return

[ "A. The 2-year", "B. The 30-year", "C. Both bonds have the same expected total return" ]

Not supported with pagination yet

table

B

Solution: B. The total return for fixed income securities includes both yield income and price appreciation. The expected price appreciation for both securities is 1.00%, but as the 30- year yield income is 1.50% more than the 2-year, it will have a higher expected total return. 2-year: Yield income = 4.75/100 = 4.75% 2-year: Price appreciation = (101.05–100)/100 = 1.05% Total return = 4.75% + 1.05% = 5.8% 30-year: Yield income = 6.00/100 = 6% 30-year: Price appreciation = (101–100)/100 = 1% Total return = 6% + 1% = 7%

hard

multiple-choice

derivatives

english

243

4

0

Not supported with pagination yet

release_basic

595

english_243_5_r1

nan

Based on Exhibit 4, the total expected return of the fund’s global bond portfolio is closest to

[ "A. 3.52%", "B. 2.31%", "C. 1.83%" ]

Not supported with pagination yet

table

C

Solution: C. <ans_image_1>

hard

multiple-choice

derivatives

english

243

5

1

Not supported with pagination yet

release_basic

596

english_243_6_r1

nan

Are Morse’s statements to Mann supporting Morse’s choice of bonds to sell correct

[ "A. Only Statement 1 is correct", "B. Only Statement 2 is correct", "C. Neither Statement 1 nor Statement 2 is correct" ]

Not supported with pagination yet

table

C

Solution: C. Since the fund’s clients are taxable investors, there is value in harvesting tax losses. These losses can be used to offset capital gains within the fund that will otherwise be distributed to the clients and cause them higher tax payments, which decreases the total value of the investment to clients. The fund has to consider the overall value of the investment to its clients, including taxes, which may result in the sale of bonds that are not viewed as overvalued. Tax-exempt investors’ decisions are driven by their investment views without regard to offsetting gains and losses for tax purposes.

hard

multiple-choice

derivatives

english

243

6

0

Not supported with pagination yet

release_basic

597

english_244_1_r1

Louis Armstrong are analysts with Cefrino Investments, which sponsors the Cefrino Sovereign Bond Fund (the Fund). Armstrong develops two alternative portfolio scenarios based on his own yield curve outlook. Construct a condor to benefit from less curvature in the 5-year to 10-year area of the yield curve. The condor will utilize the same 1-year, 5-year, 10-year, and 30-year bonds held in the Fund. The maximum allowable position in the 30-year bond in the condor is $15 million, and the bonds must have equal (absolute value) money duration. Armstrong evaluates the Fund’s positions from Exhibit 1: <image_1> Stephen Foster is concerned that the scenario analysis models for the credit portfolio underestimate tail risk, and he asks Armstrong how to address this issue. Armstrong responds, “We can change the expected correlations between prices in our models to generate more extremely unusual outcomes.” Armstrong is preparing for the annual meeting with one of the firm’s largest clients. The client wants to explore more international credit investing. Armstrong anticipates that the client will ask about differences between investing in emerging markets credits and developed markets credits. To address this potential inquiry, Armstrong plans to emphasize the following differences. Difference 1: Commodity producers and banks represent a higher proportion of emerging markets indexes than of developed market indexes. Difference 2: Total or partial government ownership of emerging markets issuers is common, which results in a higher average recovery rate for defaulted senior unsecured bonds for emerging markets than for developed markets. Difference 3: Compared with developed markets, the credit quality of emerging markets issuers tends to be more concentrated at the very high and very low portions of the credit spectrum. Armstrong also is preparing a more general discussion about domestic versus international portfolio management. The written report by Armstrong identifies three statements that he would like to check for accuracy. Statement 1 Currency risk in global credit portfolios can be mitigated by using currency swaps or by investing in credits denominated in currencies that are pegged or tightly managed by the government. Statement 2 Liquidity concerns for emerging markets credits are mitigated by their frequency of trading and modest legal risk. Statement 3 Sectors tend to perform similarly across regions.

Based on Exhibit 1, which short position is most likely to be included in the condor outlined

[ "A. 1-year $325 million", "B. 5-year $68 million", "C. 10-year $37 million" ]

Not supported with pagination yet

table

A

Solution: A. To determine the positions, we take the maximum allowance of 30 year bonds of 15 million and determine money duration. Money duration is equal to market value x modified duration divided by 100. 30 year bond money d uration = 15 million × 20.61 /100 = $ 091,5 00. The market values of the other positions are: 1 year bond: $3, 091,500 × 100/0.95 = $325 million 5 year bond: $3,091,500 × 100/4.52 = $68 million 10 year bond: $3,091,500 × 100/8.28 = $37 million To profit from a decrease in yield curve curvature, the correct condor structure will be: short 1s, long 5s, long 10s, and short 30s. The positions of the condor will be: short $3 25 million 1 year bond, long $ 68 million 5 year bond, long $37 million 10 yea r bond, and sh ort $15 million 30 year bond.This condor is structured so that it benefits from a decline in curvature, where the middle of the yield curve decreases in yield relative to the short and long ends of the yield curve.

hard

multiple-choice

fixed income

english

244

1

Not supported with pagination yet

release_basic

598

english_244_2_r1

nan

To address Foster’s tail risk concern, Armstrong should recommend that expected correlations with their models

[ "A. decrease", "B. do not change", "C. increase" ]

Not supported with pagination yet

table

C

Solution: C. Increasing the correlations would likely increase the number of extremely unusual outcomes and, thereby, increase estimated tail risk. Higher correlations in the model increase the dispersion of outcomes (effectively decreasing diversification).

hard

multiple-choice

fixed income

english

244

2

0

Not supported with pagination yet

release_basic

599

english_244_3_r1

nan

Which of Armstrong’s three differences about investing in EM credits compared with developed market credits is most correct

[ "A. Difference 1", "B. Difference 2", "C. Difference 3" ]

Not supported with pagination yet

table

A

Solution: A. Emerging markets indexes have a higher proportion of commodity producers and banks than developed market indexes have.

hard

multiple-choice

fixed income

english

244

3

0

Not supported with pagination yet

release_basic