burning0spear

Which of the following statements concerning how breakeven rate analysis can be used to make relative value or currency hedging decisions between foreign bond markets is CORRECT? Break-even analysis can be used to:

A) quantify the amount of spread widening that would erase the yield advantage from investing in a higher yielding market.

B) quantify the correct amount of currency exposure to hedge.

C) identify mispriced bonds in foreign markets and to take advantage of the mispricing.

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Breakeven rate analysis can be used to determine how many basis points the spread would have to change in order for yield advantages to be eliminated.

burning0spear

Which of the following most accurately describes the purpose of using break-even analysis (forward rates) to make relative value decisions? Break-even analysis is used to determine:

A) whether or not to hedge.

B) the currency risk isolated from interest rate risk for different markets.

C) the credit risk isolated from interest rate risk for different markets.

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The strategic outlook is what you "expect" to happen to the currency. The market price can be determined from the forward rate. Comparing the two dictates whether you should hedge or not hedge (which is the ultimate decision).

burning0spear

Which of the following is a valid reason for NOT using forwards to hedge exposure to currency risk? The portfolio manager expects:

A) the future currency exchange rate to be less than the forward exchange rate.

B) that the percentage return from exposure to a currency is greater than the forward discount or premium.

C) home interest rates to rise relative to foreign interest rates.

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If the return from being exposed to a currency is greater than the forward premium, then using the forward to hedge will result in a return less than that if there were no hedge.

burning0spear

A bond-portfolio manager is considering adding a position to the portfolio. He is choosing between a domestic bond with a duration equal to 4.8 or a foreign bond that has a duration of 6.0 and a country beta equal to 0.8. If the manager wishes to add the bond with the lower sensitivity to domestic interest rates, the manager:

A) would choose the foreign bond.

B) would choose the domestic bond.

C) would be indifferent between the two bonds.

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Both bonds have the same sensitivity to domestic rates: 6.0 × 0.8 = 4.8.

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.

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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.

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.

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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

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.

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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

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.

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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

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.

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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

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.

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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)

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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.

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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)

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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.

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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)

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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.

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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)

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

A) Option 1.

B) Option 2.

C) Option 4.

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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)

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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.

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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)