Question 1

Jack Higgins, CFA, and Tim Tyler, CFA, are analysts for Integrated Analytics (LA), a U.S.-based investment

analysis firm. JA provides bond analysis for both individual and institutional portfolio managers throughout the

world. The firm specializes in the valuation of international bonds, with consideration of currency risk. IA

typically uses forward contracts to hedge currency risk.

Higgins and Tyler are considering the purchase of a bond issued by a Norwegian petroleum products firm,

Bergen Petroleum. They have concerns, however, regarding the strength of the Norwegian krone currency

(NKr) in the near term, and they want to investigate the potential return from hedged strategies. Higgins

suggests that they consider forward contracts with the same maturity as the investment holding period, which is

estimated at one year. He states that if IA expects the Norwegian NKr to depreciate and that the Swedish krona

(Sk) to appreciate, then IA should enter into a hedge where they sell Norwegian NKr and buy Swedish Sk via a

one-year forward contract. The Swedish Sk could then be converted to dollars at the spot rate in one year.

Tyler states that if an investor cannot obtain a forward contract denominated in Norwegian NKr and if the

Norwegian NKr and euro are positively correlated, then a forward contract should be entered into where euros

will be exchanged for dollars in one year. Tyler then provides Higgins the following data on risk-free rates and

spot rates in Norway and the U.S., as well as the expected return on the Bergen Petroleum bond.

Return on Bergen Petroleum bond in Norwegian NKr 7.00%

Risk-free rate in Norway 4.80%

Expected change in the NKr relative to the U.S. dollar -0.40%

Risk-free rate in United States 2.50%

Higgins and Tyler discuss the relationship between spot rates and forward rates and comment as follows.

• Higgins: "The relationship between spot rates and forward rates is referred to as interest rate parity, where

higher forward rates imply that a country's spot rate will increase in the future."

• Tyler: "Interest rate parity depends on covered interest arbitrage which works as follows. Suppose the 1-year

U.K. interest rate is 5.5%, the 1-year Japanese interest rate is 2.3%, the Japanese yen is at a one-year forward

premium of 4.1%, and transactions costs are minimal. In this case, the international trader should borrow yen.

Invest in pound denominated bonds, and use a yen-pound forward contract to pay back the yen loan."

The following day, Higgins and Tyler discuss various emerging market bond strategies and make the following

statements.

• Higgins: "Over time, the quality in emerging market sovereign bonds has declined, due in part to contagion

and the competitive devaluations that often accompany crises in emerging markets. When one country

devalues their currency, others often quickly follow and as a result the countries default on their external debt,

which is usually denominated in a hard currency."

• Tyler: "Investing outside the index can provide excess returns. Because the most common emerging market

bond index is concentrated in Latin America, the portfolio manager can earn an alpha by investing in emerging

country bonds outside of this region."

Turning their attention to specific issues of bonds, Higgins and Tyler examine the characteristics of two bonds:

a six-year maturity bond issued by the Midlothian Corporation and a twelve-year maturity bond issued by the

Horgen Corporation. The Midlothian bond is a U.S. issue and the Horgen bond was issued by a firm based in

Switzerland. The characteristics of each bond are shown in the table below. Higgins and Tyler discuss the

relative attractiveness of each bond and, using a total return approach, which bond should be invested in,

assuming a 1-year time horizon.

Which of the following statements provides the best description of the advantage of using breakeven spread analysis? Breakeven spread analysis:

Options :

A : provides an estimate of exchange rate risk.

B : quantifies the change in spread needed to offset a foreign yield advantage.

C : assesses the risk of a foreign bond investment independent of the bond-s duration.

Answer: B

Question 2

Andre Hickock, CFA, is a newly hired fixed income portfolio manager for Deadwood Investments, LLC. Hickock

is reviewing the portfolios of several pension clients that have been assigned to him to manage. The first

portfolio, Montana Hardware, Inc., has the characteristics shown in Figure 1.

Hickock is attempting to assess the risk of the Montana Hardware portfolio. The benchmark bond index that

Deadwood uses for pension accounts similar to Montana Hardware has an effective duration of 5.25. His

supervisor, Carla Mity, has discussed bond risk measurement with Hickock. Mity is most familiar with equity risk

measures, and is not convinced of the validity of duration as a portfolio risk measure. Mity told Hickock, "I have

always believed that standard deviation is the best measure of bond portfolio risk. You want to know the

volatility, and standard deviation is the most direct measure of volatility."

Hickock is also reviewing the bond portfolio of Buffalo Sports, Inc., which is comprised of the following assets

shown in Figure 2.

The trustees of the Buffalo Sports pension plan have requested that Deadwood explore alternatives to reduce

the risk of the MBS sector of their bond portfolio. Hickock responded to their request as follows:

"I believe that the current option-adjusted spread (OAS) on the MBS sector is quite high. In order to reduce your

risk, I would suggest that we hedge the interest rate risk using a combination of 2-year and 10-year Treasury

security futures. I would further suggest that we do not take any steps to hedge spread risk at this time."

In assessing the risk of a portfolio containing both bullet maturity corporate bonds and MBS, Hickock should

always consider that:

Options :

A :

the duration of MBS securities will increase as the level of interest rates declines.

B :

MBS values will benefit from higher convexity as interest rates decline.

C :

MBS values will be more sensitive to changes in the shape of the yield curve than bullet maturity corporate

bonds.

Answer: C

Question 3

Mark Rolle, CFA, is the manager of the international bond fund for the Ryder Investment Advisory. He is

responsible for bond selection as well as currency hedging decisions. His assistant is Joanne Chen, a

candidate for the Level 1 CFA exam.

Rolle is interested in the relationship between interest rates and exchange rates for Canada and Great Britain.

He observes that the spot exchange rate between the Canadian dollar (C$) and the British pound is C$1.75/£.

Also, the 1-year interest rate in Canada is 4.0% and the 1-year interest rate in Great Britain is 11.0%. The

current 1-year forward rate is C$1.60/£.

Rolle is evaluating the bonds from the Knauff company and the Tatehiki company, for which information is

provided in the table below. The Knauff company bond is denominated in euros and the Tatehiki company bond

is denominated in yen. The bonds have similar risk and maturities, and Ryder's investors reside in the United

States.

Provided this information, Rolle must decide which country's bonds are most attractive if a forward hedge of

currency exposure is used. Furthermore, assuming that both country's bonds are bought, Rolle must also

decide whether or not to hedge the currency exposure.

Rolle also has a position in a bond issued in Korea and denominated in Korean won. Unfortunately, he is having

difficulty obtaining a forward contract for the won on favorable terms. As an alternative hedge, he has entered a

forward contract that allows him to sell yen in one year, when he anticipates liquidating his Korean bond. His

reason for choosing the yen is that it is positively correlated with the won.

One of Ryder's services is to provide consulting advice to firms that are interested in interest rate hedging

strategies. One such firm is Crawfordville Bank. One of the loans Crawfordville has outstanding has an interest

rate of LIBOR plus a spread of 1.5%. The chief financial officer at Crawfordville is worried that interest rates

may increase and would like to hedge this exposure. Rolle is contemplating either an interest rate cap or an

interest rate floor as a hedge.

Additionally, Rolle is analyzing the best hedge for Ryder's portfolio of fixed rate coupon bonds. Rolle is

contemplating using either a covered call or a protective put on a T-bond futures contract.

The hedge that Rolle uses to hedge the currency exposure of the Korean bond is best referred to as a:

Options :

A : proxy hedge.

B : cross hedge.

C : forward hedge.

Answer: A

Question 4

Eugene Price, CFA, a portfolio manager for the American Universal Fund (AUF), has been directed to pursue a

contingent immunization strategy for a portfolio with a current market value of $100 million. AUF's trustees are

not willing to accept a rate of return less than 6% over the next five years. The trustees have also stated that

they believe an immunization rate of 8% is attainable in today's market. Price has decided to implement this

strategy by initially purchasing $100 million in 10-year bonds with an annual coupon rate of 8.0%, paid

semiannually

Price forecasts that the prevailing immunization rate and market rate for the bonds will both rise from 8% to 9%

in one year.

While Price is conducting his immunization strategy he is approached by April Banks, a newly hired junior

analyst at AUF. Banks is wondering what steps need to be taken to immunize a portfolio with multiple liabilities.

Price states that the concept of single liability immunization can fortunately be extended to address the issue of

immunizing a portfolio with multiple liabilities. He further states that there are two methods for managing

multiple liabilities. The first method is cash flow matching which involves finding a bond with a maturity date

equal to the liability payment date, buying enough in par value of that bond so that the principal and final coupon

fully fund the last liability, and continuing this process until all liabilities are matched. The second method is

horizon matching which ensures that the assets and liabilities have the same present values and durations.

Price warns Banks about the dangers of immunization risk. He states that it is impossible to have a portfolio

with zero immunization risk, because reinvestment risk will always be present. Price tells Banks, "Be cognizant

of the dispersion of cash flows when conducting an immunization strategy. When there is a high dispersion of

cash flows about the horizon date, immunization risk is high. It is better to have cash flows concentrated around

the investment horizon, since immunization risk is reduced."

Regarding Price's statements on the two methods for managing multiple liabilities, determine whether his

descriptions of cash flow matching and horizon matching are correct.

Options :

A : Only his statement about cash flow matching is correct.

B : Only his statement about horizon matching is correct.

C : Both statements are correct -OR- both statements are incorrect.

Answer: B

Question 5

Smiler Industries is a U.S. manufacturer of machine tools and other capital goods. Dat Ng, the CFO of Smiler,

feels strongly that Smiler has a competitive advantage in its risk management practices. With this in mind, Ng

hedges many of the risks associated with Smiler's financial transactions, which include those of a financial

subsidiary. Ng's knowledge of derivatives is extensive, and he often uses them for hedging and in managing

Srniler's considerable investment portfolio.

Smiler has recently completed a sale to Frexa in Italy, and the receivable is denominated in euros. The

receivable is €10 million to be received in 90 days. Srniler's bank provides the following information:

Smiler borrows short-term funds to meet expenses on a temporary basis and typically makes semiannual

interest payments based on 180-day LIBOR plus a spread of 150 bp. Smiler will need to borrow S25 million in

90 days to invest in new equipment. To hedge the interest rate risk on the loan, Ng is considering the purchase

of a call option on 180-day LIBOR with a term to expiration of 90 days, an exercise rate of 4.8%, and a premium

of 0.000943443 of the loan amount. Current 90-day LIBOR is 4.8%.

Smiler also has a diversified portfolio of large cap stocks with a current value of $52,750,000, and Ng wants to

lower the beta of the portfolio from its current level of 1.25 to 0.9 using S&P 500 futures which have a multiplier

of 250. The S&P 500 is currently 1,050, and the futures contract exhibits a beta of 0.98 to the underlying.

Because Ng intends to replace the short-term LIBOR-based loan with long-term financing, he wants to hedge

the risk of a 50 bp change in the market rate of the 20-year bond Smiler will issue in 270 days. The current

spread to Treasuries for Smiler's corporate debt is 2.4%. He will use a 270-day, 20-year Treasury bond futures

contract ($100,000 face value) currently priced at 108.5 for the hedge. The CTD bond for the contract has a

conversion factor of 1.259 and a dollar duration of $6,932.53. The corporate bond, if issued today, would have

an effective duration of 9.94 and has an expected effective duration at issuance of 9.90 based on a constant

spread assumption. A regression of the YTM of 20-year corporate bonds with a rating the same as Smiler's on

the YTM of the CTD bond yields a beta of 1.05.

If Ng purchases the interest rate call, and 180-day LIBOR at option expiration is 5.73%, the annualized effective

rate for the 180-day loan is closest to:

Options :

A : 6.6982%.

B : 6.5346%.

C : 6.3785%

Answer: A

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