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Fixed Income Quiz (36 Questions, 108 Minutes)
The following information relates to Questions 1-6 Hayden Fritz, is an experienced investor who has primarily been investing in the local equities market for the past 10 years. Through a knack of spotting cheap stocks, prudent investing and a reasonable level of leverage, Hayden has managed to generate a satisfactory return over the years. However, as of late, an issue has been raised with regard to the regulation of the equities markets. This has coincided with a slowdown in the corporate earnings. As a result, Hayden has decided to tilt his portfolio towards high yield corporate debt instruments. Hayden contacts his broker who arranges a meeting on behalf of Hayden with the brokering firms fixed income analyst, Burtoch Wolfgang. During the meeting, Wolfgang explains to Hayden that he has identified two potential investments in a sector which has relatively outperformed the rest of the market and is in line with Hayden’s level of risk tolerance. Exhibit 1 – Wolfgang’s investment recommendations Debt characteristics Classification Term to maturity Coupon rate Nominal value (USD) Recovery rate Potential loss as % of nominal value Effective duration Modified Duration YTM Highfield Investments Senior secured 5 years 14% 10,000,000 80% 20% 3.2 3.5 12.5% Greenery Investments Senior secured 4 years 13.5% 15,000,000 60% 30% 2.5 2.8 11.3%
Describing the two investments, Wolfgang states that both firms operate in the Beverage Industry and are operationally very similar. Considering the firms debt structure, Wolfgang explains that in addition to its senior secured debt, Highfield Investments debt obligations also include $5 mn worth of senior subordinated debt and $7 mn senior unsecured debt outstanding. While satisfied with Wolfgang’s findings, Hayden states that while fixed income as an asset class might be less risky as a whole when compared with equities, he concedes that a fair amount of analysis is required before making a firm commitment. Hayden is particularly concerned with market liquidity risk, credit migration risk and default risk and has described one of the risk factors faced by the firms as follows: Statement 1
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an impressive turnaround has been witnessed in the firm’s earnings and the firm has pursued a successful strategy of backward and forward integ ration. could trigger a ratings downgrade.3% 35% 1. Since then. he believes that the effective and modified duration of the senior secured bond will remain unchanged.1% 58% 0. While my average holding period for any investment is one to two years.2013 CFA® Level II Fixed Income Irfanullah.” Wolfgang also states that he has conducted a thorough analysis of the two firm’s financial performance and studied the following metrics: Exhibit 2 – Financial performance comparison Metric 5-year average standard deviation of operating margin 5-year average standard deviation of CFO FCF/Debt Debt/ EBITDA Cash & cash equivalents on balance sheet Net working capital *Figures in brackets indicate negative values Highfield Investments 3% 4. Page 2 . I’m worried about the fact that the majority of Highfield Investments Debt is not publicly traded unlike Greenery Investments”.6x $130 mn ($230 mn)* In addition. His analysis encompasses credit analysis. liquidity analysis and yields and spread analysis. Wolfgang reassures Hayden that he has always been diligent and exhaustive in his analysis when it comes to his investment recommendations. Wolfgang describes a particular type of analysis he conducted on Highfield Investments as follows: Statement 2 “Highfield Investments has a young and dynamic management team which was installed three years back after a management shakeup. All rights reserved. Wolfgang has also conducted an analysis of the yield spreads of the two firms and its sensitivity to interest rate movements.co “Both firms have similar debt outstanding and have similar credit ratings. Satisfied with Wolfgang’s research and expertise. Wolfgang expects an upward revision in the YTM of Highfield Investments senior secured debt due to an impending announcement of the issue of a further $2 mn of senior unsecured debt which he believes. The new management is not afraid to accept large write-down’s and adopt a more conservative approach as it moved away from the very aggressive accounting policies of the previous regime which held a significant amount of off-balance sheet financing. Copyright © Irfanullah Financial Training.4x $ 760 mn $350 mn Greenery Investments 27% 32. Hayden decides to invest 70% of his funds in Highfield Investments senior secured debt and the remainder in Greenery Investment senior secured debt. However.
CFA is a fixed income analyst at Adroit Investments. The most appropriate Ranking of Highfield investments debt offerings from the highest to the lowest in terms of recovery rates is respectively: A.2013 CFA® Level II Fixed Income Irfanullah. Market liquidity risk B. senior secured 3. senior unsecured. 1. -1. The type of analysis undertaken by Wolfgang described in statement 2. Highfield investments is more highly geared than Greenery investments C. Capacity C. Highfield investments operates in a non-cyclical industry B. Credit migration risk C. A2 & A3). return impact of an investment in Highfield Investments senior secured debt due to an instantaneous 50bps widening in spread is closest to: A.75% C.8 mn 2. senior unsecured B. Lower by LKR 1. Senior secured. Senior secured. Default risk 4. Comparing the expected loss arising from Greenery investments senior secured debt with the expected loss arising from Highfield Investments senior secured debt.60% The following information relates to Questions 7-12 Raj Chetty. Higher by LKR 1. All rights reserved. Based on exhibit 1 and Wolfgang’s.4 mn B. senior subordinated. Hayden is most likely concerned with: A. The least likely explanation for the divergence in the ratios presented by Wolfgang in exhibit 2 is: A. Raj’s manager Osha has convened a meeting of the investment committee to review its current investment products (Denoted portfolio’s A1. . -1. Greenery Investments expected loss is most likely: A. is most likely an assessment of the firms: A. a private wealth management firm which focuses primarily on providing investment products with a tilt towards fixed income securities such as treasury securities & corporate bonds. Highfield investments has lower liquidity than Greenery investments 6. Page 3 Copyright © Irfanullah Financial Training. senior unsecured. Raj was called upon to present his view on his expectations on interest rate movements and yield curve shifts in the following 12-month period.co 1. With respect to statement 1.4 mn C. Collateral 5. Based on exhibit 1. During the meeting.75% B. Lower by LKR 1. senior subordinated C. Character B. Senior subordinated.
twists in the slope of the yield curve and changes to the humped-ness of the yield curve. Page 4 .” Osha confides in Raj that she is worried that such changes to the term structure may have materially altered the returns of the fund’s holdings in zero coupon treasury securities. Raj observed changes to the shape of the term structure of interest rates which he described as follows: Statement 1 “I think. All rights reserved. Hence we should be mindful of this when implementing a yield curve positioning strategy for our fixed income Positions”. there is no regulation governing the swap markets and hence. Raj goes on to recommend to Osha and the rest of the investment committee that they should also begin to consider the Swap curve as an alternative benchmark. In other words. Argument #1 “Unlike investments in treasuries which may be regulated by governments. This was done in order to boost investments and fuel economic growth which had witnessed a slowdown in the 4th quarter of 2012 due to declining disposable household income. I believe that the latter shares a nonlinear relationship with time to maturity.” Argument #2 Copyright © Irfanullah Financial Training.2013 CFA® Level II Fixed Income Irfanullah. which has been gaining popularity as an alternative to the treasury spot rate curve. I believe that the risk premium will not rise in a linear fashion alongside maturity. using swap rates for comparison across markets is relatively easier. As a result.co Raj. Raj replies that historically returns on such investments are influenced by parallel shifts in the yield curve. in his review of the monetary policy developments of the economy concluded that the Central Bank had recently implemented some unorthodox policy measures involving the adjustment of treasury yields of different maturities in order to bring down the Average Weighted Prime Lending Rate (AWPLR) for corporate borrowers. in the event of a policy revision that the yields towards the short end and the long end of the yield curve will increase faster than the intermediate maturity. Raj makes the following arguments in favor of its implementation as part of the funds review process. Osha asks Raj to give a possible rationale for the shape of the yield curve to which Raj responds as follows: Statement 2 “I think that while the yield curve reflects the market’s expectations of future interest rates as well as a risk premium associated with holding longer dated maturities.
Statement 3 “The government’s intention is to encourage greater long term investments. Positive Twist B. Exhibit 1 – Composition of Tarshish funds fixed income portfolio Portfolio A1 80% 20% 100% Portfolio A2 40% 30% 30% 100% Portfolio 03 90% 10% 100% 2-year maturity 16-year maturity 30-year maturity Total Having carefully considered the Central Bank’s stance on monetary policy in its latest monetary policy review as well as the IMF’s report on the economy’s prospects. the meeting is adjourned to next week. 7. To this end I expect the key rate for the 2 year maturity to rise by 40 bps while I expect the key rate for the 30 year maturity to fall by 20 bps. Positive butterfly C. Page 5 . All rights reserved. Pure expectations theory B. Liquidity preference theory C. Negative butterfly 8. Osha supplies the investment committee with details of the current mix of the funds three zero coupon treasury fixed income portfolios which are presented in exhibit 1.2013 CFA® Level II Fixed Income Irfanullah. Raj states that he expects the following changes to the rates.” After deliberating on whether the portfolios exposures should be altered based on Raj’s expectations. Preferred Habitat theory Copyright © Irfanullah Financial Training.co “Comparison with other markets is also made simple by the fact that swap rates reflect similar credit risk across markets unlike government yield curves which reflect different sovereign credit ratings” After debating on the pro’s and con’s of adopting the swap curve as a benchmark for the fund’s performance. The type of shift described in the yield curve in Raj’ statement 1 is most likely a: A. The particular theory of the term structure of interest rates Raj explains in statement 2 is best described as the: A.
the change in portfolio A1’s value is closest to: A. In the case of the firm’s stock I would compare its price to earnings (P/E) multiple and price to book value (P/BV) multiple with the FMCG sectors average P/E and P/BV multiple before making a decision. I will compare an appropriate spread measure using a benchmark of a sector spot rate curve with the same credit rating as that of Sartoni’s. In the case of debentures. The portfolio with the lowest and highest portfolio duration. Lando comes across a sell side analyst who has estimated the spot rate curve for the firm’s debentures. Argument #2 only 11. Therefore Lando also considers using the issuers own spot rate curve as an appropriate benchmark. Curvature of the yield curve 10. -0. given the relative price inelasticity of the sectors products.3% The following information relates to Questions 13-18 Lando Tung. A3 12. +1. Shape of the yield curve C. Studying a number of reports on the firm.6% C. Copyright © Irfanullah Financial Training. Of the factors mentioned by Raj which affect the shape of the yield curve. Sartoni Foods. A1. Assuming that Raj’s expectations made in statement 3 are correct. Lando discovers in his analysis of Sartoni Foods that a number of the firm’s corporate debentures are currently outstanding. The arguments cited by Raj for the increased popularity of swap curves is most likely correct with respect to: A.6% B. Argument #1 only C. is a high net worth investor who is considering taking a position in the Fast moving consumer goods (FMCG) sector of the economy as he believes that this sector has strong prospects.co 9. Argument #1 & argument #2 B. A2 B.2013 CFA® Level II Fixed Income Irfanullah. Level of interest rates B. A1. a retail chain which has a widespread distribution network and retail outlets spread in all parts of the country as a firm that is well poised to benefit from the growth in the FMCG sector. Lando outlines his investment strategy as follows: Statement 1 “I am currently considering whether to invest in Sartoni foods equity or corporate debentures. All rights reserved. +0. the firm offers 5 year bonds with an embedded call option. Osha should least likely be concerned with changes in the : A. Lando has indentified.” Subsequently. A3 C. A2. Page 6 . respectively: A.
Lando discovered that Sartoni Foods are preparing to issue USD 2 mn worth of convertible bonds. An increase in the YTM of Sartoni foods callable bond to 10% decreases the price to USD 94. the price of the callable bond in comparison to a straight bond is likely to fall due to a decrease in the value of the call option” To determine the interest rate risk arising from his investment. Based on his analysis Lando decides that Sartoni’s callable bonds would be a more suitable investment over the firm’s equities. the zero-volatility spread was 160 bps against the benchmark of 120 bps while the OAS spread was equal to zero.2013 CFA® Level II Fixed Income Irfanullah. the nominal spread was 180 bps vs.co Having considered these various measures. The following is an extract of the terms of the convertible bonds which appeared in the newspaper: Exhibit 1 – Sartoni foods callable bonds Par value Coupon rate Maturity date Non-callable period Market price of convertible bond Conversion ratio $ 1. At the same time. The rationale for his decision was described as follows: Statement 2 “I expect interest rates to be more volatile over the next 12 months which has historically depressed equity values due to higher uncertainty.000 9% 10 years 3 years $ 950 25 Exhibit 2 – Sartoni foods equity Year of listing Total number of shares outstanding Copyright © Irfanullah Financial Training. All rights reserved. A decrease in the YTM of Sartoni foods callable bond to 8% increases the price to USD 105. 2008 500 mn Page 7 . The following day while reading the Business & Finance section of the daily newspaper. Lando’s conclusion about the pricing of the Callable bond are summarized follows: Comparing the callable bond with the sector spot rate curve. the benchmark of 130 bps while the OAS spread was Negative Comparing the callable bond with Sartoni’s own spot rate curve. His findings are summarized below: The callable bond with 5 years to maturity is currently trading at USD 98 with YTM of 9%. Lando prepares the binomial tree for the callable bond adjusted for the changes to cash flow due to the exercise of the option.
The value of the call option only 17. Under priced 16.8.co Current price Dividend yield $ 30 7% Intrigued with this. 27% B. Fairly priced. Liquidity risk B. 15% C. Lando’s conclusions with respect to the price of the callable bond and the value of the call option is most likely correct with respect to: A. the conclusion Lando will most likely draw based on his findings of the value of the callable bond with respect to the sector spot rate curve and the OAS spread curve is respectively: A. -342 C. Fairly priced B.4. Based on the data presented in exhibit 1 & 2. Both the price of the callable bond and the value of the call option B. Underpriced. Assuming that Lando uses the analyst’s chosen benchmark. Credit risk C. Based only on the comparison with the OAS spread. 68 B. The effective duration and effective convexity of the callable bond for a 100bps change in interest rates is respectively: A. 5. Nominal B. Option-adjusted 14. 153 18. Overpriced. In statement 1. Zero-volatility C.6. 3. 13. Page 8 . 45% The following information relates to Questions 19-24 Copyright © Irfanullah Financial Training. The price of the callable bond only C.2013 CFA® Level II Fixed Income Irfanullah. Lando decides to compute the premium payback and the market conversion premium ratio to gauge this investment. 2. All rights reserved. the most appropriate spread measure which would meet Lando’s requirement would be the: A. Based on statement 2. Option risk 15. Over priced C. the market conversion premium ratio for Sartoni foods convertible bond is closest to: A. a zero-volatilty spread measure would least likely compensate the investor for: A.
The details of the investment are presented in exhibit 1: Exhibit 1 – Mortgage backed Security description Security name Description Credit Rating Par value (USD) Passthrough rate Pool factor Average life (years) WAC WAM Nova Non-agency mortgage passthrough security A$3 mn 6. Eddard. One of his analysts.” Statement 2 “A 175 PSA would have a higher SMM rate compared with a 100 PSA all things being equal. All rights reserved. His team of analysts has prepared a summary document outlining the salient points of a potential investment it has identified for his review. Felix who manages the fixed income desk and whose current investment exposures include domestic and international sovereign debt and high yield corporate debt is hoping to expand its operations into the mortgage backed security sector. Page 9 . Eddard explains the relationship in the following two statements: Statement 1 “The PSA benchmark is constructed on the assumption that prepayment rates are high for newly originated mortgages and then moderate overtime as they become seasoned.2% 163 months Felix is unfamiliar with some of the technical concepts like PSA benchmark and how they relate to the issue of prepayment risk.4 7. Felix is unfamiliar with some of the tranche’s described. CFA is a wealth manager with Guardian Corp. specifically the tranche named as gamma which is described as follows: Copyright © Irfanullah Financial Training. The firm primarily invests in domestic and international equities and fixed income securities. explains that these concepts are conventions used by market participants for describing the prepayment rate of a mortgage security.3% 0.co Felix Baruch. Contemporaneously the average lifetime of the pass through security is positively related to the PSA speed” The rest of the analyst’s report described the characteristics of Galaxy Corp’s Collateralized Mortgage Obligation (CMO). The team outlines two potential mortgage backed securities issued by Galaxy Corp. a private wealth management firm whose clients predominantly include small to medium scale universities and vocational training centers.82 11.2013 CFA® Level II Fixed Income Irfanullah.
Both Statement 1 and Statement 2 B. the monthly servicing fee for security Nova is closest to : A. All rights reserved. Extension risk Copyright © Irfanullah Financial Training. Which of the following least accurately describes the characteristics Felix’s choice of non agency residential mortgage backed securities: A.01% B.2013 CFA® Level II Fixed Income Irfanullah. 19. Eddard’s explanation concerning the PSA prepayment benchmark is most likely incorrect with respect to: A. Interest only (IO) mortgage strip tranche 23. 0.8% of the tranche is the difference between the collateral’s coupon rate and the tranche coupon rate. Eddard’s best response to Felix’s question in statement 3 is: A. Statement 2 only 22. Accrual tranche B. Contraction risk B. I believe that the Central Bank will be successful in meeting its objective within the next 6 months” Felix states that in addition to interest rates other factors which contribute to the prepayment rate must also be considered. Based on the data in exhibit 1. Based on Eddard expectations in statement 4.co Statement 3 “Tranche gamma’s payout is based on a notional amount of $500. What type of a tranche is this?” Felix questions the team on some of the Pro’s and Con’s of mortgage backed securities and on the team’s expectations for future interest rates.05% C. the Central bank with its moral suasion has been pressuring commercial banks to lower borrowing costs in order to facilitate the government’s infrastructure development agenda. Eddard reply to the question is as follows: Statement 4 “With the downward revision in the Central Bank’s policy rates last December. when investing in the passthrough security Felix should most likely be concerned with: A.000 where the coupon rate of 1.08% 21. Structured as either passthroughs or CMO’s 20. 0. Higher credit risk B. Credit risk C. No access to credit enhancement mechanisms C. Page 10 . Structured Interest only (IO) tranche C. 0. Statement 1 only C.
The membership involves a down payment as a joining fee followed by a renewal fee charged at the end of every calendar year. in the county in which he lives. As a result Brandon has considered securitizing the credit sales to raise additional cash for the expansion.co 24. However the bulk of QKR Comics (Almost 80%) comes from the subscription fees of existing members who can lend comics at a deep discount and lend select comics for free. Brandon wishes to expand the number of stores over the coming years in order to cater to a wider audience. After having finalized the legal requirements. The lawyer informs Brandon that he has drawn up the necessary documentation and only requires the document outlining the priority and amount of payments to the different classes of bondholders in the securitization structure. the draft of the securitization program summarizes the proposed changes to QKR Comic’s organization structure as follows: The new legal entity QKR guild will act as the Special purpose vehicle (SPV) for the ABS program QKR Comics will sell $130 mn worth of receivables to QKR Guild QKR Guild will issue bonds worth $100 mn to the public The cash raised from the sale of bonds will be returned to QKR Comics QKR Comics will retain the responsibility for servicing the above loans. Decline in spread between current mortgage rates and borrower’s contract rate B.2013 CFA® Level II Fixed Income Irfanullah. Brandon makes the necessary arrangements with his lawyer to prepare the necessary legal documentation for the ABS program. Par value ($ mn’s) $45 $20 $15 $20 $100 Page 11 . The bonds issued by QKR Guild will follow a sequential pay structure and is described as follows: Exhibit 1 – QKR Guild ABS securities Bond class A1 (Senior) A2 (Senior) A3 (Senior) B0 (Subordinate) Total Copyright © Irfanullah Financial Training. All rights reserved. the factor which is most likely to be a cause of an increase in prepayment risk is: A. The fees are usually funded by QKR comics own revolving credit card system which is funded internally by QKR comics. QKR Comics. Business has been flourishing lately with a renewed interest in mainstream comics due to recent popular TV shows and films on the subject matter. Increase in legal fees and title insurance expenses The following information relates to Questions 25-30 Brandon Kerr is the owner of a chain of specialty comic book stores. Given Felix’s worry over prepayment risk. Increase in housing turnover due to increased economic growth C.
She goes on to state that some investors might worry about large prepayments of principal during the early days of the issues and may demand some safeguards. A2 and A3 only B. that in order to improve the chances of the securities selling well. QKR Guild. Purchase agreement B. One of the firm’s unit trusts denoted “cloud 9” fund includes high yield emerging market sovereign and corporate bonds Copyright © Irfanullah Financial Training. QKR Comics. $ 20 mn C. which of the following internal credit enhancement methods has QKR Comics currently not made use of: A. The document requested by Brandon’s lawyer is most accurately described as the: A. who is a CFA charterholder and bond analyst for her opinion of the proposed QKR Guild’s ABS securities structure. QKR Comics 27. Excess spread account B. a firm managing a number of unit trusts specializing in fixed income investments. and A2 only C. $ 30 mn B. She states . The Seller. Lockout period C. QKR Comics.2013 CFA® Level II Fixed Income Irfanullah. the bond classes which are most likely to receive a payout are: A. Based on the structure in exhibit 1. Cap rate The following information relates to Questions 31-36 Richard and Abigail are two fixed income analysts working for Prima Facie Capital. B0. QKR Guild B. $ 0 mn 29. in the event of a prepayment of $70 mn. First loss piece B. Page 12 . Senior-subordinate structure 30. Based on the description of the ABS program. it should consider some internal credit enhancements in order to get a better credit rating. QKR Guild. Overcollateralization C. QKR Comics. issuer and servicer of the securitization program by QKR is respectively: A. Assuming default losses over the life of the structure is $30 mn the total loss borne by class B0 bondholders and class A1 bondholders is closest to: A. QKR Guild. 25.co Brandon also consults his cousin Lysa. A1. Waterfall 26. Servicing agreement C. QKR Comics C. All rights reserved. A1 and A2 only 28. A possible solution for investors concerns with regard to prepayment risk would be the inclusion of a: A.
Copyright © Irfanullah Financial Training. Tranche Beta 1 Beta 2 Delta 1 Delta 2 OAS spread (BPS) 60 75 65 25 Z-spread (bps) 75 90 85 50 Nominal spread (bps) 80 95 90 60 Richard comments on the fact that Tranche Delta 2 has a comparatively lower OAS spread.co as well as mortgage backed and asset backed securities.” Over dessert. Richard states that the prime reason for this is that the prepayment rate for the current month depends on whether there have been any prior opportunities to refinance the mortgage. Richard stated that the most significant shortcoming of most valuation models is its inability to accurately model prepayment risk. In the case of passthrough securities. the cash flow duration method allows for cash flows to change based on the interest rate path and is therefore a superior method to the effective duration. cash flow duration and credit curve duration and makes the following observations Statement 1 “The coupon curve duration while being simple to compute. She states. the two analysts were debating over the Pro’s and Con’s of the various valuation methods for securitized instruments. Over a lunch date. Richard asks for Abigail’s advice on a suitable valuation model for and ABS he is currently evaluating which is backed by credit card receivables.2013 CFA® Level II Fixed Income Irfanullah. She states that in the case of their sub fund “Alpha” which comprises exclusively of Mortgage passthrough securities issued by Ginnie Mae she makes use of the OAS spread. Z-Spread and OAS spread are popular tools for valuation and capturing risk. Abigail states that the nominal spread. All rights reserved. Richard states that he is excited about the new fund “Janus” which fuses both mortgage backed securities with Asset backed securities (ABS). that she has in the past made use of effective duration. Abigail goes on to describe her experience with various duration methods. Page 13 . Abigail then shows Richard the latest quotes on the tranches of the firms sub fund “Alpha”. its use is restricted to generic mortgage backed securities” Statement 2 “While the effective duration makes use of the Monte Carlo method for simulating prepayment risk.
Option-adjusted spread approach Copyright © Irfanullah Financial Training. Page 14 .2013 CFA® Level II Fixed Income Irfanullah. Nominal spread approach B. Prepayment burnout B. Incorrect with respect to statement 2 C. The valuation method Abigail will most likely recommend to Richard. Based on the data in exhibit 1.co 31. option risk 33. All rights reserved. Prepayment multiplier 32. Lower credit risk 35. Correct with respect to statement 1 and statement 2 36. The statements made by Abigail with respect to the different measures of duration is least likely A. Credit risk B. the option cost of Tranche Beta 1 is closest to: A. Zero-volatility spread approach C. The OAS spread for Subfund Alpha most likely compensates an investor for: A. 60 bps B. Lower liquidity B. liquidity risk C. Lower modeling risk C. 15 bps 34. The phenomenon described by Richard on prepayment risk is most accurately described as:: A. 20 bps C. with respect to the ABS backed by credit card receivables is: A. Refinancing rate C. correct with respect to statement 1 B. The least likely explanation for the value of Security Delta’s OAS spread is that it has comparatively: A.