jawz

A mutual fund portfolio manager has a large investment in bonds. They anticipate that interest rates are going to increase and are concerned as to how that will affect the value of their bonds. They have decided to hedge the interest rate risk. Indicate whether the portfolio manager should increase or decrease the duration of their bond portfolio and what kind of derivative product they should use?

A) Increase duration by entering into a receive fixed pay floating swap.

B) Decrease duration by entering into a receive floating pay fixed swap.

C) Decrease duration by selling Treasury futures.

---

Interest rates are predicted to increase which will decrease the value of any fixed income assets (or liabilities). In a rising interest rate environment one would want to decrease the duration of their bonds so they are less sensitive to changing interest rates. This can be accomplished through a swap by receiving floating and paying fixed or by selling Treasury futures contracts. Using a swap is the preferred method because it is cheaper to implement than using futures. The duration of a swap is determined by what is received minus what is paid out: Dswap = Dreceived − Dpay. Since the duration of the floating side is very small the duration of a receive floating pay fixed swap should be very small and lower the duration of their portfolio: Dswap = Dreceived − Dpay < 0.

jawz

A bond portfolio manager believes that interest rates are relatively stable and will not change much in the near future. The best strategy the manager can pursue in the short term is to:

A) enter into a covered call strategy using Treasury futures.

B) buy a protective put on Treasury futures.

C) do nothing.

---

In a stable interest rate environment the manager is not concerned about interest rates increasing which would decrease the value of their bond portfolio. In this type of environment they can earn additional income by entering into a covered call strategy which means they own the underlying asset, in this case bonds, and sell interest rate call options based on Treasury futures contracts. This strategy will provide income in the form of premiums earned from the sale of the call options. If interest rates decrease, the Treasury futures will increase in price and the call options will be exercised if the Treasury futures is above the strike price reducing the seller of the call options return. The covered call strategy does not protect against an increase in interest rates where bond values would decrease except for the amount of the premium earned on the sale of the call options.

jawz

The Reliable Insurance Company sells fixed rate annuities as part of its product mix and uses the proceeds to invest in floating rate notes. What kind of interest rate change should they hedge against and which is the most appropriate hedging strategy? They would be concerned with interest rates:

A) increasing and would hedge this risk by selling a floor and buying a cap.

B) decreasing and would hedge this risk by buying a cap and selling a floor.

C) decreasing and would hedge this risk by selling a cap and buying a floor.

---

An insurance company that sold a fixed rate annuity and invests the proceeds in a floating rate note would be concerned that interest rates would decrease thus causing the return on their floating rate note to be less than what they owe on the fixed rate annuity. They can mitigate this risk by selling a cap and using the proceeds to buy a floor which would payoff in the event that interest rates decreased below the floor strike price.

jawz

Which of the following refers to the risk that a bond-rating agency may lower the credit rating on a bond issue?

A) Bond rating risk.

B) Downgrade risk.

C) Credit spread risk.

---

Downgrade risk refers to the risk that a bond-rating agency lowers (or downgrades) the credit rating on the bond issue.

jawz

FI Investment Co. (FI) has recently observed an increase in the credit risk of their fixed income portfolios. Management has never used credit derivatives to hedge this risk, but thinks that this might be time to try them. Bill Bales, one of the portfolio managers, is instructed to learn about the basics of credit derivatives and then use them to hedge credit risk in FI’s portfolios.
First, Bales looks at why investors would sell credit protection. He makes some notes as to why credit protection would be sold:

• Sellers are hedging their fixed income positions.
• Sellers may expect a ratings upgrade for the asset/issuer as a likely outcome.
• Sellers may sell credit protection options to enhance portfolio income, assuming the options finish in-the-money.
• Sellers believe that a takeover by another firm is unlikely.

Next, Bales explores the use of binary credit options. He realizes there are quite a few of them. To put them in perspective, he develops a list of binary credit options that might be appropriate for FI portfolios:

• A call option that has its value tied to the difference between the market spread and a reference spread and the payoff is an increasing function of the credit spread.
• A put option that allows the holder to put the bond back to the issuer at a fixed-price if the credit rating falls.
• A call option that pays the difference between a reference value and the market value of the bond after a downgrade.
• A call option that pays additional coupon income in the event of a downgrade.

Bales’ research indicates that not only can credit derivates be used to protect FI’s fixed income portfolios from certain types of risks, but they can also be employed to lower the firm’s borrowing costs. Bales is able to convince FI’s CEO Tim Brown to issue the following bond:

• A 5-year, annual pay, $20 million bond offering at a rate of LIBOR plus 150 basis points.
• LIBOR is 6.5%.
• The bonds will be issued with a binary credit put, with a strike price at par.
• One year from today (t=1) (the day after the coupon payment is made) LIBOR moves to 7% and the yield on the bond is at 9.25%.

Regarding the sellers of credit protection, which statement is most accurate?

A) Statement 1.

B) Statement 2.

C) Statement 3.

---

Sellers of credit protection are speculators that are motivated by potential increases in credit quality. They believe in a possible ratings upgrade, takeover, or redemption of outstanding bonds due to the availability of lower cost financing sources. (Study Session 10, LOS 25.g)

---

Regarding a total return credit swap which of the following statements is least accurate?

A) The total return payer receives an amount based on a specified reference at the swap’s settlement dates.

B) The total return payer owns the underlying assets.

C) The swap can hedge many types of risk with a single contract.

---

The total return payer may or may not own the underlying securities. Entering into a credit swap as the total return payer without owning the underlying assets is a way to short a bond. A total return credit swap does hedge many types of risk. Also, the number of transactions will likely be less than trading the underlying, and the total return receiver pays an amount based on a specified reference at the swap’s settlement dates. (Study Session 10, LOS 25.g)

---

Suppose the investor who buys FI's bond issue holds 1,000 bonds with a $1 million face value position. Subsequently a credit downgrade occurs and the bond declines in value to $700. What is the option value?

A) $700.

B) $300,000.

C) $300.

---

The following equation is used:

OV = max[(strike − value), 0]
= (1,000 − 700) = $300.

(Note: if protection were purchased on the entire position, the overall payoff would be $300,000 (= $300 × 1,000), less the cost of purchasing the options.) (Study Session 10, LOS 25.g)

---

Assume that instead of a binary credit put option, FI intends to issue the bond with a credit spread call option. The bond’s risk factor is 2 and assume it is now one year from today. The value of the credit call option is closest to:

A) $225,000.

B) $300,000.

C) the credit call is out-of-the-money.

---

The value of the credit call is equal to the actual spread over the benchmark versus the specified spread over the benchmark times the principal times the risk factor. Note that the payoff is not binary – the payoff to the option will increase as the spread over the benchmark gets larger.
(0.0925 – 0.0700 – 0.0150) × $20,000,000 × 2 = $300,000
(Study Session 10, LOS 25.g)

---

With regard to the binary credit options, which of the statements given are least accurate?

A) Option 1.

B) Option 2.

C) Option 4.

---

The key to a binary option is that it assumes one of two possible states. The option either pays or does not pay. The value does not continue to rise (or fall) based on the value of the underlying. Thus, a call that has a payoff as an increasing function of the credit spread would not be binary. (Study Session 10, LOS 25.g)

---

FI holds a large position with a 10-year maturity. Recently, Bales has observed a significant increase in the spread relative to the 10-year Treasury. Today he learns that Moody’s has changed the rating on the bond from investment grade to speculative. In terms of credit risk, FI is dealing with:

A) credit spread and default risk. Credit spread risk can be managed with credit options and credit forwards. Default risk can be managed with credit forwards, swaps, and credit options.

B) credit spread, default and downgrade risk. Credit spread risk can be managed with credit options and credit forwards. Downgrade risk can be managed with either credit forwards or swaps. Default risk can only be managed with swaps.

C) credit spread and downgrade risk. Credit spread risk can be managed with credit spread options, credit spread forwards, and total return swaps. Downgrade risk can be managed with credit options, credit swaps, and total return swaps.

---

These are examples of credit spread and downgrade risks. Credit spread risk is the risk that the yield premium over the relevant risk free benchmark will increase. Downgrade risk reflects the possibility that the credit rating of an asset/issuer is downgraded by a major credit-rating organization. The investor can use credit spread options, credit spread forwards, or total return swaps to manage credit spread risk. Credit options, credit swaps, and total return swaps can be used to manage downgrade risk. (Study Session 10, LOS 25.g)

jawz

Which of the following refers to the risk that the difference between the yield on a risky asset and the yield on a risk-free asset increases?

A) Credit spread risk.

B) Interest rate risk.

C) Default risk.

---

Credit spread risk refers to the risk that the difference between the yield on a risky asset and the yield on a risk-free asset, the credit spread, increases. Default risk is the risk that the issuer will not pay principal or interest when due; and interest rate risk refers to the risk of rising rates decreasing a bond’s market value.

jawz

Which of the following is the best explanation of credit spread risk? Credit spread risk refers to the risk that an:

A) asset's bid-ask spread will increase.

B) asset will be downgraded in the future.

C) asset's appropriate discount rate increases relative to the comparable risk-free rate.

---

Credit spread risk is the risk of an increase in the yield spread on an asset. Yield spread is the asset’s yield minus the relevant risk-free benchmark. This risk is a function of potential changes in the market’s collective evaluation of credit quality, as reflected by the spread.

jawz

One way that international bond portfolio managers attempt to enhance portfolio returns is to correctly anticipate interest rate and yield curve changes. This strategy is called:

A) sector selection.

B) duration management.

C) bond market selection.

---

With duration management, bond portfolio managers are able to increase returns by correctly forecasting interest rate shifts and changes in the shape of the yield curve. By correctly estimating these changes, the bond manager can capitalize on the inverse relationship between interest rate changes and the market value of bond issues.

jawz

A U.S. investor holds a bond portfolio that includes bonds that are an obligation of a British company and denominated in British pounds. In estimating the sensitivity of the value of that foreign position to rates in the United States, with respect to the country beta for Great Britain and the British bond’s duration, it is most correct to say a:

A) higher country beta and higher bond duration will lead to higher interest rate risk.

B) lower country beta and higher bond duration will lead to lower interest rate risk.

C) lower country beta and lower bond duration will lead to higher interest rate risk.

---

The duration contribution to the domestic portfolio is the product of the country beta and the bond’s duration. It is most correct to say that when both go up, the interest rate risk increases.

jawz

Which of the following foreign bond positions will have the highest sensitivity to changes in domestic interest rates? A foreign bond that has a duration equal to:

A) 5 and a country beta equal to 0.2.

B) 2 and a country beta equal to 0.5.

C) 4 and a country beta equal to 0.3.

---

The total sensitivity is given by the duration times the country beta. The product of 4 times 0.3 is the highest of the three.