FINC 424 Test 2

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Compared with traditional investments, alternative investments are characterized by high: A. Leverage B. Liquidity C. Regulation

A

Credit Analysis

A credit analysis strategy involves detailed analysis of the bond issuer to determine expected changes in its default risk Attempts to project changes in the credit ratings assigned to bonds by rating agencies Rating changes are affected by: Internal changes in the borrower External environment

Cushion Bond

A high-yielding, long term obligation that carries a coupon substantially above the current market rate and that, due to its current call feature and call price, has a market price lower than what it should be given current market yields Used when bond portfolio managers expect a modest increase in rates because such issues provide attractive current income and protection against capital loss

Credit analysis Model

A modified Z-score model designed to predict the probability of bankruptcy within two years can also be used to predict changes in credit quality for high-yield bonds The Z-score model combines traditional financial measures with a multivariate technique known as multiple discriminant analysis to derive a set of weights for the specified variables

Contingent Management

A strategy that allows the bond manager flexibility to actively manage the portfolio subject to an overriding constraint that the portfolio remains immunized at some predetermined yield level

Option adjusted Yield Spread

Allows change in term structure based on alternative volatility estimates Bonds with embedded options are callable bond

A portfolio manager that attempts to select bonds based on their intrinsic value would be carrying out A. credit analysis. B. valuation analysis. C. yield-spread analysis. D. horizon-matching analysis. E. interest-rate analysis.

B

Horizon matching is a combination of A. cash-matching dedication and interest rates swaps. B. cash-matching dedication and immunization. C. interest rate swaps and immunization. D. enhanced indexing and immunization. E. enhanced indexing and interest rate swaps

B

Reinvestment risk is greatest for bonds that have A. short maturities and low coupon rates. B. long maturities and high coupon rates. C. short maturities and high coupon rates. D. long maturities and low coupon rates. E. none of the above

B

A bond fund would be likely to invest in a portfolio containing all of the following except: A. Corporate bonds. B. Bulldog bonds. C. U.S. Treasury bills. D. Commercial mortgage-backed securities E. U.S. Treasury notes.

C

All investment companies charge an annual A. 12b-1 fee. B. marketing and distribution. C. management fee. D. maintenance fee. E. market adjustment.

C

In core-plus bond management, A. 75 percent of the portfolio is allocated to an equity index and the balance is allocated to a bond index. B. 75 percent of the portfolio is allocated to a bond index, and the balance is allocated to an equity index. C. 75 percent of the portfolio is allocated to a bond index, and the balance is allocated to actively managed bond sectors. D. 75 percent of the portfolio is allocated to actively managed bond sectors, and the balance is allocated to a bond index. E. 75 percent of the portfolio is allocated to actively managed bond sectors, and the balance is allocated to a foreign bond index.

C

Suppose the current six-year spot rate is 8 percent and the current five-year spot rate is 7 percent. What is the one year forward rate in five years? A. 12.62 percent B. 11.58 percent C. 13.14 percent D. 14.65 percent E. 15.14 percent

C (1+8%)^6 = (1+7%)^5 x (1+6r5)^1 6r5 = [(1+8%)^6 / (1+7%)^5] -1

Core Plus Active Management

Can also be considered a form of enhanced indexing Higher returns from exploiting market inefficiencies outside the traditional core sectors Increased opportunities for exploiting the manager's security selection skills The ability to alter the composition of the fixed-income asset class in a manner consistent with the insights and views of the manager

Horizon matching

Combination of cash-matching dedication and immunization Portfolio is constructed to provide a cash match for the liabilities during this horizon period The remaining liability stream following the end of the horizon period are covered by a duration-matched strategy based on immunization principles

Stratified sampling

Create a bond portfolio to the matches the important characteristics of the underlying index such as - credit quality, maturity/duration, or average yield—while maintaining a portfolio that is more cost effective to manage

Cushion spread

Cushion spread in required yield provides flexibility for the portfolio manager to engage in active portfolio strategies

Examples of Alternative Investments are: A. Private Equity, Hedge Funds, and Equity B. Hedge Funds, Mutual Funds C. Real Estate, Commodity Funds, Bonds D. Private Equity, Hedge Funds, and Real Estate

D

If you expected interest rates to rise, you would prefer to own bonds with A. short maturities and low coupons. B. long maturities and high coupons. C. long maturities and low coupons. D. short maturities and high coupons.

D

Indexing

Designing a bond portfolio to mimic a hypothetical index

A money market fund would be likely to invest in a portfolio containing all of the following except: A. foreign commercial papers. B. banker's acceptances. C. U.S. Treasury bills. D. bank certificates of deposit. E. U.S. Treasury notes.

E

Credit analysis during strong economic expansion

Even financially weak firms may survive and prosper Ratings downgrades decrease

Closed-end investment companies never sell at discounts to their NAV. A. True B. False

False

Interest rate anticipation is one of the matched funding techniques that matches anticipated interest rates with the required rates on a portfolio. A. True B. False

False

A callable bond

Has a negative convexity As yields decline, the price increases at a slower rate and ultimately does not change at all

A non-callable bond

Has a positive convexity As yields decline, the price of the bond increases at a faster rate

bond immunization

If duration > investment horizon, then the investor faces net price risk If duration < investment horizon, then the investor faces net reinvestment risk If duration = investment horizon, then the investor is immunized

Coupon reinvestment risk

If interest rates decline, then the coupon cash flows will be reinvested at rates below the initial promised yield, and the ending wealth will be below expectations If interest rates increase, then the coupon cash flows will be reinvested at higher rates, and the ending wealth will be above expectations

Immunization Strategies

Immunization techniques attempt to derive a specified rate of return (generally quite close to the current market yield) during a given investment horizon, regardless of what happens to the future level of interest rates

For a rate decline

Increase the duration of the portfolio because the longer the duration, the greater the positive price volatility Interest rate sensitivity is critical The higher the quality of the bond, the more sensitive it is to interest rate changes High-grade securities should be used Concentrate on noncallable issues or those with strong call protection because of the substantial call risk when yields decline

Bond Swaps Risk

Interest rates may move up over the holding period and cause a loss Yield spreads may fail to respond as anticipated The new bond may not be a true substitute If the work-out time is longer than anticipated, then the realized yield might be less than expected

The pure yield pickup swap

Involves trading out of a low-coupon bond into a comparable higher-coupon bond to realize an instantaneous increase in current yield and yield to maturity

Bond swaps

Liquidating a current position and simultaneously buying a different issue with similar attributes but better return potential Trades can be executed to increase current yield, to increase yield to maturity, to take advantage of shifts in interest rates or yield spreads, to improve the quality of a portfolio, or for tax purposes

Buy and Hold Strategy

Look for a bond issue whose maturity and duration characteristics approximate their investment horizon in order to reduce price and investment risk.

Reilly and Wright

Many analysts simply adapt their basic corporate bond analysis techniques to the unique needs of high-yield bonds, which have characteristics of common stock

Matched-Funding are a form of asset-liability management

Matching techniques can range from an attempt to exactly match the levels and timing of the required cash payments to more general approaches that focus on other investment characteristics An important assumption is that the investor's liabilities are predictable

Bond Duration

Measures the sensitivity of a bond's price to interest rate movements. If we have an increase in interest rate => low duration If we have a decrease in interest rate => high duration Bonds having longer duration will have their prices affected to a greater extent by changes in the interest rate

Bond Convexity

No matter what the rate is, convexity is always good High convexity is good when interest rate increases or decreases

Credit analysis during severe economic contractions

Normally strong firms may find it very difficult to meet financial obligations Ratings downgrades increase

Price risk

Occurs because if interest rates change before the horizon date and the bond is sold before maturity, then the realized market price for the bond will differ from the expected price, assuming no change in rates If rates increased The realized price for the bond would be below expectations If rates declined The realized price for the bond would be above expectations

Problems with Dedication

Potential problems with approaches to a dedicated portfolio: When selecting potential bonds, be aware of call/prepayment possibilities with specific bonds or mortgage-backed securities Prepayment possibilities following periods of historically high rates Reinvestment of proceeds at lower rates can cause dedicated portfolios to be underfunded Not necessary to invest only in Treasury bonds if the portfolio is diversified across industries and sectors A diversified portfolio of AA- or A-rated corporate bonds can provide a current and total annual return substantially above Treasuries, which can have a significant impact on the net cost of funding a liability stream

Interest rate anticipation risk

Risk is tied to duration adjustments When portfolio duration is shortened, income could be sacrificed and the opportunity for capital gains could be lost if interest rates decline rather than rise An investor sacrifices current income by shifting from high-coupon short bonds to longer duration bonds in anticipation of a rate decline The portfolio is exposed to greater price volatility that could work against the portfolio if an unexpected increase in yields occurs

Interest rate anticipation

The idea is to: Preserve capital when an increase in interest rates is anticipated Achieve capital gains when yields are expected to decline

Potential return

The return the portfolio would achieve over the entire investment horizon if, at any point, the assets on hand were immunized at the prevailing market rate

Static Yield Spreads

The traditional yield spread compares the yields between two bonds with similar coupon and maturities Does not account the embedded option

A manager following an interest rate anticipation strategy would shorten portfolio duration if interest rates were expected to increase. A. True B. False

True

Because you expect market interest rates to decline during the next four months, if you were offered two bonds with equal duration, you would select the one with the higher measure of convexity. A. True B. False

True

In an investment company, the invested funds belong to many individuals. A. True B. False

True

Dedication portfolio

Used to prescribe set of liabilities Pure cash-matched dedicated portfolio Objective of pure cash matching is to develop a portfolio of bonds that will provide a stream of payments from coupons and principal payments that exactly match the specified liability schedules Dedication with reinvestment Allows that the bond cash flows do not have to exactly match the liability stream

Trigger point

When the value of the portfolio reaches a point of minimum return (trigger point), it is necessary to stop active portfolio management and use classical immunization with the remaining assets to ensure desired terminal wealth value is attained

Yield Spread Analysis

assumes that a normal relationship exists between the yields for bonds in different sectors or credit qualities

Bond ladder

in which investment funds are divided evenly into instruments that mature at regular intervals

Good Opportunity for credit analysis

involves high-yield (junk) bonds The yield differential between junk bonds that are rated below BBB and Treasury securities ranges from about 250 basis points to over 1,500 basis points

Interest Rate risk

is the uncertainty regarding the ending-wealth value of the portfolio due to changes in market interest rates between the time of purchase and the investor's horizon date

Contingent immunization

requires that the client be willing to accept a potential return below the current market return Referred to as a cushion spread, or the difference between the current market return and some floor rate


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