24 RELATE TO FIXED INCOME, RISK MANAGEMENT, AND DERIVATIV...

Questions 19-24 relate to Fixed Income, Risk Management, and Derivatives.

Daniel Castillo and Ramon Diaz are senior investment officers at Advanced Advisors (AA), a

large U.S.-based firm. AA uses numerous quantitative models to invest in both domestic and

international securities.

For some of its accounts, the firm uses complex multifactor trading models. In this approach,

they rotate across various asset classes and also use option combinations to produce unusual

payoff patterns.

In other accounts, they use traditional long only positions in a single asset class. For example,

they offer both a lower and higher interest rate risk bond strategy. Current statistics on the

two bond strategies include the following.

Exhibit 1

Lower Duration Strategy Higher Duration Strategy

Duration 2.57 7.32

Convexity 21.56 195.62

Expected annual return 6.25% 8.45%

Expected monthly σ 0.78% 1.13%

AA uses a variety of methods to analyze potential risk. VaR analysis is normal done at 1%

and 5% probabilities using 2.3 and 1.65 standard deviations respectively. They also use two

forms of scenario analysis-a worst case optimization and a simulation of the 2008-09

financial crisis.

Individual positions are accounted for on a marked-to-market value basis. For example, the

lower duration bond strategy is currently holding a USD 500 million swap with two years

remaining until expiration at an annual pay 7.0% versus receive LIBOR. The floating coupon

has just reset. Current one- and two-year LIBOR are 5.5% and 6.0%.

Castillo believes that euro interest rates will decline and believes they should add a swaption

position to the portfolio. Diaz retrieves current market data for payer and receiver swaptions

with a maturity of one year. The terms of each instrument are provided below:

Payer swaption fixed rate: 7.90%

Receiver swaption fixed rate: 7.60%

Current Euribor: 7.20%

Projected Euribor in one year: 5.90%

...

For the firm's complex multifactor portfolios, the firm should most likely use which of the

following methods to estimate the portfolio VaR?

A) Analytical.

B) Historical.

C) Monte Carlo simulation (MCS).

Question #20 of 60

Based on the data in Exhibit 1 and other information provided, the one-year annual VaR for

the lower duration fixed-income strategy at the 5% probability is closest to:

A) +1.8%.

B) -1.8%.

C) -3.1%.

Question #21 of 60

Diaz realizes he also needs to consider downside risk in the longer-duration strategy. He

decides to analyze what will happen if there is an immediate 60 basis point increase in

interest rates. The expected change in value of the longer-duration portfolio is closest to:

A) -4.0%.

B) -4.4%.

C) +4.8%.

Question #22 of 60

Regarding AA's use of two forms of scenario analysis, it is most correct to say:

A) using only one form would be sufficient.

B) the optimization approach will produce the most extreme outcome.

C) using an historical event such as the financial crisis does not make sense, as there is no reason to

expect an exact repetition.

Question #23 of 60

The current credit risk to AA in USD of the pay 7% fixed rate swap held in the lower

duration fixed-income strategy is closest to:

A) -11 million.

B) 0.

C) +11 million.

Question #24 of 60

Regarding Castillo's swaption strategy and assuming he will use only one swaption in his

strategy, it is most correct to say AA will have credit risk at swaption expiration only if rates

are:

A) below 7.6%.

B) above 7.9%.

C) between 7.6 and 7.9%.

Question #25 of 60