Reading 29: Fixed Income Portfol....ement - Part II－LOS d market, instead, advantages, 2008

tycoon

CFA Institute Area 8-11, 13: Asset Valuation
Session 9: Portfolio Management of Global Bonds and Fixed Income Derivatives
Reading 29: Fixed Income Portfolio Management - Part II
LOS d: Demonstrate the advantages of using futures instead of cash market instruments to alter portfolio risk.

tycoon

John Hanes serves as a portfolio manager for Stackhouse Investments. One of his clients, the Red Wing Corporation, holds a $50 million face value position in a T-bill that matures in 182 days on March 21 (today is September 21). Red Wing also owns a $100 million position in a floating rate note (FRN) that matures in one year, pays LIBOR plus 25bp and has interest rate reset dates on December 21, March 21, and June 21. Red Wing has indicated that they need to sell the T-bill investment sooner than anticipated to fund an unexpected series of cash outflows.

Which of the following positions would effectively shorten the maturity of your client's Treasury bill investment and hedge your client against adverse movements in interest rates until the sale date?

A) Buy 50 T-bill futures contracts.

B) Buy 500 T-bill futures contracts.

C) Sell 50 T-bill futures contracts.

D) Sell 500 T-bill futures contracts.

---

Answer and Explanation

Since the client owns $50 million of face value of the T-bill, we should sell 50 December T-bill futures contracts. We sell 50 contracts because each contract controls a $1 million T-bill with a 90-92 day maturity upon expiration of the futures.

---

Assuming interest rates rise, which of the following CORRECTLY describes the outcome regarding the ultimate disposal of the T-bill?

A) The T-bill futures contract will lose value, but the Treasury bill will gain in value to offset the loss.

B) The T-bill will lose value, but the short T-bill futures contracts will gain in value to offset the loss.

C) The holdings of T-bill futures contracts will have to be reduced (rebalanced) in order to maintain the current hedged relationship.

D) The holdings of T-bill futures contracts will have to be increased (rebalanced) in order to maintain the current hedged relationship.

---

Answer and Explanation

This position will also hedge your client against adverse movements in interest rates should he decide to sell before the expiry of the T-bill futures. If interest rates rise, the T-bill will lose value, but the short T-bill futures position will gain value to offset this loss.

---

Which of the following is a methodology that could be employed to convert your client's FRN to a one-year fixed rate structure?

A) Enter into a one-year, quarterly, receive-fixed interest rate swap.

B) Enter into an interest rate collar.

C) Purchase an interest rate cap.

D) Purchase a call option on the LIBOR.

---

Answer and Explanation

The swap will have a single fixed rate that will be received on a quarterly basis. The LIBOR payments from the swap will cancel with the LIBOR receipts from the clients FRN. The net cash flow will be the swap fixed rate plus 25bp.

tycoon

Which of the following is NOT an advantage of using interest rate futures instead of cash market instruments to alter portfolio risk?

A) Futures can be customized to match any specific customer needs.

B) Transaction costs are lower.

C) Short selling is much easier.

D) Margin requirements are lower, allowing for greater leverage.

---

Answer and Explanation

Futures are standardized contracts as opposed to forward contracts and cannot be customized to match any specific customer needs.

tycoon

Which of the following is an advantage of using futures instead of cash market instruments to alter portfolio risk?

A) Futures provide higher returns than cash market instruments.

B) Transaction costs for trading futures are lower than trading in the cash market.

C) Futures have unlimited upside potential but their risk is limited to the initial investment.

D) Futures can be customized to match any specific customer needs.

---

Answer and Explanation

There are three main advantages to using futures over cash market instruments. All three advantages are derived from the fact that there are low transactions costs and a great deal of depth in the futures market.

Compared to cash market instruments, futures:

1. Are more liquid.
2. Are less expensive.
3. Make short positions more readily obtainable, because the contracts can be more easily shorted than an actual bond.

There are three main advantages to using futures over cash market instruments. All three advantages are derived from the fact that there are low transactions costs and a great deal of depth in the futures market.

Compared to cash market instruments, futures:

1. Are more liquid.
2. Are less expensive.
3. Make short positions more readily obtainable, because the contracts can be more easily shorted than an actual bond.

tycoon

Which of the following is NOT an advantage of using futures instead of cash market instruments to alter portfolio risk?

A) Greater leverage opportunities.

B) Higher margin requirements.

C) Lower transaction costs.

D) Easier to short sell.

---

Answer and Explanation

Lower margin requirements are one of the advantages of using futures instead of cash market instruments. The margin requirements are lower for futures, which allows for greater leverage.

Lower margin requirements are one of the advantages of using futures instead of cash market instruments. The margin requirements are lower for futures, which allows for greater leverage.

A) Greater leverage opportunities.

B) Higher margin requirements.

C) Lower transaction costs.

D) Easier to short sell.

---

Answer and Explanation

Lower margin requirements are one of the advantages of using futures instead of cash market instruments. The margin requirements are lower for futures, which allows for greater leverage.

Lower margin requirements are one of the advantages of using futures instead of cash market instruments. The margin requirements are lower for futures, which allows for greater leverage.

tycoon

Which of the following is NOT an advantage of using financial futures for asset allocation?

A) Lower commissions.

B) More precise hedging.

C) Less portfolio disruption.

D) Time savings.

---

Answer and Explanation

Using financial futures contracts will lower commissions, save time, and cause less portfolio disruption. However, futures contracts expose the manager to basis risk, wherein the futures contract and the portfolio are not perfectly correlated, leading to return differences between the futures position and the underlying exposure that is being replicated.

tycoon

Which of the following is an advantage of using financial futures for asset allocation purposes instead of the cash market securities? Futures:

A) are priced exactly the same as the underlying cash asset.

B) can be tailored to an investor's particular requirements.

C) are traded over-the-counter which eliminates the market impact of large transactions.

D) offer time savings.

---

Answer and Explanation

It will take less time to execute the asset allocation shift using futures than with buying and selling individual stocks and bonds.

tycoon

Which of the following is NOT an advantage of using financial futures for asset allocation purposes instead of the cash market securities?

A) Futures have lower brokerage fees.

B) Futures offer significant savings in transaction time.

C) Large orders have a very small market impact in the futures market.

D) Futures are priced exactly the same as the underlying asset but are more liquid.

---

Answer and Explanation

Futures are not priced exactly the same as the underlying cash asset. The difference between the two prices is the basis which is normally not equal to zero.

tycoon

Which of the following statements about bond portfolio management is least accurate?

A) To create a zero-cost collar, a portfolio manager goes long a cap and short a floor where both the cap and floor have the same strike rate, settlement frequency, and maturity.

B) A portfolio manager with a $50 million face value in bonds and a futures contract with $100,000 face value should use 500 futures contracts according to the Face Value Naive model.

C) To increase the duration of a bond portfolio through futures, the portfolio manager should sell futures contracts.

D) The risk that a bond issue may be downgraded is known as downgrade risk.

---

Answer and Explanation

To increase the duration of a bond portfolio through futures, the portfolio manager should buy futures contracts.