Question 1

Albert Wulf, CFA, is a portfolio manager with Upsala Asset Management, a regional financial services firm that

handles investments for small businesses in Northern Germany. For the most part, Wulf has been handling

locally concentrated investments in European securities. Due to a lack of expertise in currency management he

works closely with James Bauer, a foreign exchange expert who manages international exposure in some of

Upsala's portfolios. Both individuals are committed to managing portfolio assets within the guidelines of client

investment policy statements.

To achieve global diversification, Wulf's portfolio invests in securities from developed nations including the

United States, Japan, and Great Britain. Due to recent currency market turmoil, translation risk has become a

huge concern for Upsala's managers. The U.S. dollar has recently plummeted relative to the euro, while the

Japanese yen and British pound have appreciated slightly relative to the euro. Wulf and Bauer meet to discuss

hedging strategies that will hopefully mitigate some of the concerns regarding future currency fluctuations.

Wulf currently has a $1,000,000 investment in a U.S. oil and gas corporation. This position was taken with the

expectation that demand for oil in the U.S. would increase sharply over the short-run. Wulf plans to exit this

position 125 days from today. In order to hedge the currency exposure to the U.S. dollar, Bauer enters into a

90-day U.S. dollar futures contract, expiring in September. Bauer comments to Wulf that this futures contract

guarantees that the portfolio will not take any unjustified risk in the volatile dollar.

Wulf recently started investing in securities from Japan. He has been particularly interested in the growth of

technology firms in that country. Wulf decides to make an investment of ¥25,000,000 in a small technology

enterprise that is in need of start-up capital. The spot exchange rate for the Japanese yen at the time of the

investment is ¥135/€. The expected spot rate in 90 days is ¥132/€. Given the expected appreciation of the yen,

Bauer purchases put options that provide insurance against any deprecation of the euro. While delta-hedging

this position, Bauer discovers that current at-the-money yen put options sell for €1 with a delta of -0.85. He

mentions to Wulf that, in general, put options will provide a cheaper alternative to hedging than with futures

since put options are only exercised if the local currency depreciates.

The exposure of Wulf’s portfolio to the British pound results from a 180-day pound-denominated investment of

£5,000,000. The spot exchange rate for the British pound is £0.78/€. The value of the investment is expected to

increase to £5,100,000 at the end of the 180 day period. Bauer informs Wulf that due to the minimal expected

exchange rate movement, it would be in the best interest of their clients, from a cost-benefit standpoint, to

hedge only the principal of this investment.

Before entering into currency futures and options contracts, Wulf and Bauer discuss the possibility of also

hedging market risk due to changes in the value of the assets. Bauer suggests that in order to hedge against a

possible loss in the value of an asset Wulf should short a given foreign market index. Wulf is interested in

executing index hedging strategies that are perfectly correlated with foreign investments. Bauer, however,

cautions Wulf regarding the increase in trading costs that would result from these additional hedging activities.

Regarding the Japanese investment in the technology company, determine the appropriate transaction in put

options to adjust the current delta hedge, given that the delta changes to -0.92. Assume that each yen put

allows the right to self ¥1,000,000.

Options :

A :

Sell 2 yen put options.

B :

Sell 27 euro put options.

C :

Buy 29 yen put options.

Answer: A

Question 2

Daniel Castillo and Ramon Diaz are chief investment officers at Advanced Advisors (AA), a boutique fixedincome firm based in the United States. AA employs numerous quantitative models to invest in both domestic

and international securities.

During the week, Castillo and Diaz consult with one of their investors, Sally Michaels. Michaels currently holds a

$10,000,000 fixed-income position that is selling at par. The maturity is 20 years, and the coupon rate of 7% is

paid semiannually. Her coupons can be reinvested at 8%. Castillo is looking at various interest rate change

scenarios, and one such scenario is where the interest rate on the bonds immediately changes to 8%.

Diaz is considering using a repurchase agreement to leverage Michaels's portfolio. Michaels is concerned,

however, with not understanding the factors that impact the interest rate, or repo rate, used in her strategy. In

response, Castillo explains the factors that affect the repo rate and makes the following statements:

1. "The repo rate is directly related to the maturity of the repo, inversely related to the quality of the collateral,

and directly related to the maturity of the collateral. U.S. Treasury bills are often purchased by Treasury dealers

using repo transactions, and since they have high liquidity, short maturities, and no default risk, the repo rate is

usually quite low. "

2. "The greater control the lender has over the collateral, the lower the repo rate. If the availability of the

collateral is limited, the repo rate will be higher."

Castillo consults with an institutional investor, the Washington Investment Fund, on the effect of leverage on

bond portfolio returns as well as their bond portfolio's sensitivity to changes in interest rates. The portfolio under

discussion is well diversified, with small positions in a large number of bonds. It has a duration of 7.2. Of the

$200 million value of the portfolio, $60 million was borrowed. The duration of borrowed funds is 0.8. The

expected return on the portfolio is 8% and the cost of borrowed funds is 3%.

The next day, the chief investment officer for the Washington Investment Fund expresses her concern about

the risk of their portfolio, given its leverage. She inquires about the various risk measures for bond portfolios. In

response, Diaz distinguishes between the standard deviation and downside risk measures, making the

following statements:

1. ''Portfolio managers complain that using variance to calculate Sharpe ratios is inappropriate. Since it

considers all returns over the entire distribution, variance and the resulting standard deviation are artificially

inflated, so the resulting Sharpe ratio is artificially deflated. Since it is easily calculated for bond portfolios,

managers feci a more realistic measure of risk is the semi-variance, which measures the distribution of returns

below a given return, such as the mean or a hurdle rate."

2. "A shortcoming of VAR is its inability to predict the size of potential losses in the lower tail of the expected

return distribution. Although it can assign a probability to some maximum loss, it does not predict the actual loss

if the maximum loss is exceeded. If Washington Investment Fund is worried about catastrophic loss, shortfall

risk is a more appropriate measure, because it provides the probability of not meeting a target return."

AA has a corporate client, Shaifer Materials with a €20,000,000 bond outstanding that pays an annual fixed

coupon rate of 9.5% with a 5-year maturity. Castillo believes that euro interest rates may decrease further within

the next year below the coupon rate on the fixed rate bond. Castillo would like Shaifer to issue new debt at a

lower euro interest rate in the future. Castillo has, however, looked into the costs of calling the bonds and has

found that the call premium is quite high and that the investment banking costs of issuing new floating rate debt

would be quite steep. As such he is considering using a swaption to create a synthetic refinancing of the bond

at a lower cost than an actual refinancing of the bond. He states that in order to do so, Shaifer should buy a

payer swaption, which would give them the option to pay a lower floating interest rate if rates drop.

Diaz retrieves current market data for payer and receiver swaptions with a maturity of one year. The terms of

each instrument are provided below:

Payer swaption fixed rate7.90%

Receiver swaption fixed rate7.60%

Current Euribor7.20%

Projected Euribor in one year5.90%

Diaz states that, assuming Castillo is correct, Shaifer can exercise a swaption in one year to effectively call in

their old fixed rate euro debt paying 9.5% and refinance at a floating rate, which would be 7.5% in one year.

Regarding their statements concerning the synthetic refinancing of the Shaifer Materials fixed rate euro debt,

are the comments correct?

Options :

A : Only Castillo is correct.

B : Only Diaz is correct.

C :

Both Castillo and Diaz are incorrect.

Answer: A

Question 3

Walter Skinner, CFA, manages a bond portfolio for Director Securities. The bond portfolio is part of a pension

plan trust set up to benefit retirees of Thomas Steel Inc. As part of the investment policy governing the plan and

the bond portfolio, no foreign securities are to be held in the portfolio at any time and no bonds with a credit

rating below investment grade are allowable for the bond portfolio. In addition, the bond portfolio must remain

unleveraged. The bond portfolio is currently valued at $800 million and has a duration of 6.50. Skinner believes

that interest rates are going to increase, so he wants to lower his portfolio's duration to 4.50. He has decided to

achieve the reduction in duration by using swap contracts. He has two possible swaps to choose from:

1. Swap A: 4-year swap with quarterly payments.

2. Swap B: 5-year swap with semiannual payments.

Skinner plans to be the fixed-rate payer in the swap, receiving a floating-rate payment in exchange. For

analysis, Skinner always assumes the duration of a fixed rate bond is 75% of its term to maturity.

Several years ago, Skinner decided to circumvent the policy restrictions on foreign securities by purchasing a

dual currency bond issued by an American holding company with significant operations in Japan. The bond

makes semiannual fixed interest payments in Japanese yen but will make the final principal payment in U.S.

dollars five years from now. Skinner originally purchased the bond to take advantage of the strengthening

relative position of the yen. The result was an above average return for the bond portfolio for several years.

Now, however, he is concerned that the yen is going to begin a weakening trend, as he expects inflation in the

Japanese economy to accelerate over the next few years. Knowing Skinner's situation, one of his colleagues,

Bill Michaels, suggests the following strategy:

"You need to offset your exposure to the Japanese yen by establishing a short position in a synthetic dual

currency bond that matches the terms of the dual currency bond you purchased for the Thomas Steel bond

portfolio. As part of the strategy, you will have to enter into a currency swap as the fixed-rate yen payer. The

swap will neutralize the dual-currency bond position but will unfortunately increase the credit risk exposure of

the portfolio."

Skinner has also spoken to Orval Mann, the senior economist with Director Securities, about his expectations

for the bond portfolio. Mann has also provided some advice to Skinner in the following comment:

"1 know you expect a general increase in interest rates, but I disagree with your assessment of the interest rate

shift. I believe interest rates are going to decrease. Therefore, you will want to synthetically remove the call

features of any callable bonds in your portfolio by purchasing a payer interest rate swaption."

After his lung conversation with Director Securities' senior economist, Orval Mann, Skinner has completely

changed his outlook on interest rates and has decided to extend the duration of his portfolio. The most

appropriate strategy to accomplish this objective using swaps would be to enter into a swap to pay:

Options :

A :

fixed and receive floating.

B : floating and receive fixed.

C : floating and receive floating.

Answer: B

Question 4

Joan Weaver, CFA and Kim McNally, CFA are analysts for Cardinal Fixed Income Management. Cardinal

provides investment advisory services to pension funds, endowments, and other institutions in the U.S. and

Canada. Cardinal recommends positions in investment-grade corporate and government bonds.

Cardinal has largely advocated the use of passive approaches to bond investments, where the predominant

holding consists of an indexed or enhanced indexed bond portfolio. They are exploring, however, the possibility

of using a greater degree of active management to increase excess returns. The analysts have made the

following statements.

• Weaver: "An advantage of both enhanced indexing by matching primary risk factors and enhanced indexing

by minor risk factor mismatching is that there is the potential for excess returns, but the duration of the portfolio

is matched with that of the index, thereby limiting the portion of tracking error resulting from interest rate risk."

• McNally: "The use of active management by larger risk factor mismatches typically involves large duration

mismatches from the index, in an effort to capitalize on interest rate forecasts."

As part of their increased emphasis on active bond management, Cardinal has retained the services of an

economic consultant to provide expectations input on factors such as interest rate levels, interest rate volatility,

and credit spreads. During his presentation, the economist states that he believes long-term interest rates

should fall over the next year, but that short-term rates should gradually increase. Weaver and McNally are

currently advising an institutional client that wishes to maintain the duration of its bond portfolio at 6.7. In light of

the economic forecast, they are considering three portfolios that combine the following three bonds in varying

amounts.

Weaver and McNally next examine an investment in a semiannual coupon bond newly issued by the Manix

Corporation, a firm with a credit rating of AA by Moody's. The specifics of the bond purchase are provided

below given Weaver's projections. It is Cardinal's policy that bonds be evaluated for purchase on a total return

basis.

One of Cardinal's clients, the Johnson Investment Fund (JIF), has instructed Weaver and McNally to

recommend the appropriate debt investment for $125,000,000 in funds. JIF is willing to invest an additional

15% of the portfolio using leverage. JIF requires that the portfolio duration not exceed 5.5. Weaver

recommends that JIF invest in bonds with a duration of 5.2. The maximum allowable leverage will be used and

the borrowed funds will have a duration of 0.8. JIF is considering investing in bonds with options and has asked

McNally to provide insight into these investments. McNally makes the following comments:

"Due to the increasing sophistication of bond issuers, the amount of bonds with put options is increasing, and

these bonds sell at a discount relative to comparable bullets. Putables are quite attractive when interest rates

rise, but, we should be careful if with them, because valuation models often fail to account for the credit risk of

the issuer."

Another client, Blair Portfolio Managers, has asked Cardinal to provide advice on duration management. One

year ago, their portfolio had a market value of $3,010,444 and a dollar duration of $108,000; current figures are

provided below:

The expected bond equivalent yield for the Manix Bond, using total return analysis, is closest to:

Options :

A : 5.92%.

B : 11.86%.

C : 12.12%.

Answer: B

Question 5

Mark Stober, William Robertson, and James McGuire are consultants for a regional pension consultancy. One of their clients, Richard Smitherspoon, chief investment officer of Quality Car Part Manufacturing, recently attended a conference on risk management topics for pension plans. Smitherspoon is a conservative manager who prefers to follow a long-term investment strategy with little portfolio turnover. Smitherspoon has substantial experience in managing a defined benefit plan but has little experience with risk management issues. Smitherspoon decides to discuss how Quality can begin implementing risk management techniques with Stober, Robertson, and McGuire. Quality's risk exposure is evaluated on a quarterly basis. Before implementing risk management techniques, Smitherspoon expresses confusion regarding some measures of risk management. "I know beta and standard deviation, but what is all this stuff about convexity, delta, gamma, and vega?" Stober informs Smitherspoon that delta is the first derivative of the call-stock price curve, and Robertson adds that gamma is the relationship between how bond prices change with changing time to maturity. Smitherspoon is still curious about risk management techniques, and in particular the concept of VAR. He asks, "What does a daily 5% VAR of $5 million mean? I just get so confused with whether VAR is a measure of maximum or minimum loss. Just last month, the consultant from MinRisk, a competing consulting firm, told me it was ‘a measure of maximum loss, which in your case means we are 95% confident that the maximum 1-day loss is $5.0 million." McGuire states that his definition of VAR is that "VAR is a measure that combines probabilities over a certain time horizon with dollar amounts, which in your case means that one expects to lose a minimum $5 million five trading days out of every 100." Smitherspoon expresses bewilderment at the different methods for determining VAR. "Can't you risk management types formulate a method that works like calculating a beta? It would be so easy if there were a method that allowed one to just use mean and standard deviation. I need a VAR that I can get my arms around." The next week, Stober visits the headquarters of TopTech, a communications firm. Their CFO is Ralph Long, who prefers to manage the firm's pension himself because he believes he can time the market and spot upcoming trends before analysts can. Long also believes that risk measurement for TopTech can be evaluated annually because of his close attention to the portfolio. Stober calculates TopTech's 95% surplus at risk to be S500 million for an annual horizon. The expected return on TopTech's asset base (currently at S2 billion) is 5%. The plan has a surplus of $100 million. Stober uses a 5% probability level to calculate the minimum amount by which the plan will be underfunded next year. Of the following VAR calculation methods, the measure that would most likely suit Smitherspoon is the:

Options :

A : variance-covariance method.

B : historical simulation method.

C : Monte Carlo simulation method.

Answer: A