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

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

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

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 manager of a fixed-income portfolio sells futures contracts identical to contracts it already owns. With respect to the portfolio under management, the effect of this will be to:

A) increase modified duration.

B) increase the value.

C) decrease dollar duration.

---

The only one of the choices we know for sure is that dollar duration will decline. The act of closing a futures contract does not necessarily change a portfolio’s value one way or another. The modified duration is a weighted average of the durations of the positions and not the dollar durations, it may go up or down.

jawz

A manager buys a position in futures contracts that have a dollar duration (for a forecasted interest rate change) equal to $22,500. Before buying the futures contracts, the manager’s fixed income portfolio had a dollar duration (for the forecasted interest rate change) equal to $40,500. The dollar duration of the combined position is:

A) -$18,000.

B) $63,000.

C) $18,000.

---

This is an application of the formula DDP = DDP w/o futures + DDFutures position

jawz

A portfolio manager is considering increasing the dollar duration of a portfolio by either buying more bonds or buying futures contracts. Having used a reliable model to determine a bond position and a futures position that have equal dollar durations, choosing to add the futures position to the existing portfolio will increase the final portfolio’s dollar duration:

A) by an amount equal to the proposed bond position.

B) more than the proposed bond position.

C) significantly, but less than the proposed bond position.

---

Theoretically, using bonds or futures can accomplish the same goal.

jawz

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

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

B) Futures provide higher returns than cash market instruments.

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

---

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.

jawz

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

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

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

C) Futures have lower brokerage fees.

---

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.

jawz

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 given that one T-bill contract controls $1,000,000 in T-bills?

A) Buy 50 T-bill futures contracts.

B) Sell 500 T-bill futures contracts.

C) Sell 50 T-bill futures contracts.

---

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

B) The T-bill futures contract will lose value, but the Treasury bill 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.

---

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 an interest rate collar.

B) Purchase an interest rate cap.

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

---

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 client’s FRN. The net cash flow will be the swap fixed rate plus 25bp.