Free CFA-Level-III Exam Braindumps
CFA Level III Chartered Financial Analyst Questions 186–190 (page: 39)

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.

Regarding the statements made by Diaz about downside risk measures, are the statements correct?

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.
Regarding their statements concerning the synthetic refinancing of the Shaifer Materials fixed rate euro debt, are the comments correct?

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.


Regarding the conversation on the attributes of international bond investing, are Truxel and Timberlake correct or incorrect?

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.


Regarding the conversation on domestic bond portfolio management, are Truxel and Timberlake correct or incorrect?

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.


Given a parallel shift in the yield curve of 60 basis points for Treasury yields, the approximate percent change in the value of the Truxcl portfolio is closest to: