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Total 365 Questions | Updated On: Nov 18, 2024

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Question 1

Smiler Industries is a U.S. manufacturer of machine tools and other capital goods. Dat Ng, the CFO of Smiler,

feels strongly that Smiler has a competitive advantage in its risk management practices. With this in mind, Ng

hedges many of the risks associated with Smiler's financial transactions, which include those of a financial

subsidiary. Ng's knowledge of derivatives is extensive, and he often uses them for hedging and in managing

Srniler's considerable investment portfolio.

Smiler has recently completed a sale to Frexa in Italy, and the receivable is denominated in euros. The

receivable is €10 million to be received in 90 days. Srniler's bank provides the following information:

Smiler borrows short-term funds to meet expenses on a temporary basis and typically makes semiannual

interest payments based on 180-day LIBOR plus a spread of 150 bp. Smiler will need to borrow S25 million in

90 days to invest in new equipment. To hedge the interest rate risk on the loan, Ng is considering the purchase

of a call option on 180-day LIBOR with a term to expiration of 90 days, an exercise rate of 4.8%, and a premium

of 0.000943443 of the loan amount. Current 90-day LIBOR is 4.8%.

Smiler also has a diversified portfolio of large cap stocks with a current value of $52,750,000, and Ng wants to

lower the beta of the portfolio from its current level of 1.25 to 0.9 using S&P 500 futures which have a multiplier

of 250. The S&P 500 is currently 1,050, and the futures contract exhibits a beta of 0.98 to the underlying.

Because Ng intends to replace the short-term LIBOR-based loan with long-term financing, he wants to hedge

the risk of a 50 bp change in the market rate of the 20-year bond Smiler will issue in 270 days. The current

spread to Treasuries for Smiler's corporate debt is 2.4%. He will use a 270-day, 20-year Treasury bond futures

contract ($100,000 face value) currently priced at 108.5 for the hedge. The CTD bond for the contract has a

conversion factor of 1.259 and a dollar duration of $6,932.53. The corporate bond, if issued today, would have

an effective duration of 9.94 and has an expected effective duration at issuance of 9.90 based on a constant

spread assumption. A regression of the YTM of 20-year corporate bonds with a rating the same as Smiler's on

the YTM of the CTD bond yields a beta of 1.05.

If Ng purchases the interest rate call, and 180-day LIBOR at option expiration is 5.73%, the annualized effective

rate for the 180-day loan is closest to:

A : 6.6982%.

B : 6.5346%.

C : 6.3785%

Answer: A

Question 2

Matrix Corporation is a multidivisional company with operations in energy, telecommunications, and shipping.

Matrix sponsors a traditional defined benefit pension plan. Plan assets are valued at $5.5 billion, while recent

declines in interest rates have caused plan liabilities to balloon to $8.3 billion. Average employee age at Matrix

is 57.5, which is considerably higher than the industry average, and the ratio of active to retired lives is 1.1. Joe

Elliot, Matrix's CFO, has made the following statement about the current state of the pension plan.

"Recent declines in interest rates have caused our pension liabilities to grow faster than ever experienced in our

long history, but I am sure these low rates are temporary. I have looked at the charts and estimated the

probability of higher interest rates at more than 90%. Given the expected improvement in interest rate levels,

plan liabilities will again come back into line with our historical position. Our investment policy will therefore be

to invest plan assets in aggressive equity securities. This investment exposure will bring our plan to an overfunded status, which will allow us to use pension income to bolster our profitability."

A : Critique Elliot's statement with respect to investing Matrix's plan assets by addressing the following threepoints:

B : Behavioral characteristic exhibited.ii. Plan risk and return objectives.iii. Using pension plan income to bolster firm profitability.

C : Based on the information provided, formulate a return objective and a risk objective for the MatrixCorporation pension plan. (No calculations required.)Template for Question 2-B

D : Based on the information provided, formulate an appropriate constraints section for the investment policystatement for the pension fund.Template for Question 2-C

Answer: A

Question 3

Joan Nicholson, CFA, and Kim Fluellen, CFA, sit on the risk management committee for Thomasville Asset

Management. Although Thomasville manages the majority of its investable assets, it also utilizes outside firms

for special situations such as market neutral and convertible arbitrage strategies. Thomasville has hired a

hedge fund, Boston Advisors, for both of these strategies. The managers for the Boston Advisors funds are

Frank Amato, CFA, and Joseph Garvin, CFA. Amato uses a market neutral strategy and has generated a return

of S20 million this year on the $100 million Thomasville has invested with him. Garvin uses a convertible

arbitrage strategy and has lost $15 million this year on the $200 million Thomasville has invested with him, with

most of the loss coming in the last quarter of the year. Thomasville pays each outside manager an incentive fee

of 20% on profits. During the risk management committee meeting Nicholson evaluates the characteristics of

the arrangement with Boston Advisors. Nicholson states that the asymmetric nature of Thomasville's contract

with Boston Advisors creates adverse consequences for Thomasville's net profits and that the compensation

contract resembles a put option owned by Boston Advisors.

Upon request, Fluellen provides a risk assessment for the firm's large cap growth portfolio using a monthly

dollar VAR. To do so, Fluellen obtains the following statistics from the fund manager. The value of the fund is

$80 million and has an annual expected return of 14.4%. The annual standard deviation of returns is 21.50%.

Assuming a standard normal distribution, 5% of the potential portfolio values are 1.65 standard deviations

below the expected return.

Thomasville periodically engages in options trading for hedging purposes or when they believe that options are

mispriced. One of their positions is a long position in a call option for Moffett Corporation. The option is a

European option with a 3-month maturity. The underlying stock price is $27 and the strike price of the option is

$25. The option sells for S2.86. Thomasville has also sold a put on the stock of the McNeill Corporation. The

option is an American option with a 2-month maturity. The underlying stock price is $52 and the strike price of

the option is $55. The option sells for $3.82. Fluellen assesses the credit risk of these options to Thomasville

and states that the current credit risk of the Moffett option is $2.86 and the current credit risk of the McNeill

option is $3.82.

Thomasville also uses options quite heavily in their Special Strategies Portfolio. This portfolio seeks to exploit

mispriced assets using the leverage provided by options contracts. Although this fund has achieved some

spectacular returns, it has also produced some rather large losses on days of high market volatility. Nicholson

has calculated a 5% VAR for the fund at $13.9 million. In most years, the fund has produced losses exceeding

$13.9 million in 13 of the 250 trading days in a year, on average. Nicholson is concerned about the accuracy of

the estimated VAR because when the losses exceed $13.9 million, they are typically much greater than $13.9

million.

In addition to using options, Thomasville also uses swap contracts for hedging interest rate risk and currency

exposures. Fluellen has been assigned the task of evaluating the credit risk of these contracts. The

characteristics of the swap contracts Thomasville uses are shown in Figure 1.

Fluellen later is asked to describe credit risk in general to the risk management committee. She states that

cross-default provisions generally protect a creditor because they prevent a debtor from declaring immediate

default on the obligation owed to the creditor when the debtor defaults on other obligations. Fluellen also states

that credit risk and credit VAR can be quickly calculated because bond rating firms provide extensive data on

the defaults for investment grade and junk grade corporate debt at reasonable prices.

Which of the following best describes the accuracy of the VAR measure calculated for the Special Strategies

Portfolio?

A : It is accurate but should be supplemented with scenario analysis.

B : It is accurate and provides a complete measure of the fund's risk.

C : It is inaccurate and should be supplemented with comprehensive stress testing.

Answer: C

Question 4

Dakota Watson and Anthony Smith are bond portfolio managers for Northern Capital Investment Advisors,

which is based in the U.S. Northern Capital has $2,000 million under management, with S950 million of that in

the bond market. Northern Capital's clients are primarily institutional investors such as insurance companies,

foundations, and endowments. Because most clients insist on a margin over the relevant bond benchmark,

Watson and Smith actively manage their bond portfolios, while at the same time trying to minimize tracking

error.

One of the funds that Northern Capital offers invests in emerging market bonds. An excerpt from its prospectus

reveals the following fund objectives and strategies:

“The fund generates a return by constructing a portfolio using all major fixed-income sectors within the Asian

region (except Japan) with a bias towards non-government bonds. The fund makes opportunistic investments

in both investment grade and high yield bonds. Northern Capital analysts seek those bond issues that are

expected to outperform U.S. bonds with similar credit risk, interest rate risk, and liquidity risk-Value is added by

finding those bonds that have been overlooked by other developed world bond funds. The fund favors nondollar, local currency denominated securities to avoid the default risk associated with a lack of hard currency on

the part of issuer."

Although Northern Capital does examine the availability of excess returns in foreign markets by investing

outside the index in these markets, most of its strategies focus on U.S. bonds and spread analysis of them.

Discussing the analysis of spreads in the U.S. bond market, Watson comments on the usefulness of the option

adjusted spread and the swap spread and makes the following statements:

Statement 1: Due to changes in the structure of the primary bond market in the U.S., the option adjusted

spread is increasingly valuable for analyzing the attractiveness of bond investments.

Statement 2: The advantage of the swap spread framework is that investors can compare the relative

attractiveness of fixed-rate and floating-rate bond markets.

Watson's view of the U.S. economy is decidedly bearish. She is concerned that the recent withdrawal of liquidity

from the U.S. financial system will result in a U.S. recession, possibly even a depression. She forecasts that

interest rates in the U.S. will continue to fall as the demand for loanable funds declines with the lack of business

investment. Meanwhile, she believes that the Federal Reserve will continue to keep short-term rates low in

order to stimulate the economy. Although she sees the level of yields declining, she believes that the spread on

risky securities will increase due to the decline in business prospects. She therefore has reallocated her bond

portfolio away from high-yield bonds and towards investment grade bonds.

Smith is less decided about the economy. However, his trading strategy has been quite successful in the past.

As an example of his strategy, he recently sold a 20-year AA-rated $50,000 Mahan Corporation bond with a

7.75% coupon that he had purchased at par. With the proceeds, he then bought a newly issued A-rated Quincy

Corporation bond that offered an 8.25% coupon. By swapping the first bond for the second bond, he enhanced

his annual income, which he considers quite favorable given the declining yields in the market.

Watson has become quite interested in the mortgage market. With the anticipated decline in interest rates, she

expects that the yields on mortgages will decline. As a result, she has reallocated the portion of Northern

Capital's bond portfolio dedicated to mortgages. She has shifted the holdings from 8.50% coupon mortgages to

7.75% coupon mortgages, reasoning that if interest rates do drop, the lower coupon mortgages will rise in price

more than the higher coupon mortgages. She identifies this trade as a structure trade.

Smith is examining the liquidity of three bonds. Their characteristics are listed in the table below:

Which of the following best describes the relative value analysis used in the Northern Capita! Emerging market

bond fund? It is a:

A : top-down approach.

B : bottom-up approach.

C : combination of a top-down approach and a bottom-up approach.

Answer: B

Question 5

Dan Draper, CFA is a portfolio manager at Madison Securities. Draper is analyzing several portfolios which

have just been assigned to him. In each case, there is a clear statement of portfolio objectives and constraints,

as welt as an initial strategic asset allocation. However, Draper has found that all of the portfolios have

experienced changes in asset values. As a result, the current allocations have drifted away from the initial

allocation. Draper is considering various rebalancing strategies that would keep the portfolios in line with their

proposed asset allocation targets.

Draper spoke to Peter Sterling, a colleague at Madison, about calendar rebalancing. During their conversation,

Sterling made the following comments:

Comment 1: Calendar rebalancing will be most efficient when the rebalancing frequency considers the volatility

of the asset classes in the portfolio.

Comment 2: Calendar rebalancing on an annual basis will typically minimize market impact relative to more

frequent rebalancing.

Draper believes that a percentage-of-portfolio rebalancing strategy will be preferable to calendar rebalancing,

but he is uncertain as to how to set the corridor widths to trigger rebalancing for each asset class. As an

example, Draper is evaluating the Rogers Corp. pension plan, whose portfolio is described in Figure 1.

Draper has been reviewing Madison files on four high net worth individuals, each of whom has a $1 million

portfolio. He hopes to gain insight as to appropriate rebalancing strategies for these clients. His research so far

shows:

Client A is 60 years old, and wants to be sure of having at least $800,000 upon his retirement. His risk tolerance

drops dramatically whenever his portfolio declines in value. He agrees with the Madison stock market outlook,

which is for a long-term bull market with few reversals.

Client B is 35 years old and wants to hold stocks regardless of the value of her portfolio. She also agrees with

the Madison stock market outlook.

Client C is 40 years old, and her absolute risk tolerance varies proportionately with the value of her portfolio.

She does not agree with the Madison stock market outlook, but expects a choppy stock market, marked by

numerous reversals, over the coming months.

In selecting a rebalancing strategy for his clients, Draper would most likely select a constant mix strategy for:

A : Client A.

B : Client B.

C : Client C.

Answer: C

Page: 1 / 73

Total 365 Questions | Updated On: Nov 18, 2024

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