CFA LEVEL 3 – TEST BANK WITH SOLUTIONS
Question: Discuss the notion of agency friction in terms of its effects on pension fund investment decisions.
Answer:
People hire money managers because they believe managers can do something for them that they cannot do for themselves.
However, the client-firm relationship creates a friction between investing appropriately to generate a high return and investing conservatively enough so as to not loose money in the short term. Of course, these two objectives are diametrically opposed.
As a result, investment managers, feeling the client's sensitivity to minimize short-term losses, will often select an investment strategy which is short-term focused rather than long-term (high-yield) focused.
Pension funds have investment horizons of generally less than three years and decisions may be more influenced by the reputation of the manager rather than long-term considerations.
Question: Prepare a bullet-and-barbell analysis to specify appropriate strategies for various changes in the shape of the yield curve.
Answer:
The yield curve is the relationship between maturity and yield on U.S. Treasury securities. The shape of this curve varies over time; such changes have varying price effects on each bond.
Duration provides a first approximation of the change in price resulting from a change in interest rates. Convexity provides a second approximation.
When the yield curve STEEPENS (short rates go down; long rates go up), THE BULLET OUTPERFORMS THE BARBELL.
When the yield curve FLATTENS (short rates go up; long rates go down), the BARBELL OUTPERFORMS THE BULLET.
Remember that duration is a straight line approximation of the price change due to a change in yield FOR SMALL CHANGES IN YIELD ONLY. (it is the straight line tangent to the price/yield curve, or the first derivative of the price/yield equation, in calculus terms).
Also, recall that convexity more completely describes the price change for a change in yield because it shows the actual curvature of the price/yield relationship. Thus convexity can measure a change in price for a LARGER YIELD CHANGE. (it is the second derivative of the price/yield equation)
So, for small changes in yield, duration is an adequate measure. For larger yield changes, you need convexity to fully describe the price effect.
Looking at it in terms of DURATION:
When the yield curve steepens, the price decline of the longer maturity bond of the barbell will be greater than the price increase of the short maturity bond, giving a net decline in price, while the bullet stays almost the same.
When the yield curve flattens, the opposite occurs, resulting in a net price increase for the barbell, while the bullet remains the same.
And in terms of CONVEXITY:
Even though the bullet and barbell have the same DURATION, they will have different CONVEXITIES. Fabozzi shows that the convexity of the bullet is less than the barbell.
More convexity is good, but more so when rates change by large amounts. The barbell will, therefore, outperform the bullet (even for a steepening curve) when rates change by more than, say 250 bp, but the convexity effect will be minimal in the 100bp. range. i.e. duration captures the price effect almost entirely.
Finally, in the case of a parallel shift, the bullet almost always outperforms the barbell for small changes in yield (in the 100bp range).
This analysis highlights that looking at measures such as yield (yield to maturity or some type of portfolio yield measure), duration or convexity reveals little about performance over some investment horizon, because performance depends on the magnitude of the change in yields and how the yield curve shifts.
Question: Explain the diversification benefits of closed-end funds.
Answer:
Most emerging market funds are closed-end because of the difficulty redeeming in a possibly illiquid market. Most are "country" funds, concentrating on a particular economy. Some are regional e.g. Asian Tigers and Latin America. Templeton and Morgan Stanley have funds diversified in the broad emerging market group.
The factors affecting returns of closed end funds are:
1. funds trade on the NYSE, so fund performance could be linked to NYSE movements
2. the correlation with the underlying market that the fund represents. i.e. manager performance
3. the existence of a discount/premium to NAV may result from factors outside the performance of the portfolio itself (perceived liquidity).
Return results from the study are mixed. On a risk-adjusted basis (Sharpe ratio), the broad-based funds marginally under/out-performed the benchmark but did better than the country funds, showing the effects of diversification.
Diversification Benefits and Outside Factors
Correlations of the funds with the S&P 500 were low, but numerically higher than the correlations of their respective benchmarks with the S&P 500.
THIS MEANS THAT GREATER DIVERSIFICATION WOULD HAVE BEEN OBTAINED INVESTING IN THE BENCHMARK.
This would appear to be due to outside factors influencing the movement of the funds. e.g. effects of the market in which the fund trades.
The conclusion is that an indexing strategy might be superior to using closed-end funds ( i.e. invest in the benchmark, not the fund).
Question: Addresses immunization risk, credit risk, and call risk in the context of an immunized portfolio.
Answer:
Immunization risk - Assume that we invest in a bond or bond portfolio that:
1. the Macaulay duration is equal to the investment horizon, and
2. the initial present value of the cash flow from the bond (or portfolio) equals the present value of the future liability.
This strategy will work as long as any rate changes in the yield curve are parallel. If rate changes alter the shape of the yield curve, matching Macaulay duration to investment horizon will not assure immunization.
Immunization risk is reinvestment risk. The portfolio that has the least reinvestment risk will have the least immunization risk. The wider the dispersion of cash flows around the investment horizon, the greater the immunization risk. If all of the cash flows are received at the investment horizon, the immunization risk is zero.
The objective in constructing an immunized portfolio, then, is to match the Macaulay duration of the portfolio to the investment horizon and select the portfolio that minimizes the immunization risk.
Target yield may not be achieved if any of the bonds default or decrease in value because of credit quality deterioration. If Treasury securities are selected the default risk would be eliminated, however, the target yield, which could be achieved would be lower and the cost of funding the liability would be increased.
The more credit risk accepted the higher the achievable target yield, but the greater the risk that the immunized portfolio will fail to meet its target.
Call Risk - The target yield may be jeopardized by inclusion of a callable that is subsequently called. If noncallable and deep-discount bonds are used for immunization, the target yield will be lower, thus increasing the cost of funding.
Question: Explain the differences of the cash flow matching and multiperiod immunization strategies.
Answer:
The cash flow matching and multiperiod immunization strategies differ in the following ways:
Unlike the immunization approach, the cash flow matching approach has no duration requirements. While rebalancing is required with immunization even if interest rates do not change, no rebalancing is necessary for cash flow matching except to delete and replace any issue whose quality rating has declined below an acceptable level. Barring any defaults, there is no risk that the liabilities will not be satisfied with a cash flow-matched portfolio. Under multiperiod immunization, there is immunization risk due to reinvestment risk.
These differences appear to favor cash flow matching; its disadvantage is that it is relatively more expensive because typically, the matching of cash flows to liabilities is not perfect and therefore, more funds than necessary must be set aside to match the liabilities. Under multiperiod immunization, all reinvestment returns are assumed to be locked in at a higher target rate of return. Money managers face a trade-off between the two strategies: avoidance of the risk of not satisfying the liability stream under cash flow matching versus the lower cost attainable with multiperiod immunization.
Question: Determine the factors that an active manager might exploit to enhance returns on a fixed-income portfolio.
Answer:
The five factors are:
1. Changes in the level of interest rates
This involves increasing duration if interest rates are expected to fall and reducing duration if interest rates are expected to rise. Rate anticipation swaps (exchanging bonds in the portfolio for those that will achieve the desired duration) and interest rate futures contracts may also alter duration. Academic literature finds that interest rates cannot be accurately forecasted, which means that risk-adjusted excess returns cannot be consistently realized. Other active strategies rely on forecasts of future interest rate levels. Future interest rates affect the value of options embedded in callable bonds and the value of prepayment options embedded in mortgage-backed securities. Callable corporate and municipal bonds with coupon rates above the expected future interest rate will underperform relative to non-callable bonds or low-coupon bonds.
2. Changes in the shape of the yield curve
Because a portfolio consists of bonds with varying maturities, changes in the shape of the yield curve will have varying price effects on each bond. Two portfolios with the same duration will perform differently if the yield curve does not shift in parallel. Looking at yield, duration or convexity tells us little about performance over some investment horizon, because performance depends on the magnitude of the change in yields and how the yield curve shifts. Managers will adopt a bullet or barbell strategy in anticipation of a yield curve reshaping.
3. Changes in yield spreads among bond sectors
This involves positioning a portfolio to capitalize on expected changes in yield spreads between sectors of the bond market. Intermarket spread swaps are swaps taken when the manager believes that prevailing yield spreads between two bonds are out of line with the historical yield spread and that yield spreads will realign by the end of the investment horizon.
Credit or quality spreads change because of expected changes in economic prospects. Spreads between Treasury and non-Treasury issues widen in a declining or contracting economy and narrow during economic expansion.
Research reflects that relative yield spreads - ratio of the yield spread to the level of Treasury yields - tend to be stable over time. The yield ratio (non-Treasury yields divided by Treasury
yields) also has been stable over time.
Spreads attributable to differences in callable and non-callable bonds and differences in coupons of callable bonds will change as a result of expected changes in:
a. direction of the change in interest rates
b. interest rate volatility
An increase in interest rate volatility increases the value of the call and thus, increases the spread over the non-callable bond.
4. Changes in the yield spread for a particular bond
There are several active strategies that managers pursue to identify mispriced securities. The most common strategy identifies an issue as undervalued because:
a. its yield is higher than that of comparably rated issues, or
b. its yield is expected to decline (and price rise) because credit analysis indicates
that the rating will improve.
5. Changes in option-adjusted spreads.
Many bonds contain embedded options and their yield can be measured in terms of their option-adjusted spread. Investors can choose securities that will benefit from expectations about how the option-adjusted spread will change over the portfolio's investment horizon. Empirical studies support the view that an option-adjusted spread-based trading strategy may be superior to a trading strategy based on traditional yield spreads.
Question: Compare the properties of the suggested value function for individual investors to the traditional concave utility function and discuss the implications for investor behavior.
Answer:
When losses are involved, people often exhibit risk-seeking behavior rather than risk aversion. This results from an aversion to loss. Given the choice of a sure loss of $80 or an 80% probability of losing $100, most people would prefer the gamble.
Risk aversion holds for gains and risk seeking holds for losses. This behavior cannot be represented by the traditional concave utility function. The suggested value function replaces the traditional concave utility function, which assumes a decreasing marginal utility of wealth.
The suggested value function has three essential properties:
1. The function is not defined in terms of wealth, but in terms of differences in wealth. With investments, people think in terms of gains and losses, not terminal wealth values.
2. It is S-shaped: It is concave above the reference point and convex below it. This is consistent with risk aversion in the domain of gains and risk seeking in the domain of losses.
3. It is asymmetric: The loss curve is much steeper than the gain curve, indicating that losses loom much larger than gains. A symmetric investment that offers an equal chance for a large loss is very unattractive to most investors.
Question: When a firm presents portfolios included in a wrap-fee composite that do not meet the wrap-fee definition, what must the firm disclose for each year presented?
Answer:
What must be presented is:
1. the dollar amount of assets represented and
2. the fee deducted.
When wrap-fee composite returns are presented before fees (acceptable only in presentations to non-wrap-fee prospective clients), the performance presentation must disclose:
1. fees,
2. investments style, and
3. the information that "pure" gross-of-fees return does not include transaction costs.
Question: Discuss the relevance of day-to-day correlation ratios for risk diversification.
Answer:
VAR measures depend on correlation assumptions. These correlations reflect the relationships between the markets during typical movements in a normal environment. However, during major market events, correlations change dramatically in absolute value terms. The problem is that we cannot predict if the correlation will be positive or negative. Because of this missing piece of information, what appeared to be a good hedge in normal market conditions might turn out to be a very good hedge or a very bad hedge under different market events.
One possible way to deal with this uncertainty is to use scenario analysis. This tool enumerates various market events and their implications. The market exposures of the firm can then be determined by analyzing various scenarios.
During major market events, correlations are unpredictable and large market moves tend to be contagious. A dislocation in one market does not leave the other markets untouched. Thus, the correlation between the markets is compounded by an increase in the volatility across markets. This implies that diversification across markets has its limits and that these limits are most constraining in periods of market crisis - ironically, when diversification is needed the most.
Question: What are key market variables needed to evaluate international real estate decisions?
Answer:
International investors have typically taken a common approach to their worldwide investment strategy and its re-evaluation. A working group of senior real estate officers, international company equities experts and outside consultants is assigned to deciding whether or not international real estate investment has the appropriate risk-reward scheme for the investor. If it is, the strategy is pursued and each outside advisor is assigned to report in his or her area of expertise. The advisors who can explain and minimize the systematic risks involved in the investment are those who will usually be most useful.
The process that explores only the possibility of an international real estate investment is very long. Senior staff must be aware of all the aspects involved in reaching the decision, since they will determine the rank ordering of criteria for country and market selection. The complexities that are present when one is attempting to select real estate within selected countries entails:
1. Identifying the pertinent variables by which countries and local markets can be compared.
2. Determining whether the characteristics of countries as a whole, as opposed to variables pertaining to a single market, have the greatest primacy in weighting a selection.
3. Applying comparison and rank ordering. This will narrow down the number of countries to a manageable amount, which can then be studied in more detail.