Christopher Robinson, chairman of the board of directors for a private endowment fund, believes that the endowment fund for which he is responsible has diverged too far from its stated objectives. Over several years the board has increased the size of the fund's equity position beyond the stated limits of the investment policy statement. In an effort to realign the fund's investments, Robinson has elected to choose a mortgage-backed security (MBS) for inclusion in the endowment's portfolio. After surveying the MBS market, Robinson has selected four MBS securities to present as potential investments at the next investment committee meeting. Details on the selected MBS securities are presented below:At the investment committee meeting, a fellow board member raises his concerns over the potential MBS investments stating, "While we all agree that the fixed-income proportion of the endowment is much too small, I am not sure the suggested MBS securities will fulfill the cash flow requirements of the endowment. What risks are we taking on by allocating a portion of the portfolio to these investments? We cannot afford to end up with a timing mismatch between the cash needs of the endowment and the cash provided from its investments. Also, we have given no consideration to commercial mortgage backed securities (CMBS). Isn't our analysis incomplete if we fail to give proper discussion of potential CMBS investment opportunities?"Robinson responded to his fellow board member by addressing the board member's concerns as follows:"Since the cash requirements of the endowment fund fluctuate directly with interest rates, the cash flows provided from the MBS will provide adequate protection against cash shortfalls arising from differences in the timing of cash needs and cash sources. In addition, we can further reduce uncertainty surrounding the timing of cash flows by purchasing planned amortization class CMOs, which are securities issued against pools of MBS. CMBS were not presented due to the unacceptable risk profile of the comparable CMBS trading in the marketplace."Robinson commented that the MBS cash flows would match the cash needs of the endowment, and also that planned amortization class CMOs also help mitigate cash flow timing risk. Are Robinson's comments correct?
Answer(s): B
Robinsons statement regarding the cash flows of the MBS is incorrect. Cash flows from an MBS will, in general, vary inversely with interest rates. As interest rates fall, prepayments will increase, causing cash flows to be realised earlier than expected. The opposite is true in a rising interest rate environment when refinancing becomes less attractive and prepayments decrease, delaying expected cash flows. If the endowment fund has cash flow needs that vary directly with interest rates, it will need a source of funds that varies in the same way. Robinson is correct about the planned amortization claw CMOs. The structure gives these securities a relatively predictable life. (Study Session 15, LOS 55.f,h)
Martha Garret, CFA, manages fixed income portfolios for Jones Brothers, Inc. (JBI). JBI has been in the portfolio management business for over 23 years and provides investors with access to actively managed equity and fixed-income portfolios. All of JBI's fixed-income portfolios are constructed using U.S. debt instruments. Garret's primary portfolio responsibilities are the Quasar Fund and the Nova Fund, both of which are long fixed-income portfolios consisting of Treasury securities in all maturity ranges. The Quasar Fund holdings as of March 15 are provided in Exhibit 1. A comparison of key rate durations for the Quasar Fund and Nova Fund is provided in Exhibit 2.Of particular importance to Garret and her colleagues is the degree of interest rate risk exposure unique to each portfolio under JBI's management. Driving the increased awareness of the portfolios' interest rate exposure is the double digit growth in assets under management that JBI's fixed-income portfolios have experienced in the last five years. Interest in the company's fixed- income portfolios continues to grow and as a result, all portfolio managers are required to attend weekly meetings to discuss key portfolio risk factors. At the last meeting, Miranda Walsh, a principal at JBI, made the following comments:"The variance of daily interest rate changes has been trending higher over the last three months leading us to believe that a period of high volatility is approaching in the next twelve to eighteen months. However, the reliability is questionable since the volatility estimates were derived using an option pricing model, which assumes constant interest rates.""Also, the Treasury spot rate curve currently has a similar shape to the yield curve on Treasury coupon securities, which, according to the market segmentation theory of interest rate term structure, indicates a relatively high level of demand from investors for intermediate term securities. Overzealous trading by investors unwilling to move into other maturity ranges may create mispricing and opportunities for arbitrage."After the meeting, Walsh and JBI's other principals met to discuss a new international portfolio opportunity. At Walsh's suggestion, the principals selected Garret as the lead portfolio manager for the new fund, which will be titled the Atlantic Fund. One of the other portfolio managers, Greg Terry, CFA, suggested to Garret that she utilize the LIBOR swap curve as a benchmark for the Atlantic fund rather than using local government yield curves. Terry justifies his suggestion by claiming that "the lack of government regulation in the swap market makes swap rates and curves directly comparable between different countries despite fewer maturity points with which to construct the curve as compared to a government yield curve. Furthermore, credit risk in the swap curves of various countries is similar, thus avoiding the complications associated with different levels of sovereign risk embedded in government yield curves.” Intrigued by the idea of using the swap curve, Garret has her assistant begin gathering a range of current and forward LIBOR rates.Assume that Bond A is currently callable at 105 and will be callable at 103 in six months. If the yield curve experiences a negative butterfly shift over the next month, which of the following results is most likely to be observed?
Answer(s): C
Bond A is priced at par value. A negative butterfly shift would increase the humped nature of the yield curve, either through a bigger increase in intermediate rates than short and long rates or a smaller decrease in intermediate rates than short- and long-term rates. Because Bond A has a much lower duration than Bond C, a yield curve shift would have more of a price impact on Bond C than Bond A. Long-term investors would not be drawn to such a short-term bond unless the yield shift created significant mispricing, which is unlikely. Choice C is the only answer that accurately reflects a possible result of a negative butterfly shift. Bond A would increase in price if the shift saw short-term rates falling more than intermediate rates. The increase in price will be limited, however, by the call price and thus the callable bond would experience price compression (usually observed at low interest rates). The interest rate decrease would be consistent with a negative butterfly shift. (Study Session 14, LOS 53.a)
Martha Garret, CFA, manages fixed income portfolios for Jones Brothers, Inc. (JBI). JBI has been in the portfolio management business for over 23 years and provides investors with access to actively managed equity and fixed-income portfolios. All of JBI's fixed-income portfolios are constructed using U.S. debt instruments. Garret's primary portfolio responsibilities are the Quasar Fund and the Nova Fund, both of which are long fixed-income portfolios consisting of Treasury securities in all maturity ranges. The Quasar Fund holdings as of March 15 are provided in Exhibit 1. A comparison of key rate durations for the Quasar Fund and Nova Fund is provided in Exhibit 2.Of particular importance to Garret and her colleagues is the degree of interest rate risk exposure unique to each portfolio under JBI's management. Driving the increased awareness of the portfolios' interest rate exposure is the double digit growth in assets under management that JBI's fixed-income portfolios have experienced in the last five years. Interest in the company's fixed- income portfolios continues to grow and as a result, all portfolio managers are required to attend weekly meetings to discuss key portfolio risk factors. At the last meeting, Miranda Walsh, a principal at JBI, made the following comments:"The variance of daily interest rate changes has been trending higher over the last three months leading us to believe that a period of high volatility is approaching in the next twelve to eighteen months. However, the reliability is questionable since the volatility estimates were derived using an option pricing model, which assumes constant interest rates.""Also, the Treasury spot rate curve currently has a similar shape to the yield curve on Treasury coupon securities, which, according to the market segmentation theory of interest rate term structure, indicates a relatively high level of demand from investors for intermediate term securities. Overzealous trading by investors unwilling to move into other maturity ranges may create mispricing and opportunities for arbitrage."After the meeting, Walsh and JBI's other principals met to discuss a new international portfolio opportunity. At Walsh's suggestion, the principals selected Garret as the lead portfolio manager for the new fund, which will be titled the Atlantic Fund. One of the other portfolio managers, Greg Terry, CFA, suggested to Garret that she utilize the LIBOR swap curve as a benchmark for the Atlantic fund rather than using local government yield curves. Terry justifies his suggestion by claiming that "the lack of government regulation in the swap market makes swap rates and curves directly comparable between different countries despite fewer maturity points with which to construct the curve as compared to a government yield curve. Furthermore, credit risk in the swap curves of various countries is similar, thus avoiding the complications associated with different levels of sovereign risk embedded in government yield curves.” Intrigued by the idea of using the swap curve, Garret has her assistant begin gathering a range of current and forward LIBOR rates.Calculate the effect of a 75 basis point decrease in the 15-year interest rate and a 50 basis point increase in the 2-year interest rate on the value of the Nova Fund.
To find the overall effect on the value of the fund, multiply the key rate durations for the appropriate maturities by the change in the interest rate for that maturity. effect of rate changes on the Nova Fund: Nova = [-0.40(0.50%)] + [-3.4(-075%)] = +2.35% (Study Session 14, LOS 53-f)
Martha Garret, CFA, manages fixed income portfolios for Jones Brothers, Inc. (JBI). JBI has been in the portfolio management business for over 23 years and provides investors with access to actively managed equity and fixed-income portfolios. All of JBI's fixed-income portfolios are constructed using U.S. debt instruments. Garret's primary portfolio responsibilities are the Quasar Fund and the Nova Fund, both of which are long fixed-income portfolios consisting of Treasury securities in all maturity ranges. The Quasar Fund holdings as of March 15 are provided in Exhibit 1. A comparison of key rate durations for the Quasar Fund and Nova Fund is provided in Exhibit 2.Of particular importance to Garret and her colleagues is the degree of interest rate risk exposure unique to each portfolio under JBI's management. Driving the increased awareness of the portfolios' interest rate exposure is the double digit growth in assets under management that JBI's fixed-income portfolios have experienced in the last five years. Interest in the company's fixed- income portfolios continues to grow and as a result, all portfolio managers are required to attend weekly meetings to discuss key portfolio risk factors. At the last meeting, Miranda Walsh, a principal at JBI, made the following comments:"The variance of daily interest rate changes has been trending higher over the last three months leading us to believe that a period of high volatility is approaching in the next twelve to eighteen months. However, the reliability is questionable since the volatility estimates were derived using an option pricing model, which assumes constant interest rates.""Also, the Treasury spot rate curve currently has a similar shape to the yield curve on Treasury coupon securities, which, according to the market segmentation theory of interest rate term structure, indicates a relatively high level of demand from investors for intermediate term securities. Overzealous trading by investors unwilling to move into other maturity ranges may create mispricing and opportunities for arbitrage."After the meeting, Walsh and JBI's other principals met to discuss a new international portfolio opportunity. At Walsh's suggestion, the principals selected Garret as the lead portfolio manager for the new fund, which will be titled the Atlantic Fund. One of the other portfolio managers, Greg Terry, CFA, suggested to Garret that she utilize the LIBOR swap curve as a benchmark for the Atlantic fund rather than using local government yield curves. Terry justifies his suggestion by claiming that "the lack of government regulation in the swap market makes swap rates and curves directly comparable between different countries despite fewer maturity points with which to construct the curve as compared to a government yield curve. Furthermore, credit risk in the swap curves of various countries is similar, thus avoiding the complications associated with different levels of sovereign risk embedded in government yield curves.” Intrigued by the idea of using the swap curve, Garret has her assistant begin gathering a range of current and forward LIBOR rates.Which of the following statements regarding the effects of interest rate changes on the Quasar Fund and Nova Fund is most accurate? The value of the:
Answer(s): A
In a negative butterfly shift in which all interest rates decrease, the long-term and short-term interest rates will decrease by a greater amount than will the intermediate-term interest rates. The Quasar fund has a very large interest rate sensitivity (as measured by the 30- year key rate duration) to long-term interest rates. Therefore, if the interest rates at the long end decrease by a greater amount than intermediate-term rates, the effect on the value of the Quasar Fund will be greater than the effect on the Nova Fund, which has large exposure to intermediate- term rates but much less exposure to long-term rates. Recall that a decrease in interest rates causes the value of a fixed-income security to rise. Thus, the percentage gain in the value of the Quasar Fund will be greater than the Nova Fund in this scenario. (Study Session 14, LOS 53-0
Martha Garret, CFA, manages fixed income portfolios for Jones Brothers, Inc. (JBI). JBI has been in the portfolio management business for over 23 years and provides investors with access to actively managed equity and fixed-income portfolios. All of JBI's fixed-income portfolios are constructed using U.S. debt instruments. Garret's primary portfolio responsibilities are the Quasar Fund and the Nova Fund, both of which are long fixed-income portfolios consisting of Treasury securities in all maturity ranges. The Quasar Fund holdings as of March 15 are provided in Exhibit 1. A comparison of key rate durations for the Quasar Fund and Nova Fund is provided in Exhibit 2.Of particular importance to Garret and her colleagues is the degree of interest rate risk exposure unique to each portfolio under JBI's management. Driving the increased awareness of the portfolios' interest rate exposure is the double digit growth in assets under management that JBI's fixed-income portfolios have experienced in the last five years. Interest in the company's fixed- income portfolios continues to grow and as a result, all portfolio managers are required to attend weekly meetings to discuss key portfolio risk factors. At the last meeting, Miranda Walsh, a principal at JBI, made the following comments:"The variance of daily interest rate changes has been trending higher over the last three months leading us to believe that a period of high volatility is approaching in the next twelve to eighteen months. However, the reliability is questionable since the volatility estimates were derived using an option pricing model, which assumes constant interest rates.""Also, the Treasury spot rate curve currently has a similar shape to the yield curve on Treasury coupon securities, which, according to the market segmentation theory of interest rate term structure, indicates a relatively high level of demand from investors for intermediate term securities. Overzealous trading by investors unwilling to move into other maturity ranges may create mispricing and opportunities for arbitrage."After the meeting, Walsh and JBI's other principals met to discuss a new international portfolio opportunity. At Walsh's suggestion, the principals selected Garret as the lead portfolio manager for the new fund, which will be titled the Atlantic Fund. One of the other portfolio managers, Greg Terry, CFA, suggested to Garret that she utilize the LIBOR swap curve as a benchmark for the Atlantic fund rather than using local government yield curves. Terry justifies his suggestion by claiming that "the lack of government regulation in the swap market makes swap rates and curves directly comparable between different countries despite fewer maturity points with which to construct the curve as compared to a government yield curve. Furthermore, credit risk in the swap curves of various countries is similar, thus avoiding the complications associated with different levels of sovereign risk embedded in government yield curves.” Intrigued by the idea of using the swap curve, Garret has her assistant begin gathering a range of current and forward LIBOR rates.Which of the following factors would have the most explanatory power for the historical returns of the Quasar Fund? Changes in the:
Research conducted by Litterman and Scheinkman indicated that changes in the level of interest rates had the most explanatory power for returns on Treasury securities. Since the Quasar fund is composed of Treasuries of various maturities, Litterman and Scheinkmans research would be applicable. (Study Session 14, LOS 53-b)
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