THROUGH 54 RELATE TO PORTFOLIO MANAGEMENT OF GLOBAL BONDS...

Questions 49 through 54 relate to Portfolio Management of Global Bonds. Bae Chung Case Scenario Bae Chung, CFA, is the owner of Kyung Securities, a small boutique firm that manages US$4.2 billion in leveraged fixed income portfolios for clients. Chung has been meeting with managers of a pension fund that is interested in placing $500 million under Kyung’s management and is preparing a proposal for them. At a meeting with the pension fund’s representatives, Chung was asked to explain Kyung’s use of leverage. Chung replied, “We use the repo market to borrow against client assets and leverage up portfolio returns. Our mandate allows us to borrow between 0 and 75 percent of the equity of the portfolio, depending on our market outlook. Chung then makes the following statements: Statement 1: In the current market, our average client portfolio has an expected asset return of 7.40 percent, our average portfolio leverage is 40 percent, and we pay 4.25 percent in the repo market. Statement 2: We place client assets that are used in these repurchase agreements in a custodial account at our bank, rather than using wire transfer of title. This delivery method results in lower delivery charges and lower repo rates.” The proposal that Chung is creating discusses Kyung’s fixed income investment philosophy: “We seek the highest risk-adjusted returns by purchasing bonds and other fixed income securities that our models indicate are underpriced with respect to credit risk characteristics. Our investment policy requires that we purchase only investment grade (BBB-rated or higher) securities and sell any security that is downgraded to speculative grade. Further, our policy requires that we use derivatives to hedge credit risk for any position rated below A. We do not consider a client’s target duration until after the portfolio is formed, at which time we use interest rate futures contracts to modify the duration of the portfolio, as necessary.” Chung develops an example of changing a portfolio’s duration based on the data in Exhibit 1. By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered CFA candidates. Candidates may view and print the exam for personal exam preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose. Exhibit 1 Bond Portfolio and Bond Futures Data Portfolio value $10,000,000 Portfolio duration 6.5 years Target duration 9.0 years Price of cheapest to deliver bond $98,000 Duration of cheapest to deliver bond 8.62 Conversion factor for cheapest to deliver bond 1.15 Based on earlier discussions with the pension fund’s managers, Chung was prepared to recommend a model portfolio with a duration of 5.0 years, measured against U.S. interest rates. More recently, Chung was told that the pension fund owns $100 million worth of Australian bonds that must be held in the $500 million portfolio for the next 12 months. These bonds have a duration of 3.2 years and Chung estimates that Australia’s country beta is 0.80. The expected (local currency) return on the bonds is 8.50 percent, and the 1-year risk-free yields are 1.3 percent in the U.S. and 4.6 percent in Australia. The spot exchange rate is USD0.69/AUD and the one-year forward rate is USD0.67/AUD. 49. Based on Statement 1, the expected return of Kyung’s average client portfolio is closest to: A. 8.66%. B. 10.55%. C. 11.81%. 50. Chung’s Statement 2 regarding delivery of assets in repurchase agreements is most likely: A. correct. B. incorrect with respect to repo rates. C. incorrect with respect to delivery charges. 51. Chung’s proposal mentions the use of derivatives to hedge credit risk. Given Kyung’s policy, which of the following instruments would most likely be used? A. Binary credit options B. Credit spread options C. Credit spread forwards 52. According to the data in Exhibit 1, the number of futures contracts that must be purchased to meet the portfolio’s target duration is closest to: A. 26. B. 30. C. 34. 53. The contribution to the portfolio’s duration from the Australian bond is closest to: A. 0.51 years. B. 1.44 years. C. 2.56 years. 54. Given the exchange rate and interest rate data provided, if the Australian currency risk is fully hedged, the bond’s expected return will be closest to: A. 3.90%. B. 5.20%. C. 5.60%.