andytrader

Which of the following refers to the differences in interest rate sensitivity of the firm’s assets relative to its liabilities?

A) Interest rate risk.

B) Cap risk.

C) Tracking error risk.

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Interest rate risk refers to differences in the interest rate sensitivity of the firm’s assets versus its liabilities.

optiix

Which of the following risks associated with managing a bond portfolio is least accurate?

A) Contingent claim risk is the risk that interest rates could increase, resulting in the cost of the firm's liabilities exceeding the return on its fixed-rate assets.

B) Combination matching for multiple liabilities is the same as horizon matching.

C) Price risk and reinvestment risk are the two components that comprise interest rate risk.

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Contingent claim risk (a.k.a. call risk or prepayment risk) is the risk that interest rates could decrease with the bonds in the portfolio being called resulting in reinvesting the principal at reduced rates of return. To adjust for this potential, rather than simply comparing the portfolio duration to that of the liability, the manager must consider the convexity of the bonds. Cap risk is the risk that interest rates could increase, resulting in the cost of the firm’s liabilities exceeding the return on its floating rate assets if those assets contain caps.

optiix

Which of the following is the best definition of cap risk? Cap risk is the risk:

A) associated with the issuer of a floating rate note with an embedded cap.

B) that a floating rate note has an embedded cap.

C) that the funding rate used to purchase a floating rate note exceeds the notes cap rate.

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Cap risk is the risk that the cost of the firm's interest rate-sensitive liabilities exceeds the return on its capped assets in an environment of rising interst rates. Cap risk is a particular concern to investors who borrow at a floating rate.

optiix

Which of the following CORRECTLY describes cash flow matching for a single liability? Cash flow matching involves:

A) selecting a bond with a present value equal to the present value of the liability and with the same maturity.

B) selecting a bond with the same duration as the liability.

C) selecting a bond whose cash flows coincide exactly with the payments of the liability.

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Cash flow matching is matching up the cash flows from a bond to fund a liability stream so that the asset value of the bond is zero after the last liability is paid.

optiix

Which strategy for funding multiple liabilities uses a process for selecting bonds that have cash flows that correspond to those of the liability stream?

A) Multiple liability immunization.

B) Combination matching.

C) Cash flow matching.

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The cash flow matching strategy for funding multiple liabilities uses a process for selecting bonds that have cash flows that correspond to those of the liability stream.

optiix

The manager of a bond portfolio must immunize the portfolio with respect to a given set of liabilities. The manager is choosing between two immunization strategies: Strategy A and Strategy B. Strategy A has a lower return, lower risk, and a 99% probability of providing the required return to meet the given set of liabilities. The manager should choose Strategy B:

A) under no circumstances, because risk minimization is the point of immunization.

B) if that strategy’s higher risk is justified by the higher return, and only if the probability of meeting the liabilities is equal to or higher than that of Strategy A.

C) if that strategy’s higher risk is justified by the higher return, and the probability of meeting the liabilities is equal to or only slightly lower than that of Strategy A.

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In immunizing a portfolio a manager must consider a trade off between risk minimization and return maximization. Taking on extra risk under the indicated circumstances is appropriate. The probability of not meeting the liabilities can be allowed to decrease a little. There is no strict rule about the return and risk levels remaining “proportional”.

optiix

The manager of a bond fund is assessing several choices in attempting to immunize a portfolio to meet a lump-sum liability. If maximizing the return of the portfolio by taking on more risk with active management is the goal of the manager, then the manager should:

A) choose a portfolio with a high and positive cushion spread.

B) choose a portfolio with a low and positive cushion spread.

C) not consider immunizing the portfolio at all because maximizing return is incompatible with immunization.

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Maximizing return is not incompatible with immunization. The manager can engage in more active trading to maximize return when the cushion spread is higher.

optiix

The manager of a bond fund is assessing several choices in attempting to immunize a portfolio. To meet a predetermined liability, the manager needs a five percent return. Which of the choices below would be the best in pursuit of that goal? An immunized strategy with a target return equal to:

A) 5.2% with a 95% confidence interval at +/- 20 basis points.

B) 6.0% with a 95% confidence interval at +/- 100 basis points.

C) 5.6% with a 95% confidence interval at +/- 50 basis points.

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Of the three portfolios, the portfolio with a 5.6% target return and a +/-50 basis point confidence interval has the best chance of achieving the needed return. The chance of not meeting the 5% return is LESS THAN (1-95%)/2 = 2.5% because, the 95% interval does not include the target 5%. The portfolios with the 6% target return and 5.2% would have exactly a 2.5% probability of not achieving the goal.

optiix

Which of the following explains the extension of cash flow matching for multiple liabilities? Cash flow matching for multiple liabilities is achieved by:

A) selecting a bond whose principal plus final coupon is equal to the last liability, then selecting another bond whose principal plus final coupon along with the first bond's coupon is equal to the second to last liability, and so on until all liabilities have been matched.

B) buying and selling bonds in a way to match the cash flows of a liability stream.

C) selecting bonds with present values equal to the present value of the liability stream and with the same maturity.

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The first bond is matched to the last liability, the remaining elements of the liability stream are reduced by the coupon payments of this bond, and another bond is chosen for the next to last liability, adjusted for any coupon payments of the first bond selected. This process is continued until all liabilities have been matched by payments on the securities selected for the portfolio.

optiix

Which of the following statements concerning the process of cash flow matching for funding multiple liabilities is CORRECT? Find bonds with:

A) an average duration equal to the average duration of the liabilities.

B) durations equal to the durations of each liability.

C) maturity dates equal to the maturity dates of each liability payment.

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The process is to find bonds with maturity dates equal to the maturity dates of each liability payment.