Free CFA-Level-III Exam Braindumps (page: 47)

Paul Dennon is senior manager at Apple Markets Associates, an investment advisory firm. Dennon has been examining portfolio risk using traditional methods such as the portfolio variance and beta. He has ranked portfolios from least risky to most risky using traditional methods.
Recently, Dennon has become more interested in employing value at risk (VAR) to determine the amount of money clients could potentially lose under various scenarios. To examine VAR, Paul selects a fund run solely for Apple's largest client, the Jude Fund. The client has $100 million invested in the portfolio. Using the variance-covariance method, the mean return on the portfolio is expected to be 10% and the standard deviation is expected to be 10%. Over the past 100 days, daily losses to the Jude Fund on its 10 worst days were (in millions): 20, 18, 16, 15, 12, 11, 10, 9, 6, and 5. Dennon also ran a Monte Carlo simulation (over 10,000 scenarios). The following table provides the results of the simulation:

Figure 1: Monte Carlo Simulation Data

The top row (Percentile) of the table reports the percentage of simulations that had returns below those reported in the second row (Return). For example, 95% of the simulations provided a return of 15% or less, and 97.5% of the simulations provided a return of 20% or less.
Dennon's supervisor, Peggy Lane, has become concerned that Dennon's use of VAR in his portfolio management practice is inappropriate and has called for a meeting with him. Lane begins by asking Dennon to justify his use of VAR methodology and explain why the estimated VAR varies depending on the method used to calculate it. Dennon presents Lane with the following table detailing VAR estimates for another Apple client, the York Pension Plan.

To round out the analytical process. Lane suggests that Dennon also incorporate a system for evaluating portfolio performance. Dennon agrees to the suggestion and computes several performance ratios on the York Pension Plan portfolio to discuss with Lane. The performance figures are included in the following table. Note that the minimum acceptable return is the risk-free rate.
Figure 3: Performance Ratios for the York Pension Plan


Using the performance evaluation information compiled by Dennon, determine which of the following statements is most likely correct with regard to the York Pension Plan. Over the last three years, the:

Daniel Castillo and Ramon Diaz are chief investment officers at Advanced Advisors (AA), a boutique fixed- income firm based in the United States. AA employs numerous quantitative models to invest in both domestic and international securities.
During the week, Castillo and Diaz consult with one of their investors, Sally Michaels. Michaels currently holds a $10,000,000 fixed-income position that is selling at par. The maturity is 20 years, and the coupon rate of 7% is paid semiannually. Her coupons can be reinvested at 8%. Castillo is looking at various interest rate change scenarios, and one such scenario is where the interest rate on the bonds immediately changes to 8%.
Diaz is considering using a repurchase agreement to leverage Michaels's portfolio. Michaels is concerned, however, with not understanding the factors that impact the interest rate, or repo rate, used in her strategy. In response, Castillo explains the factors that affect the repo rate and makes the following statements:
1. "The repo rate is directly related to the maturity of the repo, inversely related to the quality of the collateral, and directly related to the maturity of the collateral. U.S. Treasury bills are often purchased by Treasury dealers using repo transactions, and since they have high liquidity, short maturities, and no default risk, the repo rate is usually quite low. "
2. "The greater control the lender has over the collateral, the lower the repo rate. If the availability of the collateral is limited, the repo rate will be higher."
Castillo consults with an institutional investor, the Washington Investment Fund, on the effect of leverage on bond portfolio returns as well as their bond portfolio's sensitivity to changes in interest rates. The portfolio under discussion is well diversified, with small positions in a large number of bonds. It has a duration of 7.2. Of the
$200 million value of the portfolio, $60 million was borrowed. The duration of borrowed funds is 0.8. The expected return on the portfolio is 8% and the cost of borrowed funds is 3%.
The next day, the chief investment officer for the Washington Investment Fund expresses her concern about the risk of their portfolio, given its leverage. She inquires about the various risk measures for bond portfolios. In response, Diaz distinguishes between the standard deviation and downside risk measures, making the following statements:
1. ''Portfolio managers complain that using variance to calculate Sharpe ratios is inappropriate. Since it considers all returns over the entire distribution, variance and the resulting standard deviation are artificially inflated, so the resulting Sharpe ratio is artificially deflated. Since it is easily calculated for bond portfolios, managers feci a more realistic measure of risk is the semi-variance, which measures the distribution of returns below a given return, such as the mean or a hurdle rate."
2. "A shortcoming of VAR is its inability to predict the size of potential losses in the lower tail of the expected return distribution. Although it can assign a probability to some maximum loss, it does not predict the actual loss if the maximum loss is exceeded. If Washington Investment Fund is worried about catastrophic loss, shortfall risk is a more appropriate measure, because it provides the probability of not meeting a target return."
AA has a corporate client, Shaifer Materials with a €20,000,000 bond outstanding that pays an annual fixed coupon rate of 9.5% with a 5-year maturity. Castillo believes that euro interest rates may decrease further within the next year below the coupon rate on the fixed rate bond. Castillo would like Shaifer to issue new debt at a lower euro interest rate in the future. Castillo has, however, looked into the costs of calling the bonds and has found that the call premium is quite high and that the investment banking costs of issuing new floating rate debt would be quite steep. As such he is considering using a swaption to create a synthetic refinancing of the bond at a lower cost than an actual refinancing of the bond. He states that in order to do so, Shaifer should buy a payer swaption, which would give them the option to pay a lower floating interest rate if rates drop.
Diaz retrieves current market data for payer and receiver swaptions with a maturity of one year. The terms of each instrument are provided below:
Payer swaption fixed rate7.90% Receiver swaption fixed rate7.60% Current Euribor7.20%
Projected Euribor in one year5.90%
Diaz states that, assuming Castillo is correct, Shaifer can exercise a swaption in one year to effectively call in their old fixed rate euro debt paying 9.5% and refinance at a floating rate, which would be 7.5% in one year.

Calculated in bond equivalent yield terms, Michacls's return over the next year, if interest rates change as expected, is closest to:

Daniel Castillo and Ramon Diaz are chief investment officers at Advanced Advisors (AA), a boutique fixed- income firm based in the United States. AA employs numerous quantitative models to invest in both domestic and international securities.
During the week, Castillo and Diaz consult with one of their investors, Sally Michaels. Michaels currently holds a $10,000,000 fixed-income position that is selling at par. The maturity is 20 years, and the coupon rate of 7% is paid semiannually. Her coupons can be reinvested at 8%. Castillo is looking at various interest rate change scenarios, and one such scenario is where the interest rate on the bonds immediately changes to 8%.
Diaz is considering using a repurchase agreement to leverage Michaels's portfolio. Michaels is concerned, however, with not understanding the factors that impact the interest rate, or repo rate, used in her strategy. In response, Castillo explains the factors that affect the repo rate and makes the following statements:
1. "The repo rate is directly related to the maturity of the repo, inversely related to the quality of the collateral, and directly related to the maturity of the collateral. U.S. Treasury bills are often purchased by Treasury dealers using repo transactions, and since they have high liquidity, short maturities, and no default risk, the repo rate is usually quite low. "
2. "The greater control the lender has over the collateral, the lower the repo rate. If the availability of the collateral is limited, the repo rate will be higher."
Castillo consults with an institutional investor, the Washington Investment Fund, on the effect of leverage on bond portfolio returns as well as their bond portfolio's sensitivity to changes in interest rates. The portfolio under discussion is well diversified, with small positions in a large number of bonds. It has a duration of 7.2. Of the
$200 million value of the portfolio, $60 million was borrowed. The duration of borrowed funds is 0.8. The expected return on the portfolio is 8% and the cost of borrowed funds is 3%.
The next day, the chief investment officer for the Washington Investment Fund expresses her concern about the risk of their portfolio, given its leverage. She inquires about the various risk measures for bond portfolios. In response, Diaz distinguishes between the standard deviation and downside risk measures, making the following statements:
1. ''Portfolio managers complain that using variance to calculate Sharpe ratios is inappropriate. Since it considers all returns over the entire distribution, variance and the resulting standard deviation are artificially inflated, so the resulting Sharpe ratio is artificially deflated. Since it is easily calculated for bond portfolios, managers feci a more realistic measure of risk is the semi-variance, which measures the distribution of returns below a given return, such as the mean or a hurdle rate."
2. "A shortcoming of VAR is its inability to predict the size of potential losses in the lower tail of the expected return distribution. Although it can assign a probability to some maximum loss, it does not predict the actual loss if the maximum loss is exceeded. If Washington Investment Fund is worried about catastrophic loss, shortfall risk is a more appropriate measure, because it provides the probability of not meeting a target return."
AA has a corporate client, Shaifer Materials with a €20,000,000 bond outstanding that pays an annual fixed coupon rate of 9.5% with a 5-year maturity. Castillo believes that euro interest rates may decrease further within the next year below the coupon rate on the fixed rate bond. Castillo would like Shaifer to issue new debt at a lower euro interest rate in the future. Castillo has, however, looked into the costs of calling the bonds and has found that the call premium is quite high and that the investment banking costs of issuing new floating rate debt would be quite steep. As such he is considering using a swaption to create a synthetic refinancing of the bond at a lower cost than an actual refinancing of the bond. He states that in order to do so, Shaifer should buy a payer swaption, which would give them the option to pay a lower floating interest rate if rates drop.
Diaz retrieves current market data for payer and receiver swaptions with a maturity of one year. The terms of each instrument are provided below:
Payer swaption fixed rate7.90% Receiver swaption fixed rate7.60% Current Euribor7.20%
Projected Euribor in one year5.90%
Diaz states that, assuming Castillo is correct, Shaifer can exercise a swaption in one year to effectively call in their old fixed rate euro debt paying 9.5% and refinance at a floating rate, which would be 7.5% in one year.
Determine whether each of Castillo's statements about repos is correct or incorrect.

Daniel Castillo and Ramon Diaz are chief investment officers at Advanced Advisors (AA), a boutique fixed- income firm based in the United States. AA employs numerous quantitative models to invest in both domestic and international securities.
During the week, Castillo and Diaz consult with one of their investors, Sally Michaels. Michaels currently holds a $10,000,000 fixed-income position that is selling at par. The maturity is 20 years, and the coupon rate of 7% is paid semiannually. Her coupons can be reinvested at 8%. Castillo is looking at various interest rate change scenarios, and one such scenario is where the interest rate on the bonds immediately changes to 8%.
Diaz is considering using a repurchase agreement to leverage Michaels's portfolio. Michaels is concerned, however, with not understanding the factors that impact the interest rate, or repo rate, used in her strategy. In response, Castillo explains the factors that affect the repo rate and makes the following statements:

1. "The repo rate is directly related to the maturity of the repo, inversely related to the quality of the collateral, and directly related to the maturity of the collateral. U.S. Treasury bills are often purchased by Treasury dealers using repo transactions, and since they have high liquidity, short maturities, and no default risk, the repo rate is usually quite low. "
2. "The greater control the lender has over the collateral, the lower the repo rate. If the availability of the collateral is limited, the repo rate will be higher."
Castillo consults with an institutional investor, the Washington Investment Fund, on the effect of leverage on bond portfolio returns as well as their bond portfolio's sensitivity to changes in interest rates. The portfolio under discussion is well diversified, with small positions in a large number of bonds. It has a duration of 7.2. Of the
$200 million value of the portfolio, $60 million was borrowed. The duration of borrowed funds is 0.8. The expected return on the portfolio is 8% and the cost of borrowed funds is 3%.
The next day, the chief investment officer for the Washington Investment Fund expresses her concern about the risk of their portfolio, given its leverage. She inquires about the various risk measures for bond portfolios. In response, Diaz distinguishes between the standard deviation and downside risk measures, making the following statements:
1. ''Portfolio managers complain that using variance to calculate Sharpe ratios is inappropriate. Since it considers all returns over the entire distribution, variance and the resulting standard deviation are artificially inflated, so the resulting Sharpe ratio is artificially deflated. Since it is easily calculated for bond portfolios, managers feci a more realistic measure of risk is the semi-variance, which measures the distribution of returns below a given return, such as the mean or a hurdle rate."
2. "A shortcoming of VAR is its inability to predict the size of potential losses in the lower tail of the expected return distribution. Although it can assign a probability to some maximum loss, it does not predict the actual loss if the maximum loss is exceeded. If Washington Investment Fund is worried about catastrophic loss, shortfall risk is a more appropriate measure, because it provides the probability of not meeting a target return."
AA has a corporate client, Shaifer Materials with a €20,000,000 bond outstanding that pays an annual fixed coupon rate of 9.5% with a 5-year maturity. Castillo believes that euro interest rates may decrease further within the next year below the coupon rate on the fixed rate bond. Castillo would like Shaifer to issue new debt at a lower euro interest rate in the future. Castillo has, however, looked into the costs of calling the bonds and has found that the call premium is quite high and that the investment banking costs of issuing new floating rate debt would be quite steep. As such he is considering using a swaption to create a synthetic refinancing of the bond at a lower cost than an actual refinancing of the bond. He states that in order to do so, Shaifer should buy a payer swaption, which would give them the option to pay a lower floating interest rate if rates drop.
Diaz retrieves current market data for payer and receiver swaptions with a maturity of one year. The terms of each instrument are provided below:
Payer swaption fixed rate7.90% Receiver swaption fixed rate7.60% Current Euribor7.20%
Projected Euribor in one year5.90%
Diaz states that, assuming Castillo is correct, Shaifer can exercise a swaption in one year to effectively call in their old fixed rate euro debt paying 9.5% and refinance at a floating rate, which would be 7.5% in one year.
The return on the Washington Investment Fund portfolio is closest to: