QUESTION: 193 Exam Topic: Alternative Assets

Ellen Truxel is the principal at Truxel Investment Management. Her firm uses bonds for income enhancement as well as capital gains. She occasionally uses sector quality bets and yield curve positioning to exploit her beliefs on the relative changes in sector credit quality and the direction of interest rates. She has recently hired John Timberlake to assist her in preparing data for the analysis of bond portfolios. Timberlake is a recent graduate of an outstanding undergraduate program in finance.
Truxel is considering investing in international bonds, as this is an arena she has previously ignored. During conversations, Truxel says it is her understanding that changes in international bond markets have made it easier to manage the duration of an international bond portfolio. Timberlake notes that the European Monetary Union has increased the availability of corporate bonds, making it easier to rotate across sectors.
In the domestic arena, Truxel is considering constructing a portfolio that matches the index on quality, call, sector, and cash flow dimensions and tilts the portfolio duration small amounts to take advantage of predictions of yield curve shifts. She states that this would be referred to as enhanced indexing with minor mismatches.
Timberlake tells her that the most important determinant of her performance relative to other bond managers will be her ability to perform credit analysis.
Truxel then tells Timberlake that before they venture into new areas, she wants him to prepare an analysis of their current positions. Timberlake obliges and presents the following data on Truxel’s current portfolio.

In evaluating relative valuation methodologies, which of the following rationales for trading in the secondary bond market is least appropriate?

Cash flow reinvestment.
New issue swaps.
Seasonality.

Answer(s): C

Explanation:

The following are rationales for trading in the secondary bond market:
• Yield/spread pickup trades.
• Credit-upside trades.
• Credit-defense trades.
• New issue swaps.
• Sector-rotation trades.
• Curve-adjustment trades.
• Structure trades.
• Cash flow reinvestment.
Seasonality is a secondary trading constraint (i.e., reason for not trading). (Study Session 10, LOS30.e)

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QUESTION: 194 Exam Topic: Alternative Assets

Mark Rolle, CFA, is the manager of the international bond fund for the Ryder Investment Advisory. He is responsible for bond selection as well as currency hedging decisions. His assistant is Joanne Chen, a candidate for the Level 1 CFA exam.
Rolle is interested in the relationship between interest rates and exchange rates for Canada and Great Britain. He observes that the spot exchange rate between the Canadian dollar (C$) and the British pound is C$1.75/£. Also, the 1-year interest rate in Canada is 4.0% and the 1-year interest rate in Great Britain is 11.0%. The current 1-year forward rate is C$1.60/£.
Rolle is evaluating the bonds from the Knauff company and the Tatehiki company, for which information is provided in the table below. The Knauff company bond is denominated in euros and the Tatehiki company bond is denominated in yen. The bonds have similar risk and maturities, and Ryder's investors reside in the United States.

Provided this information, Rolle must decide which country's bonds are most attractive if a forward hedge of currency exposure is used. Furthermore, assuming that both country's bonds are bought, Rolle must also decide whether or not to hedge the currency exposure.
Rolle also has a position in a bond issued in Korea and denominated in Korean won. Unfortunately, he is having difficulty obtaining a forward contract for the won on favorable terms. As an alternative hedge, he has entered a forward contract that allows him to sell yen in one year, when he anticipates liquidating his Korean bond. His reason for choosing the yen is that it is positively correlated with the won.
One of Ryder's services is to provide consulting advice to firms that are interested in interest rate hedging strategies. One such firm is Crawfordville Bank. One of the loans Crawfordville has outstanding has an interest rate of LIBOR plus a spread of 1.5%. The chief financial officer at Crawfordville is worried that interest rates may increase and would like to hedge this exposure. Rolle is contemplating either an interest rate cap or an interest rate floor as a hedge.
Additionally, Rolle is analyzing the best hedge for Ryder's portfolio of fixed rate coupon bonds. Rolle is contemplating using either a covered call or a protective put on a T-bond futures contract.

Given the current forward rate of C$1.60/£ what is the exact forward premium or discount for the £ against the C$?

-9.37%.
-8.57%.
8.57%.

Answer(s): B

Explanation:

Because interest rates are higher in Great Britain, we know by covered interest rate parity that its currency must trade at a forward discount. To determine the exact forward discount, we calculate a simple percentage change using the formula:
fd,f= F- S0S0 where:fd,f = forward premium or discount for currency f in terms of dF = forward rateS0 = spot rate
In the formula, be sure to put the currency that you want to make a statement about (whether it is at a premium or discount) in the denominator. Here we are discussing the £.
fd,f= C$1.60-C$1.75C$1.75=8.75%
So the British pound is trading at an 8.57% forward discount relative to the Canadian dollar. Note: Since the current l-year rates in Great Britain and Canada are 11% and 4%, respectively, we would expect the £ to depreciate relative to the $C (Study Session 10, LOS 31.i)

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QUESTION: 195 Exam Topic: Alternative Assets

Mark Rolle, CFA, is the manager of the international bond fund for the Ryder Investment Advisory. He is responsible for bond selection as well as currency hedging decisions. His assistant is Joanne Chen, a candidate for the Level 1 CFA exam.
Rolle is interested in the relationship between interest rates and exchange rates for Canada and Great Britain. He observes that the spot exchange rate between the Canadian dollar (C$) and the British pound is C$1.75/£. Also, the 1-year interest rate in Canada is 4.0% and the 1-year interest rate in Great Britain is 11.0%. The current 1-year forward rate is C$1.60/£.
Rolle is evaluating the bonds from the Knauff company and the Tatehiki company, for which information is provided in the table below. The Knauff company bond is denominated in euros and the Tatehiki company bond is denominated in yen. The bonds have similar risk and maturities, and Ryder's investors reside in the United States.

Provided this information, Rolle must decide which country's bonds are most attractive if a forward hedge of currency exposure is used. Furthermore, assuming that both country's bonds are bought, Rolle must also decide whether or not to hedge the currency exposure.
Rolle also has a position in a bond issued in Korea and denominated in Korean won. Unfortunately, he is having difficulty obtaining a forward contract for the won on favorable terms. As an alternative hedge, he has entered a forward contract that allows him to sell yen in one year, when he anticipates liquidating his Korean bond. His reason for choosing the yen is that it is positively correlated with the won.
One of Ryder's services is to provide consulting advice to firms that are interested in interest rate hedging strategies. One such firm is Crawfordville Bank. One of the loans Crawfordville has outstanding has an interest rate of LIBOR plus a spread of 1.5%. The chief financial officer at Crawfordville is worried that interest rates may increase and would like to hedge this exposure. Rolle is contemplating either an interest rate cap or an interest rate floor as a hedge.
Additionally, Rolle is analyzing the best hedge for Ryder's portfolio of fixed rate coupon bonds. Rolle is contemplating using either a covered call or a protective put on a T-bond futures contract.

What must the 1-year forward exchange rate be between the CS and Great Britain's currency (£) so that no arbitrage opportunities are available?

0.6364 C$ per £.
1.6396 C$ per £.
1.8510 C$ per £.

Answer(s): B

Explanation:

Covered interest arbitrage will assure that the forward rate given by the interest rate parity relationship will prevail. The interest rate parity condition that expresses the relationship between the Canadian dollar and the British pound is expressed as follows:
where:F = forward exchange rate between the Canadian dollar and British poundSO = spot exchange rate between Canadian dollars and the British poundCd = the cash rate in the domestic currency (here the Canadian dollar)Cf = the cash rate in the foreign currency (here the British pound)
Using the information provided and covered interest rate parity, the forward exchange rate between C$ and £ must be:
FC$,£ = 1.75 [(1 +0.04)/(I +0.11)] = 1.6396 C$/£
(Study Session 10, LOS 31.i)

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QUESTION: 196 Exam Topic: Alternative Assets

Mark Rolle, CFA, is the manager of the international bond fund for the Ryder Investment Advisory. He is responsible for bond selection as well as currency hedging decisions. His assistant is Joanne Chen, a candidate for the Level 1 CFA exam.
Rolle is interested in the relationship between interest rates and exchange rates for Canada and Great Britain. He observes that the spot exchange rate between the Canadian dollar (C$) and the British pound is C$1.75/£. Also, the 1-year interest rate in Canada is 4.0% and the 1-year interest rate in Great Britain is 11.0%. The current 1-year forward rate is C$1.60/£.
Rolle is evaluating the bonds from the Knauff company and the Tatehiki company, for which information is provided in the table below. The Knauff company bond is denominated in euros and the Tatehiki company bond is denominated in yen. The bonds have similar risk and maturities, and Ryder's investors reside in the United States.

Provided this information, Rolle must decide which country's bonds are most attractive if a forward hedge of currency exposure is used. Furthermore, assuming that both country's bonds are bought, Rolle must also decide whether or not to hedge the currency exposure.
Rolle also has a position in a bond issued in Korea and denominated in Korean won. Unfortunately, he is having difficulty obtaining a forward contract for the won on favorable terms. As an alternative hedge, he has entered a forward contract that allows him to sell yen in one year, when he anticipates liquidating his Korean bond. His reason for choosing the yen is that it is positively correlated with the won.
One of Ryder's services is to provide consulting advice to firms that are interested in interest rate hedging strategies. One such firm is Crawfordville Bank. One of the loans Crawfordville has outstanding has an interest rate of LIBOR plus a spread of 1.5%. The chief financial officer at Crawfordville is worried that interest rates may increase and would like to hedge this exposure. Rolle is contemplating either an interest rate cap or an interest rate floor as a hedge.
Additionally, Rolle is analyzing the best hedge for Ryder's portfolio of fixed rate coupon bonds. Rolle is contemplating using either a covered call or a protective put on a T-bond futures contract.

Assuming Rolle uses forward contracts to hedge the currency risk of the bond investment, determine which bond is the better investment.

The Knauff bond because its return is 8.0%.
The Tatehiki bond because its excess return is 4.0%.
The Knauff bond because its excess currency return is 3.2%.

Answer(s): B

Explanation:

Rolle should recommend investment in the Tatehiki bond if a hedged position will be taken. The easiest way to make this determination is to examine their excess returns, which is the bond return minus the risk-free rate in the foreign country.
The Knauff company bond return: 8.0% - 5-0% = 3.0%.The Tatehiki company bond return: 6.0% - 2.0% = 4.0%. Note that we assume both bonds have similar risk and maturities so the decision is based solely on the returns. (Study Session 10, LOS 31.i)

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