Questions 31-36 relate to Fixed Income Portfolio Management.
Duncan MacIvor is a senior fund manager at Alpha+ Capital (AC), a Philadelphia-based
mutual fund management company specializing in actively managed bond funds. Alpha+
Capital's flagship fund is the AC Global Bond Fund, a USD-denominated fund.
MacIvor has directed his analysts to recommend strategies for the fund using the A-rated
USD-denominated government bonds issued by the Republic of Borduria. Currently, there
are par bonds available for maturities between one and six years, as shown in Exhibit 1. All
coupons are annual pay. Borduria uses the USD as its currency. It also has a liquid market in
mortgage-backed securities and options on government bonds. The MBS are modelled on and
behave like MBS in the United States.
Exhibit 1: Bordurian Government Bonds (BGBs)
Maturity (years) Coupon Price Modified Duration (MD) Projected MD at Year End
1 2.00% 100 0.980 0.000
2 2.40% 100 1.930 0.978
3 2.75% 100 2.842 1.922
4 2.99% 100 3.718 2.828
5 3.18% 100 4.556 3.698
6 3.33% 100 5.358 4.509
The analysts all have different market views and are unable to agree on the most appropriate
strategy. They offer several recommendations.
Statement 1: Assume the yield curve will be unchanged for the next year and "ride the
curve."
Statement 2: Assume that the curve will reshape in such a way that in one year, all bonds
remain at a price of par. We can use a carry trade to profit in that scenario.
Statement 3: Assume the yield curve may change but will be more stable than current market
consensus estimates of volatility, and sell volatility.
Peter Armstrong is one of the analysts and has also been looking at the government yield
curve for the Republic of Syldavia. Exhibit 2 shows selected points along that curve, with the
current levels of yield and Armstrong's expectations of the ending level of rates. He expects
these changes to happen very quickly, what he calls near term.
Exhibit 2: Syldavian Government Bond Yields
Maturity (years) Yield Now Near Term Projection of Ending Yield
2 1.23% 1.03%
5 1.82% 1.82%
10 2.45% 2.60%
30 3.86% 3.61%
Based on Exhibit 2, Armstrong proposes three possible portfolios of Syldavian government
bonds:
1. A laddered portfolio comprising equal investments in 2-, 5-, and 10-year
2. A bullet portfolio entirely invested in the 5-year
3. A barbell portfolio comprising equal investments in the 2- and 10-year SGBs
Lydia Connors is another analyst and agrees with the forecast in Exhibit 2. She proposes
some combination of barbell and wings portfolio using the 5-, 10-, and 30-year bonds.
MacIvor also manages AC's U.S. Corporate Bond Fund. The corporate bond fund is currently
valued at USD 94.5 million, with a modified duration of 5.3. MacIvor is concerned that U.S.
yields are about to rise and wants to temporarily reduce the fund's modified duration to a 4.5.
He will use a swap to make the change and wants to use the smallest notional principal
amount that he can. Exhibit 3 gives price value of a basis point (PVBP) data for three
potential swaps. All data is for 1 million notional amounts:
Exhibit 3: USD Plain-Vanilla Interest Rate Swaps (per 1 million notional)
Maturity PVBP floating PVBP fixed
3-year 25 215
5-year 25 476
8-year 25 728
...
If the 6-year bond is purchased to implement strategy 1, what is the expected return of that
bond over the one-year horizon?
A) 3.89%.
B) 4.01%.
C) 4.13%.
Question #32 of 60
The optimal leveraged trade combination to implement the carry trade in strategy 2 for the
highest expected one-year holding period return is buy the:
A) 6-year and short the 1-year.
B) 2-year and short the 1-year.
C) 6-year and short the 5-year.
Question #33 of 60
To implement strategy 3, it is most correct to say that MacIvor should buy:
A) MBS and buy puts.
B) MBS and shift towards a bullet portfolio.
C) puts and calls plus shift to a barbell portfolio.
Question #34 of 60
Treating Armstrong's near term forecast in Exhibit 2 as meaning immediate changes in yield,
the best portfolio of 2-, 5-, and 10-year Syldavian bonds is the:
A) laddered portfolio.
B) bullet portfolio.
C) barbell portfolio.
Question #35 of 60
Again based on the near term forecast in Exhibit 2, Connor's would most likely recommend as
the best portfolio of 5-, 10-, and 30-year Syldavian bonds a:
A) butterfly, short in the wings and long in the body.
B) butterfly, long in the wings and short in the body.
C) barbell instead of a butterfly.
Question #36 of 60
Assuming that MacIvor chooses one of the three swaps in Exhibit 3, what position in the
swap should be taken to effect the desired change in duration of the Corporate Bond Fund?
A) Receive fixed - pay floating, with notional principal of $10.04 million.
B) Receive floating - pay fixed, with notional principal of $10.04 million.
C) Receive floating - pay fixed, with notional principal of $10.75 million.
Question #37 of 60
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