A HEDGE FUND MANAGER WANTS TO CHANGE HER INTEREST RATE EXPOSURE BY...
15.
A hedge fund manager wants to change her interest rate exposure by investing in fixed-income securities
with negative duration. Which of the following securities should she buy?
a.
Short maturity calls on zero-coupon bonds with long maturity
b.
Short maturity puts on interest-only strips from long maturity conforming mortgages
c.
Short maturity puts on zero-coupon bonds with long maturity
d.
Short maturity calls on principal-only strips from long maturity conforming mortgages
Correct Answer: c
Rationale:
In order to change her interest rate exposure by acquiring securities with negative duration, the manager
will need to invest in securities that decrease in value as interest rates fall (and increase in value as interest rates
rise). Zero coupon bonds with long maturity will increase in value as interest rates fall, so calls on these bonds will
increase in value as rates fall but puts on these bonds will decrease in value and this makes C the correct choice.
Interest-only strips from long maturity conforming mortgages will decrease in value as interest rates fall, so puts on
them will increase in value, while principal strips on these same mortgages will increase in value, so calls on them
will also increase in value.
Section:
Valuation and Risk Models
Reference:
Bruce Tuckman, Fixed Income Securities, 3rd Edition, Chapter 4, “One-Factor Risk Metrics and Hedges.”
Learning Objective:
Define, compute and interpret the effective duration of a fixed income security given a change
in yield and the resulting change in price.
Section:
Financial Markets and Products
Reference:
Bruce Tuckman, Fixed Income Securities, 3rd Edition, Chapter 20, "Mortgages and Mortgage-Backed
Securities."
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2015 Financial Risk Manager (FRM®) Practice Exam