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Fixed Income II - Problem Solving Session

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1 Fixed Income II - Problem Solving Session
FIXED INCOME: CFA LEVEL I Harvard Extension School MGMT E-2900b CFA Exam Level I March 30, 2010

2 Fixed Income I Problem Solving Session
Rich Gibble Lecturer Tray Spilker Teaching Assistant FIXED INCOME: CFA LEVEL I

3 Fixed Income II: Risks Associated with Bonds
Study Session 15 Reading 61 FIXED INCOME: CFA LEVEL I

4 Risks Associated with Bonds
A 6.25% yielding bond, with a duration of 2.5 is trading at $ If the yield increases to 6.84%, the bond’s new price is closest to: $103.00 $100.00 $101.50 FIXED INCOME: CFA LEVEL I

5 Risks Associated with Bonds
A 6.25% yielding bond, with a duration of 2.5 is trading at $ If the yield increases to 6.84%, the bond’s new price is closest to: $103.00 $100.00 $101.50 FIXED INCOME: CFA LEVEL I % ∆ in bond price = – (dur. x % ∆ in yield)  % = – [2.5(6.84% %)]  $ [1+ (– 1.475%)] ≈ $100

6 Risks Associated with Bonds
If interest rate volatility increases, which of the following bonds will experience a price increase? A straight coupon bond A putable bond A callable bond FIXED INCOME: CFA LEVEL I

7 Risks Associated with Bonds
If interest rate volatility increases, which of the following bonds will experience a price increase? A straight coupon bond A putable bond A callable bond FIXED INCOME: CFA LEVEL I

8 Risks Associated with Bonds
Explained: An increase in volatility increases the value of an option. The option of a callable bond is held by the issuer, thus the bond price falls as volatility increases. Conversely, putable bonds increase in value because the owner of the option is the bondholder. FIXED INCOME: CFA LEVEL I

9 Risks Associated with Bonds
Price-Yield Curve for a Callable Bond Price-Yield Curve for a Putable Bond FIXED INCOME: CFA LEVEL I

10 Risks Associated with Bonds
An option-free, zero-coupon, 10-year AA-rated bond, yielding 7% is most likely to have ______ risk, and least likely to have ______ risk: default, inflation interest rate, reinvestment reinvestment, interest rate FIXED INCOME: CFA LEVEL I

11 Risks Associated with Bonds
An option-free, zero-coupon, 10-year AA-rated bond, yielding 7% is most likely to have ______ risk, and least likely to have ______ risk: default, inflation interest rate, reinvestment reinvestment, interest rate FIXED INCOME: CFA LEVEL I

12 Risks Associated with Bonds
Explained: Zero-coupon bonds have no reinvestment risk given their lack of reinvestable cash flows prior to maturity. They are more prone, however, to interest rate risk given their longer duration sensitivities. While a AA- rated bond has some default risk, it is relatively small. FIXED INCOME: CFA LEVEL I

13 Risks Associated with Bonds
Which of the following has the least interest rate risk? A 4%, 5-year option-free bond paying 3% A 4%, 5-year putable bond paying 3% A 4%, 5-year option-free bond paying 5% FIXED INCOME: CFA LEVEL I

14 Risks Associated with Bonds
Which of the following has the least interest rate risk? A 4%, 5-year option-free bond paying 3% A 4%, 5-year putable bond paying 3% A 4%, 5-year option-free bond paying 5% FIXED INCOME: CFA LEVEL I Embedded options reduce the duration of a bond, and thus interest rate risk. Lower yielding straight bonds are subject to higher interest rate risks than higher yielding straight bonds.

15 Risks Associated with Bonds
Which of the following durations most closely matches that of a bond quoted at 98:16, whose value falls to 95:29 if rates rise by 75bps? 3.5 4.0 4.5 FIXED INCOME: CFA LEVEL I

16 Risks Associated with Bonds
Which of the following durations most closely matches that of a bond quoted at 98:16, whose value falls to 95:29 if rates rise by 75bps? 3.5 4.0 4.5 FIXED INCOME: CFA LEVEL I Duration = – (% ∆ in price / % yield ∆); price and yield are inversely correlated. 95:29 = 95(29/32) = $ ≈ $95.91 98:16 = 98(16/32) = $98.50 Duration = – [(95.91/98.50) – 1]/ = ≈ 3.5

17 Risks Associated with Bonds
A floating-rate bullet-bond will have the lowest duration: one day after its reset date one day before its reset date the day after initial issuance FIXED INCOME: CFA LEVEL I

18 Risks Associated with Bonds
A floating-rate bullet-bond will have the lowest duration: one day after its reset date one day before its reset date the day after initial issuance FIXED INCOME: CFA LEVEL I Duration of a floating-rate note is smallest just prior to its coupon payment/reset date. It’s largest duration , therefore, is just after each reset date.

19 Risks Associated with Bonds
Questions 7-10: A straight 4% bond with five years to maturity is quoted at $ and has a duration of 4.52: Which of the following values most closely matches the price change if interest rates fall by 1.5%? $30.14 -$60.29 $60.29 FIXED INCOME: CFA LEVEL I

20 Risks Associated with Bonds
Questions 7-10: A straight 4% bond with five years to maturity is quoted at $ and has a duration of 4.52: Which of the following values most closely matches the price change if interest rates fall by 1.5%? $30.14 -$60.29 $60.29 FIXED INCOME: CFA LEVEL I $ Price ∆ = – [(Duration) x (% ∆ Yield) x (Bond Price)]  = – [(4.52) x (–0.015) x ($889.20)]  = $60.29

21 Risks Associated with Bonds
Questions 7-10 (cont.): A straight 4% bond with five years to maturity is quoted at $ and has a duration of 4.52: What is the option value of a similar callable bond quoted at $810.12? $79.08 -$79.08 $110.08 FIXED INCOME: CFA LEVEL I

22 Risks Associated with Bonds
Questions 7-10 (cont.): A straight 4% bond with five years to maturity is quoted at $ and has a duration of 4.52: What is the option value of a similar callable bond quoted at $810.12? $79.08 -$79.08 $110.08 FIXED INCOME: CFA LEVEL I Call option value = $ $810.12 = $79.08

23 Risks Associated with Bonds
Questions 7-10 (cont.): A straight 4% bond with five years to maturity is quoted at $ and has a duration of 4.52: What is the option value of a similar putable bond quoted at % of par? $58.75 $117.50 -$58.75 FIXED INCOME: CFA LEVEL I

24 Risks Associated with Bonds
Questions 7-10 (cont.): A straight 4% bond with five years to maturity is quoted at $ and has a duration of 4.52: What is the option value of a similar putable bond quoted at % of par? $58.75 $117.50 -$58.75 FIXED INCOME: CFA LEVEL I Put option value = $ $889.20 = $117.50

25 Risks Associated with Bonds
Questions 7-10 (cont.): A straight 4% bond with five years to maturity is quoted at $ and has a duration of 4.52: Compared to the straight bond, what will most likely happen to the price of a similar callable bond if interest rates rise? Cannot be determine with given information The price of the callable bond will fall more than the price of the straight bond The price of the callable bond will fall less than the price of the straight bond FIXED INCOME: CFA LEVEL I

26 Risks Associated with Bonds
Questions 7-10 (cont.): A straight 4% bond with five years to maturity is quoted at $ and has a duration of 4.52: Compared to the straight bond, what will most likely happen to the price of a similar callable bond if interest rates rise? Cannot be determine with given information The price of the callable bond will fall more than the price of the straight bond The price of the callable bond will fall less than the price of the straight bond FIXED INCOME: CFA LEVEL I

27 Risks Associated with Bonds
Price-Yield Curve for a Callable Bond The price of an option-free bond falls more (Ps1 Ps2) than that of a callable bond (Pc1 Pc2) because the price of the embedded call option also declines. FIXED INCOME: CFA LEVEL I Ps1 Ps2 Pc1 Pc2 Y1 Y2

28 Risks Associated with Bonds
Which of the following attributes contributes to a security having more reinvestment risk: prepayment option an amortizing security a coupon rate above the market rate a call feature 1, 2, & 3 3 & 4 1, 2, 3, & 4 FIXED INCOME: CFA LEVEL I

29 Risks Associated with Bonds
Which of the following attributes contributes to a security having more reinvestment risk: prepayment option an amortizing security a coupon rate above the market rate a call feature 1, 2, & 3 3 & 4 1, 2, 3, & 4 FIXED INCOME: CFA LEVEL I

30 FIXED INCOME: CFA LEVEL I
Reinvestment Risk Reinvestment risk refers to risk borne by the investor from having to reinvest cash flows from fixed income instruments at potentially lower yields. Cash flows prior to the stated maturity from principle prepayments, amortizing securities, interest payments, and bond calls are subject to reinvestment risk. FIXED INCOME: CFA LEVEL I

31 Risks Associated with Bonds
Which of the following bonds most likely has the lowest interest rate risk? Zero-coupon bond A floating-rate bond A callable 5.5% fixed-coupon bond FIXED INCOME: CFA LEVEL I

32 Risks Associated with Bonds
Which of the following bonds most likely has the lowest interest rate risk? Zero-coupon bond A floating-rate bond A callable 5.5% fixed-coupon bond FIXED INCOME: CFA LEVEL I A floating rate bond is subject to less interest rate risk as coupon payments are periodically reset (usually quarterly) and tied to interest rate indices (e.g., Libor). Duration is normally near zero.

33 Risks Associated with Bonds
Portfolio duration is an approximation of the price sensitivity of a bond portfolio to a ______ shift in the yield curve. Yield curve risk refers to a ______ shift in the yield curve parallel, non-parallel non-parallel, parallel parallel, parallel FIXED INCOME: CFA LEVEL I

34 Risks Associated with Bonds
Portfolio duration is an approximation of the price sensitivity of a bond portfolio to a ______ shift in the yield curve. Yield curve risk refers to a ______ shift in the yield curve parallel, non-parallel non-parallel, parallel parallel, parallel FIXED INCOME: CFA LEVEL I

35 Risks Associated with Bonds
Yield Curve Risk: risk of decreases in portfolio value from changes in the shape of the yield curve; i.e., non-parallel curve shifts. non-parallel shift Yield FIXED INCOME: CFA LEVEL I parallel shift Initial Yield Curve Maturity

36 Risks Associated with Bonds
Which of the following is most likely to be considered an event risk for fixed income securities? An increase in the federal funds rate An act of god A stock market crash FIXED INCOME: CFA LEVEL I

37 Risks Associated with Bonds
Which of the following is most likely to be considered an event risk for fixed income securities? An increase in the federal funds rate An act of god A stock market crash FIXED INCOME: CFA LEVEL I

38 Risks Associated with Bonds
Federal reserve actions and a market crashes are financial market related events, and thus, not considered event risks. Event risk encompasses risks outside of the financial markets like natural disasters, changes in regulation, and corporate events (e.g., M&A). An ‘act of god’ is a legal term for events outside of human control, such as sudden floods or other natural disasters, for which no one can be held responsible. FIXED INCOME: CFA LEVEL I

39 Risks Associated with Bonds
Which of the following has the least interest rate risk? The bond with a: 2.5% coupon and 5-year maturity 3% coupon and 10-year maturity 3.5% coupon and 5-year maturity FIXED INCOME: CFA LEVEL I

40 Risks Associated with Bonds
Which of the following has the least interest rate risk? The bond with a: 2.5% coupon and 5-year maturity 3% coupon and 10-year maturity 3.5% coupon and 5-year maturity FIXED INCOME: CFA LEVEL I Interest rate risk is directly related to a bond’s maturity (duration) and inversely related to a bond’s yield.

41 Risks Associated with Bonds
Due to (1)_______ risk, investors demand (2)________ expected returns from (3)________? FIXED INCOME: CFA LEVEL I (1) (2) (3) A. Credit Higher 10-Year Treasury Notes B. Exchange Rate Lower A large-cap emerging market company’s bonds C. Liquidity A U.S. mid-cap biotech company’s bonds

42 Risks Associated with Bonds
Due to (1)_______ risk, investors demand (2)________ expected returns from (3)________? FIXED INCOME: CFA LEVEL I (1) (2) (3) A. Credit Higher 10-Year Treasury notes B. Exchange Rate Lower A large-cap emerging market company’s bonds C. Liquidity A U.S. mid-cap biotech company’s bonds

43 Risks Associated with Bonds
U.S. Treasuries are “risk free” and investors expect lower returns as a result. Exchange rate risk increases risk, causing investors to demand higher expected returns. An increase in liquidity risk causes investor’s to demand higher expected returns. A mid- cap biotech company’s bonds will exhibit lower liquidity versus bonds of a larger-cap company or U.S. Treasuries. FIXED INCOME: CFA LEVEL I

44 Risks Associated with Bonds
Which of the following investments has the lowest liquidity risk? Japanese Treasury notes Bonds from a U.S. mid-cap biotech company Bonds form a large-cap emerging market company FIXED INCOME: CFA LEVEL I

45 Risks Associated with Bonds
Which of the following investments has the lowest liquidity risk? Japanese Treasury notes Bonds from a U.S. mid-cap biotech company Bonds form a large-cap emerging market company FIXED INCOME: CFA LEVEL I Bid-ask spreads are an indication of liquidity; the wider the spread the lower the liquidity. When no price data is available, periodic valuation on illiquid securities is referred to as marking-to-market

46 Risks Associated with Bonds
A 5-Year Treasury note is least likely to have _______, but most like to have________: currency risk, credit risk volatility risk, reinvestment risk inflation risk, interest rate risk FIXED INCOME: CFA LEVEL I

47 Risks Associated with Bonds
A 5-Year Treasury note is least likely to have _______, but most like to have________: currency risk, credit risk volatility risk, reinvestment risk inflation risk, interest rate risk FIXED INCOME: CFA LEVEL I

48 Risks Associated with Bonds
The Treasury note will most likely have the following risks: inflation, interest rate, reinvestment and currency risk (for non-domestic investors). The Treasury note will most likely not have the following risks: volatility (applies to bonds with embedded options) and credit risk (risk free). FIXED INCOME: CFA LEVEL I

49 Risks Associated with Bonds
An investor is considering a BB-rated bond but is concerned with the possibility that the market premium for this bond may widen against the Treasury yield curve. Which of the following most closely matches the risk the investor is referring to: yield curve risk downgrade risk credit spread risk FIXED INCOME: CFA LEVEL I

50 Risks Associated with Bonds
An investor is considering a BB-rated bond but is concerned with the possibility that the market premium for this bond may widen against the Treasury yield curve. Which of the following most closely matches the risk the investor is referring to: yield curve risk downgrade risk credit spread risk FIXED INCOME: CFA LEVEL I

51 Risks Associated with Bonds
Credit Spread Risk: Uncertainty regarding a bond’s yield spread versus the treasury curve for a given bond rating. Yield Curve Risk: Risk of decreases in portfolio value from changes in the shape of the yield curve; i.e., non-parallel curve shifts. Downgrade Risk: Risk of the reduction in the bond’s rating; as determined by the ratings agencies (S&P, Fitch, Moody’s, etc.) FIXED INCOME: CFA LEVEL I

52 Ethics & Professional Standards
FIXED INCOME: CFA LEVEL I

53 Ethics Item Set CFA Sample Questions
Monique Stein, CFA, conducted a thorough analysis and issued a research report on a manufacturing company. In the report, which was made available to all clients of her firm, Stein included her opinion that she was uncertain about the ability of the company to perform on a contract. The Chief Executive Officer of the company disagreed and submitted a complaint to Stein’s supervisor. The complaint alleged that employees of the manufacturing company explained the contract to Stein, but that she did not accept their explanation. According to the Standards of Practice Handbook, did Stein violate the CFA Institute Standard of Professional Conduct relating to: communication with clients and prospective clients? diligence and reasonable basis? No No No Yes Yes No FIXED INCOME: CFA LEVEL I

54 Ethics Item Set CFA Sample Questions
Monique Stein, CFA, conducted a thorough analysis and issued a research report on a manufacturing company. In the report, which was made available to all clients of her firm, Stein included her opinion that she was uncertain about the ability of the company to perform on a contract. The Chief Executive Officer of the company disagreed and submitted a complaint to Stein’s supervisor. The complaint alleged that employees of the manufacturing company explained the contract to Stein, but that she did not accept their explanation. According to the Standards of Practice Handbook, did Stein violate the CFA Institute Standard of Professional Conduct relating to: communication with clients and prospective clients? diligence and reasonable basis? No No No Yes Yes No FIXED INCOME: CFA LEVEL I

55 Ethics Item Set CFA Sample Questions
Communication with Clients and Prospective Clients: “Disclose to clients and prospective clients the basic format and general principles of the investment process used to analyze investments” ; “Distinguish between fact and opinion in the presentation of investment analysis and recommendation.” - Standards of Practice Handbook, 9th Ed., Pg. 105 FIXED INCOME: CFA LEVEL I

56 Ethics Item Set CFA Sample Questions
Diligence and Reasonable Basis: “Exercise diligence, independence, and thoroughness in analyzing investments, making investment recommendations, and taking investment actions”; “If members and candidates rely on secondary or third-party research, they must make reasonable and diligent efforts to determine whether such research is sound…If a member or candidate has reason to suspect that either secondary or third-party research or information comes from a source that lacks a sound basis, the member or candidate must refrain from relying on that information.” - Standards of Practice Handbook, 9th Ed., Pg. 99 FIXED INCOME: CFA LEVEL I

57 Ethics Item Set CFA Sample Questions
Harbour Island Financial advertises that each of its portfolio managers are CFA’s and that each passed the three exams on their first attempts. As a result, Harbour Island Financial states that investors should expect superior returns. Has Harbour Island Financial violated the Standards of Practice? No. Yes, the CFA designation must not be used as a noun and they cannot advertise their success at passing each exam Yes, the CFA designation must not be used as a noun and they cannot link success in passing each exam with greater portfolio returns FIXED INCOME: CFA LEVEL I

58 Ethics Item Set CFA Sample Questions
Harbour Island Financial advertises that each of its portfolio managers are CFA’s and that each passed the three exams on their first attempts. As a result, Harbour Island Financial states that investors should expect superior returns. Has Harbour Island Financial violated the Standards of Practice? No. Yes, the CFA designation must not be used as a noun and they cannot advertise their success at passing each exam Yes, the CFA designation must not be used as a noun and they cannot link success in passing each exam with greater portfolio returns FIXED INCOME: CFA LEVEL I

59 Ethics Item Set CFA Sample Questions
Standard VII (B) - Reference to CFA Institute, the CFA designation, and the CFA Program: “The Chartered Financial Analyst and CFA marks must always be used either after a charterholder’s name or as adjectives (never as nouns) in written documents or oral conversations. For Example, to refer to oneself as ‘a CFA’ or ‘a Chartered Financial Analyst’ is improper.” - Standards of Practice Handbook, 9th Ed., Pg. 138 FIXED INCOME: CFA LEVEL I

60 Ethics Item Set CFA Sample Questions
Standard VII (B) - Reference to CFA Institute, the CFA designation, and the CFA Program: “If a candidate passes each level of the exam on the first try and wants to state that he or she did so, that is not a violation of Standard VII (B) because it is a statement of fact. If the candidate then goes on to claim or imply superior ability by obtaining the designation in only three years, he or she is in violation of Standard VII (B).” - Standards of Practice Handbook, 9th Ed., Pg. 137 FIXED INCOME: CFA LEVEL I


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