jawz

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

A) Lower transaction costs.

B) Higher margin requirements.

C) Greater leverage opportunities.

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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.

jawz

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

A) Less portfolio disruption.

B) More precise hedging.

C) Time savings.

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Using financial futures contracts will 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.

jawz

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

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

B) A portfolio managers sold a floor to finance the purchase of a cap in anticipation of higher interest rates on a floating-rate liability.

C) 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.

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

jawz

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

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

B) offer time savings.

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

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

jawz

An analyst is assessing the risk of a bond portfolio by applying measures of risk to the returns of the portfolio and the bonds. The portfolio includes a large position in bonds with embedded derivatives. Using the standard deviation as a risk measure for the bond portfolio is:

A) not appropriate because the existence of the embedded derivatives would make the distribution of returns normal.

B) not appropriate because the existence of the embedded derivatives would make the distribution of returns not normal.

C) appropriate because the existence of the embedded derivatives would make the distribution of returns not normal.

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The standard deviation is a measure for normal distributions. Embedded options would make the distribution of the bond returns not normal. Therefore, the standard deviation would not be an appropriate measure.

jawz

An analyst is considering various risk measures to apply to a bond portfolio. She requires a measure that accounts for the magnitude of the losses. Given this requirement, as she considers using the semivariance and/or shortfall risk, she would reject using:

A) both shortfall risk and the semivariance.

B) the semivariance but not shortfall risk.

C) shortfall risk but not the semivariance.

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Shortfall risk gives an indication of the probability of not achieving a minimum return. The semivariance gives a measure expressed in returns.

jawz

An analyst is considering various risk measures to apply to a bond portfolio. He requires a measure that will use all the data so no information will be lost. Given this requirement, as he considers using the semivariance and/or value at risk, he would reject:

A) value at risk but not the semivariance.

B) the semivariance but not value at risk.

C) both value at risk and the semivariance.

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The measures to compute value at risk use all the data. The semivariance only uses the portion of data below a given value.

jawz

Carlos Mendoza is a portfolio manager for a money management firm that caters to high net worth individuals. Mendoza’s firm has recently acquired the account of a new client, Forrest Thompson, and Mendoza has just met with him to establish his investment profile, return requirements, and tolerance for risk. Subsequent to the meeting, Mendoza has written an investment policy statement for Thompson that outlines approximate asset class allocations. Thompson informed Mendoza that his main investment objective is to maximize current income rather than to pursue aggressive growth opportunities. With this in mind, Mendoza suggested that approximately 40 percent of the portfolio’s assets should be allocated to fixed income securities, 40 percent in domestic equities, with the remainder in cash or cash equivalents. In accordance with Thompson’s tolerance for risk, suitable fixed-income investments have been defined as U.S. Treasury securities, mortgage-backed securities, asset-backed securities, and corporate bonds. All investments purchased for the portfolio must be rated investment grade or higher.
For the fixed income portion of the portfolio, Mendoza, with the approval of Thompson, has established the Salomon Brothers Broad Investment Grade Index (BIG) as the return benchmark. Mendoza will typically seek to keep the portfolio’s duration equal to that of the index. However, when market conditions warrant, the portfolio composition will be allowed to deviate slightly from the index from time to time in order to capitalize on short-term opportunities. In specific, Mendoza is authorized to alter the portfolio duration, within a specified range, to take advantage of any anticipated rate shifts. Because deviations from the index have the potential to lead to increased exposure to tracking risk, the portfolio is expected to outperform the index by 50 basis points, less management and transaction fees.
Thompson’s portfolio was previously managed by another asset management firm that Thompson felt had exposed his portfolio to excessive risk. One practice the other money manager frequently engaged in was to utilize repurchase transactions as a short-term investment vehicle. From time to time, cash in Thompson’s portfolio was loaned to broker-dealers in exchange for Treasury securities, which were deposited in a custodial account at a mutually agreed-upon bank. The repos were structured for time periods of thirty days or less, and Thompson was paid the prevailing rate of interest. Thompson has never been quite sure what the risks involved in the repo transactions were, and thought the previous manager did not provide him with enough information. Thompson has asked Mendoza to evaluate whether or not entering into repo agreements is an appropriate practice given his risk tolerance, and Mendoza offered to outline the associated advantages and risks.
Thompson’s inquiry about the basics of repo transactions leads Mendoza to examine other investment strategies that may or may not be appropriate for Thompson’s investment profile. Mendoza gives some consideration to introducing leverage to the portfolio, but he is concerned that Thompson does not fully understand the implications of a leveraged portfolio. Mendoza believes that without leverage, it will be difficult to achieve the stated objective of outperforming the BIG index by 50 basis points. He decides to demonstrate the effect of leverage on a sample portfolio to enable Thompson to be able to make informed decisions regarding basic portfolio management decisions. Mendoza constructs a hypothetical $5,000,000 bond portfolio with an unleveraged duration of 3.1 years. He then runs scenario analyses utilizing several levels of leverage under different changes in interest rates. Mendoza then calculates how the leverage affects the overall risk of the portfolio by measuring the change in the portfolio’s duration. He believes this is the best way to demonstrate to Thompson the potential benefits and drawbacks from such a strategy. Mendoza’s normal approach to the management of Thompson’s bond portfolio would most likely be classified as:

A) enhanced indexing by matching primary risk factors.

B) indexing by minor risk factor mismatching.

C) active management by larger risk factor mismatches.

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Indexing by minor risk factor mismatching allows minor mismatches in certain risk factors of the index, such as sector and quality, but is generally supposed to have the same duration as the index. Mendoza is allowed to deviate from the index to capitalize on market opportunities, but he will generally mimic the index. Also, as noted in the vignette, this strategy assumes more tracking risk. (Study Session 9, LOS 23.b)

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In the course of managing Thompson’s portfolio, Mendoza will utilize which of the following value-added strategies?

A) Market selection.

B) Yield curve management.

C) Sector selection.

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Since Mendoza plans to alter the portfolio duration, within a specified range, to take advantage of any anticipated interest rate changes, he plans to use an interest rate expectations strategy also referred to as duration management or yield curve management which involves forecasting interest rates and adjusting the portfolio accordingly. (Study Session 10, LOS 25.h)

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Which one of the following statements regarding repo transactions is most accurate?

A) The credit risk of a repo agreement depends solely upon the quality of the collateral.

B) As a short-term investment, a properly structured repurchase agreement is considered to be a high-quality investment.

C) When a securities dealer uses a repurchase agreement to borrow funds, it is called a reverse repo transaction.

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A repurchase agreement is generally considered to be a high-quality money market investment. Repos are considerably much more risky when used as a source of funds to create leverage. (Study Session 10, LOS 25.b)

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Mendoza decides to loan out $4,000,000 of the portfolio’s Treasury securities on a 30-day repo. Assuming a repo margin of 3% and a repo rate of 4.5%, calculate the cash due at the conclusion of the trade.

A) $3,894,550.

B) $3,894,351.

C) $3,880,000.

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Amount of Loan = $4,000,000 × (100%- 3%) = $3,880,000.
Cash due at conclusion of repo = $3,880,000 + ($3,880,000 × 4.5% × (30/360)) = $3,894,550.
(Study Session 10, LOS 25.b)

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Which of the following factors is least likely to cause a lower repo rate from the perspective of the lender?

A) Delivery of the collateral to the lender.

B) Collateral with a short term to maturity.

C) Hot collateral.

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The repo rate is a function of the repo term and not a function of the maturity of the collateral securities. (Study Session 10, LOS 25.b)

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Utilize the hypothetical portfolio constructed by Mendoza and assume the portfolio is leveraged by 10 percent using a 30-day repo transaction. What is the duration of the leveraged portfolio?

A) 3.10 years.

B) 2.82 years.

C) 3.44 years.

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10% leverage equals $4,500,000 in equity and $500,000 of debt.
The duration of the repo is very close to zero.
The duration of the portfolio is calculated as follows:
Dp = (Di</SUB)I - DI - D</SUB)I - DBB)/E
Dp = [(3.1)( 5,000,000) - (0)(500,000)] / 4,500,000 = 3.44
Where:

Dp = Duration of portfolio

Di = Duration of invested assets

DB = Duration of borrowed funds

I = amount of invested funds

B = amount of borrowed funds

E = amount of equity invested

(Study Session 10, LOS 25.a)

jawz

Which of the following is least likely to expose the lender in a repurchase agreement (repo) to credit risk related to the delivery of the collateral?

A) The borrower files for bankruptcy before the collateral is delivered.

B) The borrower sells the collateral prior to delivery.

C) The borrower has their bank hold the collateral instead of the lender in the repo agreement.

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While the lender would prefer to have possession of the collateral, having the borrower’s bank hold the collateral is the least likely of the above to expose the lender to credit risk.

jawz

An agreement whereby the seller of a security agrees to “repurchase” it from the buyer on an agreed upon date at an agreed upon price is called a:

A) commercial paper.

B) repurchase agreement.

C) negotiable certificate of deposit.

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An agreement whereby the seller of a security agrees to “repurchase” it from the buyer on an agreed upon date at an agreed upon price is called a repurchase agreement.