LOS e: Contrast and illustrate the use of total return analysis and scenario analysis to assess the risk and return characteristics of a proposed trade.

Q1. Frank Meyers, CFA, is a fixed-income portfolio manager for a large pension fund. A member of the Investment Committee, Fred Spice, is very interested in learning about the management of fixed-income portfolios. Spice has approached Meyers with several questions. Specifically, Spice would like to know how fixed-income managers position portfolios to capitalize on their expectations on interest rates.

Meyers has decided to illustrate fixed-income trading strategies to Spice using a fixed rate bond and note. Both bonds have semi-annual coupon periods. Unless otherwise stated all interest rate changes are parallel. The characteristics of these securities are show in Table 1. He also considers a nine-year floating rate bond (floater) that pays a floating rate semi annually and is currently yielding 5%.

Table 1:

Spice asks Meyers about how a fixed-income manager would position his portfolio to capitalize on his expectations of increasing interest rates. Which of the following would be the most appropriate strategy for Meyers to use to help answer Spice's query?

A)   Shorten his portfolio duration.

B)   Buy fixed rate bonds.

C)   Lenghten his portfolio duration.

Q2. Spice asks Meyers to quantify the value changes from changes in interest rates. To illustrate, Meyers computes the value change for the fixed rate note in Table 1. Specifically, he assumes an increase in the level of interest rate of 100 basis points. Using the information in Table 1, which of the following is the best estimate of the change in value of the fixed rate note?

A)   -$3.59.

B)   -$7.17.

C)   $3.51.

Q3. Spice just does not seem to get it and asks Meyers to repeat the computation for the fixed rate bond in Table 1. Meyers obliges. Specifically, he assumes an increase in the level of interest rate of 100 basis points. Using the information in Table 1, which of the following is the best estimate of the change in value of the fixed rate bond?

A)   -$4.63.

B)   -$5.73.

C)   -$7.49.

Q4. Spice wonders how a fixed-income manager could position his portfolio to capitalize on the expectaion of an upward shifting and twisting term structure. To help Spice understand Meyers introduces the following scenario: interest rates increasing by more than short-term interest rates. Using Table 1, which of the following is the most appropriate strategy to profit under this scenario?

A)   Sell bonds and buy notes.

B)   Buy bonds and sell notes.

C)   Buy floaters.

Q5. Why should total return analysis be used to assess the potential performance of a trade before the trade is implemented? Because total return analysis:

A)   allows to quantify the potential performance of any trading strategy.

B)   can be used to assess the likelihood of a certain outcome which will affect the potential performance of a trading strategy.

C)   identifies the range of possible outcomes and therefore provides the manager with a feel for the risk associated with a trade.

Q6. Why should scenario analysis be used to assess the potential performance of a trade before the trade is implemented? Because scenario analysis:

A)   consists of evaluating the worst-case scenario which enables an investor to know his highest potential loss of a trade.

B)   identifies the range of possible outcomes and therefore provides the manager with a feel for the risk associated with a trade.

C)   involves measuring the reactions of market participants under a variety of different scenarios which the manager needs to know before he makes a trade.

Q7. Potential performance and how that performance will vary can be assessed by which two factors, respectively?

A)   Trend analysis, scenario analysis.

B)   Scenario analysis, total return analysis.

C)   Total return analysis, scenario analysis.

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