FIXED INCOME: CFA LEVEL I Fixed Income II - Problem Solving Session Harvard Extension School MGMT...

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L I Fixed Income II -

Problem Solving Session

Harvard Extension SchoolMGMT E-2900b

CFA Exam Level IMarch 30, 2010

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Rich GibbleLecturer

Tray SpilkerTeaching Assistant

Fixed Income I Problem Solving Session

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L I Fixed Income II:

Risks Associated with Bonds

Study Session 15Reading 61

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1. A 6.25% yielding bond, with a duration of 2.5 is trading at $101.50. If the yield increases to 6.84%, the bond’s new price is closest to:

A. $103.00B. $100.00C. $101.50

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1. A 6.25% yielding bond, with a duration of 2.5 is trading at $101.50. If the yield increases to 6.84%, the bond’s new price is closest to:

A. $103.00B. $100.00C. $101.50

% ∆ in bond price = – (dur. x % ∆ in yield) -1.475% = – [2.5(6.84% - 6.25%)] $101.50 [1+ (– 1.475%)] ≈ $100

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2. If interest rate volatility increases, which of the following bonds will experience a price increase?

A. A straight coupon bondB. A putable bondC. A callable bond

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2. Explained: An increase in volatility increases

the value of an option. The option of a callable bond is held by the issuer, thus the bond price falls as volatility increases. Conversely, putable bonds increase in value because the owner of the option is the bondholder.

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Price-Yield Curve for a Callable Bond

Price-Yield Curve for a Putable Bond

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3. An option-free, zero-coupon, 10-year AA-rated bond, yielding 7% is most likely to have ______ risk, and least likely to have ______ risk:

A. default, inflationB. interest rate, reinvestmentC. reinvestment, interest rate

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3. Explained: Zero-coupon bonds have no

reinvestment risk given their lack of reinvestable cash flows prior to maturity. They are more prone, however, to interest rate risk given their longer duration sensitivities. While a AA-rated bond has some default risk, it is relatively small.

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4. Which of the following has the least interest rate risk?

A. A 4%, 5-year option-free bond paying 3%

B. A 4%, 5-year putable bond paying 3%C. A 4%, 5-year option-free bond paying

5%

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4. Which of the following has the least interest rate risk?

A. A 4%, 5-year option-free bond paying 3%B. A 4%, 5-year putable bond paying 3%C. A 4%, 5-year option-free bond paying 5%

Embedded options reduce the duration of a bond, and thus interest rate risk. Lower yielding straight bonds are subject to higher interest rate risks than higher yielding straight bonds.

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5. Which of the following durations most closely matches that of a bond quoted at 98:16, whose value falls to 95:29 if rates rise by 75bps?

A. 3.5B. 4.0C. 4.5

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5. Which of the following durations most closely matches that of a bond quoted at 98:16, whose value falls to 95:29 if rates rise by 75bps?

A. 3.5B. 4.0C. 4.5

Duration = – (% ∆ in price / % yield ∆); price and yield are inversely correlated.

95:29 = 95(29/32) = $95.90625 ≈ $95.9198:16 = 98(16/32) = $98.50

Duration = – [(95.91/98.50) – 1]/0.0075 = 3.506 ≈ 3.5

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6. A floating-rate bullet-bond will have the lowest duration:

A. one day after its reset dateB. one day before its reset dateC. the day after initial issuance

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6. A floating-rate bullet-bond will have the lowest duration:

A. one day after its reset dateB. one day before its reset dateC. the day after initial issuance

Duration of a floating-rate note is smallest just prior to its coupon payment/reset date. It’s largest duration , therefore, is just after each reset date.

–

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Questions 7-10:A straight 4% bond with five years to

maturity is quoted at $889.20 and has a duration of 4.52:

7. Which of the following values most closely matches the price change if interest rates fall by 1.5%?

A. $30.14B. -$60.29C. $60.29

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Questions 7-10:A straight 4% bond with five years to maturity

is quoted at $889.20 and has a duration of 4.52:

7. Which of the following values most closely matches the price change if interest rates fall by 1.5%?

A. $30.14

B. -$60.29

C. $60.29

$ Price ∆ = – [(Duration) x (% ∆ Yield) x (Bond Price)] = – [(4.52) x (–0.015) x ($889.20)] = $60.29

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Questions 7-10 (cont.):A straight 4% bond with five years to


8. What is the option value of a similar callable bond quoted at $810.12?

A. $79.08

B. -$79.08

C. $110.08

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8. What is the option value of a similar callable bond quoted at $810.12?

A. $79.08

B. -$79.08

C. $110.08

Call option value = $889.20 - $810.12

= $79.08

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9. What is the option value of a similar putable bond quoted at 100.67% of par?

A. $58.75

B. $117.50

C. -$58.75

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9. What is the option value of a similar putable bond quoted at 100.67% of par?

A. $58.75

B. $117.50

C. -$58.75

Put option value = $1006.70 - $889.20

= $117.50

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10.Compared to the straight bond, what will most likely happen to the price of a similar callable bond if interest rates rise?

A. Cannot be determine with given informationB. The price of the callable bond will fall more

than the price of the straight bondC. The price of the callable bond will fall less

than the price of the straight bond

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Price-Yield Curve for a Callable Bond

Y1 Y2

Ps1Ps2

Pc1Pc2

The price of an option-free bond falls more (Ps1 Ps2) than that of a callable bond (Pc1 Pc2) because the price of the embedded call option also declines.

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11. Which of the following attributes contributes to a security having more reinvestment risk:

1) prepayment option2) an amortizing security3) a coupon rate above the market rate4) a call feature

A. 1, 2, & 3B. 3 & 4C. 1, 2, 3, & 4

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Reinvestment Risk

Reinvestment risk refers to risk borne by the investor from having to reinvest cash flows from fixed income instruments at potentially lower yields.

Cash flows prior to the stated maturity from principle prepayments, amortizing securities, interest payments, and bond calls are subject to reinvestment risk.

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11. Which of the following bonds most likely has the lowest interest rate risk?

A. Zero-coupon bondB. A floating-rate bondC. A callable 5.5% fixed-coupon bond

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11. Which of the following bonds most likely has the lowest interest rate risk?

A. Zero-coupon bondB. A floating-rate bondC. A callable 5.5% fixed-coupon bond

A floating rate bond is subject to less interest rate risk as coupon payments are periodically reset (usually quarterly) and tied to interest rate indices (e.g., Libor). Duration is normally near zero.

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11. Portfolio duration is an approximation of the price sensitivity of a bond portfolio to a ______ shift in the yield curve. Yield curve risk refers to a ______ shift in the yield curve

A. parallel, non-parallelB. non-parallel, parallelC. parallel, parallel

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Yield Curve Risk: risk of decreases in portfolio value from changes in the shape of the yield curve; i.e., non-parallel curve shifts.

Yield

Maturity

non-parallel shift

parallel shift

Initial Yield Curve

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11. Which of the following is most likely to be considered an event risk for fixed income securities?

A. An increase in the federal funds rateB. An act of godC. A stock market crash

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Federal reserve actions and a market crashes are financial market related events, and thus, not considered event risks. Event risk encompasses risks outside of the financial markets like natural disasters, changes in regulation, and corporate events (e.g., M&A).

An ‘act of god’ is a legal term for events outside of human control, such as sudden floods or other natural disasters, for which no one can be held responsible.

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12. Which of the following has the least interest rate risk? The bond with a:

A. 2.5% coupon and 5-year maturityB. 3% coupon and 10-year maturityC. 3.5% coupon and 5-year maturity

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12. Which of the following has the least interest rate risk? The bond with a:

A. 2.5% coupon and 5-year maturityB. 3% coupon and 10-year maturityC. 3.5% coupon and 5-year maturity

Interest rate risk is directly related to a bond’s maturity (duration) and inversely related to a bond’s yield.

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13. Due to (1)_______ risk, investors demand (2)________ expected returns from (3)________?

(1) (2) (3)A. Credit Higher 10-Year Treasury

Notes

B.Exchange

Rate LowerA large-cap

emerging market company’s bonds

C. Liquidity Higher A U.S. mid-cap biotech company’s

bonds

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13. Due to (1)_______ risk, investors demand (2)________ expected returns from (3)________?

(1) (2) (3)A. Credit Higher 10-Year Treasury

notes

B.Exchange

Rate LowerA large-cap

emerging market company’s bonds

C. Liquidity Higher A U.S. mid-cap biotech company’s

bonds

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U.S. Treasuries are “risk free” and investors expect lower returns as a result.

Exchange rate risk increases risk, causing investors to demand higher expected returns.

An increase in liquidity risk causes investor’s to demand higher expected returns. A mid-cap biotech company’s bonds will exhibit lower liquidity versus bonds of a larger-cap company or U.S. Treasuries.

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14. Which of the following investments has the lowest liquidity risk?

A. Japanese Treasury notesB. Bonds from a U.S. mid-cap biotech

companyC. Bonds form a large-cap emerging

market company

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14. Which of the following investments has the lowest liquidity risk?

A. Japanese Treasury notesB. Bonds from a U.S. mid-cap biotech

companyC. Bonds form a large-cap emerging

market companyBid-ask spreads are an indication of liquidity; the wider the spread the lower the liquidity. When no price data is available, periodic valuation on illiquid securities is referred to as marking-to-market

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15. A 5-Year Treasury note is least likely to have _______, but most like to have________:

A. currency risk, credit riskB. volatility risk, reinvestment riskC. inflation risk, interest rate risk

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The Treasury note will most likely have the following risks: inflation, interest rate, reinvestment and currency risk (for non-domestic investors).

The Treasury note will most likely not have the following risks: volatility (applies to bonds with embedded options) and credit risk (risk free).

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16. An investor is considering a BB-rated bond but is concerned with the possibility that the market premium for this bond may widen against the Treasury yield curve. Which of the following most closely matches the risk the investor is referring to:

A. yield curve riskB. downgrade riskC. credit spread risk

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Credit Spread Risk: Uncertainty regarding a bond’s yield spread versus the treasury curve for a given bond rating.

Yield Curve Risk: Risk of decreases in portfolio value from changes in the shape of the yield curve; i.e., non-parallel curve shifts.

Downgrade Risk: Risk of the reduction in the bond’s rating; as determined by the ratings agencies (S&P, Fitch, Moody’s, etc.)

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Ethics & Professional Standards

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L I Ethics Item Set

CFA Sample QuestionsMonique Stein, CFA, conducted a thorough analysis and issued a research report on a manufacturing company. In the report, which was made available to all clients of her firm, Stein included her opinion that she was uncertain about the ability of the company to perform on a contract. The Chief Executive Officer of the company disagreed and submitted a complaint to Stein’s supervisor. The complaint alleged that employees of the manufacturing company explained the contract to Stein, but that she did not accept their explanation. According to the Standards of Practice Handbook, did Stein violate the CFA Institute Standard of Professional Conduct relating to:

communication with clients and prospective clients? diligence and reasonable basis?

A. No No B. No Yes – Yes No

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L I Ethics Item Set

CFA Sample QuestionsMonique Stein, CFA, conducted a thorough analysis and issued a research report on a manufacturing company. In the report, which was made available to all clients of her firm, Stein included her opinion that she was uncertain about the ability of the company to perform on a contract. The Chief Executive Officer of the company disagreed and submitted a complaint to Stein’s supervisor. The complaint alleged that employees of the manufacturing company explained the contract to Stein, but that she did not accept their explanation. According to the Standards of Practice Handbook, did Stein violate the CFA Institute Standard of Professional Conduct relating to:

communication with clients and prospective clients? diligence and reasonable basis?

A. No No – No Yes – Yes No

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L I Ethics Item Set

CFA Sample QuestionsCommunication with Clients and Prospective Clients: “Disclose to clients and prospective clients the basic format and general principles of the investment process used to analyze investments” ; “Distinguish between fact and opinion in the presentation of investment analysis and recommendation.”

- Standards of Practice Handbook, 9th Ed., Pg. 105

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L I Ethics Item Set

CFA Sample QuestionsDiligence and Reasonable Basis: “Exercise diligence, independence, and thoroughness in analyzing investments, making investment recommendations, and taking investment actions”; “If members and candidates rely on secondary or third-party research, they must make reasonable and diligent efforts to determine whether such research is sound…If a member or candidate has reason to suspect that either secondary or third-party research or information comes from a source that lacks a sound basis, the member or candidate must refrain from relying on that information.”- Standards of Practice Handbook, 9th Ed., Pg. 99

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L I Ethics Item Set

CFA Sample QuestionsHarbour Island Financial advertises that each of its portfolio managers are CFA’s and that each passed the three exams on their first attempts. As a result, Harbour Island Financial states that investors should expect superior returns. Has Harbour Island Financial violated the Standards of Practice?A.No.B.Yes, the CFA designation must not be used as a noun and they cannot advertise their success at passing each examC.Yes, the CFA designation must not be used as a noun and they cannot link success in passing each exam with greater portfolio returns

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L I Ethics Item Set

CFA Sample QuestionsStandard VII (B) - Reference to CFA Institute, the CFA designation, and the CFA Program: “The Chartered Financial Analyst and CFA marks must always be used either after a charterholder’s name or as adjectives (never as nouns) in written documents or oral conversations. For Example, to refer to oneself as ‘a CFA’ or ‘a Chartered Financial Analyst’ is improper.”


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L I Ethics Item Set

CFA Sample QuestionsStandard VII (B) - Reference to CFA Institute, the CFA designation, and the CFA Program: “If a candidate passes each level of the exam on the first try and wants to state that he or she did so, that is not a violation of Standard VII (B) because it is a statement of fact. If the candidate then goes on to claim or imply superior ability by obtaining the designation in only three years, he or she is in violation of Standard VII (B).”


FIXED INCOME: CFA LEVEL I Fixed Income II - Problem Solving Session Harvard Extension School MGMT...

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