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

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Presentation on theme: "FIXED INCOME: CFA LEVEL I Fixed Income II - Problem Solving Session Harvard Extension School MGMT E-2900b CFA Exam Level I March 30, 2010."— Presentation transcript:

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

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

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

4 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 1. 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: A. $ B. $ C. $101.50

5 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 1. 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: A. $ B. $ C. $ % ∆ in bond price = – (dur. x % ∆ in yield)  % = – [2.5(6.84% %)]  $ [1+ (– 1.475%)] ≈ $100

6 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 2. If interest rate volatility increases, which of the following bonds will experience a price increase? A. A straight coupon bond B. A putable bond C. A callable bond

7 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 2. If interest rate volatility increases, which of the following bonds will experience a price increase? A. A straight coupon bond B. A putable bond C. A callable bond

8 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 2. 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.

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

10 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 3. An option-free, zero-coupon, 10-year AA- rated bond, yielding 7% is most likely to have ______ risk, and least likely to have ______ risk: A. default, inflation B. interest rate, reinvestment C. reinvestment, interest rate

11 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 3. An option-free, zero-coupon, 10-year AA- rated bond, yielding 7% is most likely to have ______ risk, and least likely to have ______ risk: A. default, inflation B. interest rate, reinvestment C. reinvestment, interest rate

12 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 3. 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.

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

14 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 4. Which of the following has the least interest rate risk? A. A 4%, 5-year option-free bond paying 3% B. A 4%, 5-year putable bond paying 3% C. A 4%, 5-year option-free bond paying 5% 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 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 5. 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? A. 3.5 B. 4.0 C. 4.5

16 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 5. 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? A. 3.5 B. 4.0 C. 4.5 Duration = – (% ∆ in price / % yield ∆); price and yield are inversely correlated. 95:29 = 95(29/32) = $ ≈ $ :16 = 98(16/32) = $98.50 Duration = – [(95.91/98.50) – 1]/ = ≈ 3.5

17 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 6. A floating-rate bullet-bond will have the lowest duration: A. one day after its reset date B. one day before its reset date C. the day after initial issuance

18 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 6. A floating-rate bullet-bond will have the lowest duration: A. one day after its reset date B. one day before its reset date C. the day after initial issuance 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 FIXED INCOME: CFA LEVEL I 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: 7. Which of the following values most closely matches the price change if interest rates fall by 1.5%? A. $30.14 B. -$60.29 C. $60.29

20 FIXED INCOME: CFA LEVEL I 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: 7. Which of the following values most closely matches the price change if interest rates fall by 1.5%? A. $30.14 B. -$60.29 C. $60.29 $ Price ∆ = – [(Duration) x (% ∆ Yield) x (Bond Price)]  = – [(4.52) x (–0.015) x ($889.20)]  = $60.29

21 FIXED INCOME: CFA LEVEL I 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: 8. What is the option value of a similar callable bond quoted at $810.12? A. $79.08 B. -$79.08 C. $110.08

22 FIXED INCOME: CFA LEVEL I 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: 8. What is the option value of a similar callable bond quoted at $810.12? A. $79.08 B. -$79.08 C. $ Call option value = $ $ = $79.08

23 FIXED INCOME: CFA LEVEL I 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: 9. What is the option value of a similar putable bond quoted at % of par? A. $58.75 B. $ C. -$58.75

24 FIXED INCOME: CFA LEVEL I 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: 9. What is the option value of a similar putable bond quoted at % of par? A. $58.75 B. $ C. -$58.75 Put option value = $ $ = $117.50

25 FIXED INCOME: CFA LEVEL I 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: 10. Compared to the straight bond, what will most likely happen to the price of a similar callable bond if interest rates rise? A. Cannot be determine with given information B. The price of the callable bond will fall more than the price of the straight bond C. The price of the callable bond will fall less than the price of the straight bond

26 FIXED INCOME: CFA LEVEL I 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: 10. Compared to the straight bond, what will most likely happen to the price of a similar callable bond if interest rates rise? A. Cannot be determine with given information B. The price of the callable bond will fall more than the price of the straight bond C. The price of the callable bond will fall less than the price of the straight bond

27 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds Price-Yield Curve for a Callable Bond Y1Y2 Ps1 Ps2 Pc1 Pc2 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.

28 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 11. Which of the following attributes contributes to a security having more reinvestment risk: 1) prepayment option 2) an amortizing security 3) a coupon rate above the market rate 4) a call feature A. 1, 2, & 3 B. 3 & 4 C. 1, 2, 3, & 4

29 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 11. Which of the following attributes contributes to a security having more reinvestment risk: 1) prepayment option 2) an amortizing security 3) a coupon rate above the market rate 4) a call feature A. 1, 2, & 3 B. 3 & 4 C. 1, 2, 3, & 4

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.

31 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 11. Which of the following bonds most likely has the lowest interest rate risk? A. Zero-coupon bond B. A floating-rate bond C. A callable 5.5% fixed-coupon bond

32 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 11. Which of the following bonds most likely has the lowest interest rate risk? A. Zero-coupon bond B. A floating-rate bond C. A callable 5.5% fixed-coupon bond 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 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 11. 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 A. parallel, non-parallel B. non-parallel, parallel C. parallel, parallel

34 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 11. 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 A. parallel, non-parallel B. non-parallel, parallel C. parallel, parallel

35 FIXED INCOME: CFA LEVEL I 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. Yield Maturity non-parallel shift parallel shift Initial Yield Curve

36 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 11. Which of the following is most likely to be considered an event risk for fixed income securities? A. An increase in the federal funds rate B. An act of god C. A stock market crash

37 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 11. Which of the following is most likely to be considered an event risk for fixed income securities? A. An increase in the federal funds rate B. An act of god C. A stock market crash

38 FIXED INCOME: CFA LEVEL I 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.

39 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 12. Which of the following has the least interest rate risk? The bond with a: A. 2.5% coupon and 5-year maturity B. 3% coupon and 10-year maturity C. 3.5% coupon and 5-year maturity

40 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 12. Which of the following has the least interest rate risk? The bond with a: A. 2.5% coupon and 5-year maturity B. 3% coupon and 10-year maturity C. 3.5% coupon and 5-year maturity Interest rate risk is directly related to a bond’s maturity (duration) and inversely related to a bond’s yield.

41 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 13. Due to (1)_______ risk, investors demand (2)________ expected returns from (3)________? (1)(2)(3) A.CreditHigher10-Year Treasury Notes B. Exchange Rate Lower A large-cap emerging market company’s bonds C.LiquidityHigherA U.S. mid-cap biotech company’s bonds

42 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 13. Due to (1)_______ risk, investors demand (2)________ expected returns from (3)________? (1)(2)(3) A.CreditHigher10-Year Treasury notes B. Exchange Rate Lower A large-cap emerging market company’s bonds C.LiquidityHigherA U.S. mid-cap biotech company’s bonds

43 FIXED INCOME: CFA LEVEL I 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.

44 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 14. Which of the following investments has the lowest liquidity risk? A. Japanese Treasury notes B. Bonds from a U.S. mid-cap biotech company C. Bonds form a large-cap emerging market company

45 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 14. Which of the following investments has the lowest liquidity risk? A. Japanese Treasury notes B. Bonds from a U.S. mid-cap biotech company C. Bonds form a large-cap emerging market company 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 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 15. A 5-Year Treasury note is least likely to have _______, but most like to have________: A. currency risk, credit risk B. volatility risk, reinvestment risk C. inflation risk, interest rate risk

47 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 15. A 5-Year Treasury note is least likely to have _______, but most like to have________: A. currency risk, credit risk B. volatility risk, reinvestment risk C. inflation risk, interest rate risk

48 FIXED INCOME: CFA LEVEL I 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).

49 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 16. 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: A. yield curve risk B. downgrade risk C. credit spread risk

50 FIXED INCOME: CFA LEVEL I Risks Associated with Bonds 16. 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: A. yield curve risk B. downgrade risk C. credit spread risk

51 FIXED INCOME: CFA LEVEL I 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.)

52 FIXED INCOME: CFA LEVEL I Ethics & Professional Standards

53 FIXED INCOME: CFA LEVEL I 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? A. No No B. No Yes C. Yes No

54 FIXED INCOME: CFA LEVEL I 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? A. No No B. No Yes C. Yes No

55 FIXED INCOME: CFA LEVEL I 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, 9 th Ed., Pg. 105

56 FIXED INCOME: CFA LEVEL I 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, 9 th Ed., Pg. 99

57 FIXED INCOME: CFA LEVEL I 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? A. No. B. Yes, the CFA designation must not be used as a noun and they cannot advertise their success at passing each exam C. Yes, the CFA designation must not be used as a noun and they cannot link success in passing each exam with greater portfolio returns

58 FIXED INCOME: CFA LEVEL I 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? A. No. B. Yes, the CFA designation must not be used as a noun and they cannot advertise their success at passing each exam C. Yes, the CFA designation must not be used as a noun and they cannot link success in passing each exam with greater portfolio returns

59 FIXED INCOME: CFA LEVEL I 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, 9 th Ed., Pg. 138

60 FIXED INCOME: CFA LEVEL I 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, 9 th Ed., Pg. 137


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