THROUGH 60 RELATE TO FIXED INCOME DEFENSE INSURANCE PROVI...

Questions 55 through 60 relate to Fixed Income Defense Insurance Providers (DIP) Case Scenario Defense Insurance Providers (DIP) is a life and casualty insurance firm based in Wisconsin, USA. The firm not only provides life insurance, but also protection against most risks to property including fire, weather damage, and theft. DIP manages its risk at an enterprise level by diversifying its liabilities over a large client base, and by offering specialized insurance including flood insurance, earthquake insurance and fire insurance. Nathan Bowen heads the risk management and finance department at the firm, which includes a team of risk managers, portfolio managers, research and finance analysts, and economists. Bowen has instructed Alyson Moore, a fixed-income analyst, to manage a cash liability of $7.5 million due in five years. Moore has constructed three bond portfolios to immunize this liability. Exhibit 1 displays the features and characteristics of each of these portfolios. Exhibit 1: Bond Portfolios Portfolio A Portfolio B Portfolio C Macaulay Duration 4.98 4.99 5.03 PV $7.50 $7.60 $7.65 Convexity 55.69 64.21 69.20 Cash flow yield 3.55% 3.57% 3.60% In addition to this, Bowen also assigns Moore the task of immunizing a set of liabilities with a value of $20,029,650 and a cash flow yield of 4.520%, stated on a semiannual basis. The duration and convexity of the debt portfolio are 7 years and 56.90 respectively. The dispersion equals 9.55. Moore presents Bowen with the following four portfolios as options for this purpose. Exhibit 2: Multiple Liability Immunization Bond Portfolios Portfolio A Portfolio B Portfolio C Portfolio D Cash Flow Yield 4.53% 3.79% 3.88% 4.99% PV $20.029648 $20.890129 $20.030333 $20.000120 Convexity 58.00 56.32 57.00 57.03 Dispersion 11.40 10.90 12.10 8.20 Macaulay Duration 7.01 6.98 6.80 7.00 When talking to Bowen about the attractiveness of each portfolio, Moore makes the following comments: Comment 1: “Since the present value of Portfolio B is greater than the present value of the liability portfolio, we will have considerable surplus to pursue contingent immunization.” Comment 2: “To immunize with Portfolio C, we would need to go long a certain number of futures contracts. The greater these contracts are spread out across the yield curve, the lower the structural risk.” During the discussion, Bowen inquired about how model risk could affect the ultimate effectiveness of the immunization strategy. Moore agreed that such a risk is always inherent in these situations especially if portfolio duration is measured using a weighted average of the individual durations of the bonds. He added that using futures contracts would also add spread risk to the liability driven investment strategy. Bowen decided to further this discussion the next day. 55. Which of the bond portfolios given in Exhibit 1 is most likely the correct immunizing portfolio for the single liability? A. Portfolio A. B. Portfolio B. C. Portfolio C.

CFA Level III Mock Exam 3 – Solutions (PM)

56. Which of the bond portfolios given in Exhibit 2 is most likely the correct immunizing portfolio for the set of liabilities? 57. In Exhibit 2, structural risk will most likely be highest for: A. Portfolio B. B. Portfolio C. C. Portfolio D. 58. Moore is most accurate with respect to: A. Comment 1 only. B. Comment 2 only. C. Both comments 1 and 2. 59. Moore’s concern about model risk will least likely be mitigated if: A. the underlying yield curve is flat. B. future cash flows are concentrated in a particular segment of the yield curve. C. cash flow yield is used to discount the future coupon and principal payments. 60. Spread risk in derivatives overlay liability driven investing most likely arises from: A. a large duration gap between the asset portfolio and the liability portfolio. B. Not incorporating short-term rates and accrued interest in the determination of the futures BPV. C. The fact that yields on high-quality bonds are less volatile than on more-liquid government bonds.