Fixed income analysis multiple choice
Rosemary Denson makes these comments:
Comment 1: If Jones Company has a higher probability of default than McDavis Company, then Jones Company will have a higher expected loss.
Comment 2: If Company X has a higher expected loss on its bond than Company Y, then Company Y will have a higher present value of the expected loss.
Are her comments correct?
| Both comments are not correct. | ||
| Only comment 1 is correct. | ||
| Only comment 2 is correct. |
Vega’s firm has invested in a mortgage-backed Special Purpose Vehicle (SPV) that has four tranches: the senior bond tranche, mezzanine bond tranche, junior bond tranche, and equity. Vega’s colleague Jeremy Maklin advises her that the quality of the collateral pool is important to evaluating the different tranches. He says,
Waterfall: “The waterfall contains triggers based on the characteristics of the collateral pool that divert more cash flows to the most senior bond tranches if the collateral pool’s cash flows decline significantly.”
Equivalence: “Furthermore, I do not consider the cash flows and risk of an asset-backed bond and a corporate bond to be equivalent even if they have the same coupon payments, face value, maturity, and bond ratings.”
Are Maklin’s statements about the waterfall and the equivalence of asset-backed bonds and corporate bonds correct?
| Only his statement about the waterfall is correct. | ||
| Only his statement about the equivalence of the types of bonds is correct. | ||
| Both of these statements are correct. |
Jiang Hu made two comments about credit analysis.
Comment 1: A narrowing of the credit spread increases a bond’s holding period return.
Comment 2: For high-yield bonds, credit risk can vary greatly depending on bonds’ seniority ranking.
Are his comments correct?
| Both comments are correct. | ||
| Only comment 1 is correct. | ||
| Only comment 2 is correct. |
Jiang Hu also made these two comments about credit analysis.
Comment 1: Higher priority of claim implies a higher recovery rate-lower loss severity-in the event of default.
Comment 2: A B+ rating is a higher credit rating than a BBB-.
Are his comments correct?
| Both comments are correct. | ||
| Only comment 1 is correct. | ||
| Only comment 2 is correct. |
Jiang Hu also made these two comments about credit analysis
Comment 1: Credit rating changes usually lead changes in the market values of bonds.
Comment 2: The default rates by rating category (such as for rating BB) can vary considerably in different years.
Are his comments correct?
| Both comments are correct. | ||
| Only comment 1 is correct. | ||
| Only comment 2 is correct. |
__________ are private investment vehicles that manage portfolios of securities and derivative positions using a variety of strategies. They may employ long and short positions, are often highly leveraged, and aim to deliver investment performance that is independent of broad market performance.
| Hedge funds | ||
| Private equity funds | ||
| Real estate investment trusts | ||
| Infrastructure funds |
A major active investment strategy is the “absolute return” strategy. Absolute return strategies seek to generate returns that are independent of market returns; theoretically, betas of funds using absolute return strategies should be:
| close to zero. | ||
| close to one. | ||
| close to zero in bear markets and close to one in bull markets. | ||
| close to one in bear markets and close to zero in bull markets. |
Based on the last four years of returns, the table below includes the Sharpe ratios (annual) for four private equity funds and the frequency of monthly returns below -5%.
| Sharpe ratio | Frequency | |
| PE Fund 1 | 0.60 | 16.7% |
| PE Fund 2 | 0.60 | 12.5% |
| PE Fund 3 | 0.50 | 16.7% |
| PE Fund 4 | 0.50 | 12.5% |
Which fund has the best performance?
| PE Fund 1 | ||
| PE Fund 2 | ||
| PE Fund 3 | ||
| PE Fund 4 |
When the spot curve is upward sloping, the forward curve
| lies above the spot curve. | ||
| lies below the spot curve. | ||
| is identical to the spot curve. |
Which of these statements is true?
Statement 1: The Z-spread is the constant basis point spread that would need to be added to the implied Treasury spot yield curve so that the discounted cash flows of a corporate bond would be equal to its current market price.
Statement 2: The TED spread is the difference between Libor and the yield on a T-bill of matching maturity.
| Both statements are true. | ||
| Only the Z-spread statement is true. | ||
| Only the TED spread statement is true. |
Compared to traditional investments such as stocks and bonds, which of the following would NOT be a characteristic of alternative investments?
| Illiquidity of underlying investments | ||
| Narrow manager specialization | ||
| High correlation of returns with those of traditional investments | ||
| Low level of regulation and less transparency |
French Capital is a hedge fund with $400 million of initial investment capital. They charge a 2% management fee based on assets under management at year-end and a 20% incentive fee. The incentive fee is calculated gross of the management fee. In the first year, the hedge fund assets have a 25% return.
What are the fees earned by French Capital and what is an investor’s effective return given the fee structure?
| French Capital fees are $28 million and investor’s rate of return is 20%. | ||
| French Capital fees are $28 million and investor’s rate of return is 18%. | ||
| French Capital fees are $30 million and investor’s rate of return is 19.5%. | ||
| French Capital fees are $30 million and investor’s rate of return is 17.5%. |
French Capital is a hedge fund with $400 million of initial investment capital. They charge a 2% management fee based on assets under management at year-end and a 20% incentive fee. The incentive fee is calculated gross of the management fee. In the first year, the hedge fund assets have a 25% return.
If the fee structure specifies a hurdle rate of 5% and the incentive fee is based on returns in excess of the hurdle rate, this would tend to _____ French Capital fees and _____ the investor’s effective rate of return.
| increase, increase | ||
| increase, decrease | ||
| decrease, increase | ||
| decrease, decrease |
Luna Canutti is discussing the returns and risks of an equity investment in real estate compared to traditional stocks and bonds.
Statement 1: Real estate is typically less liquid than stocks, but more liquid than bonds.
Statement 2: Real estate should have more protection against unexpected increases in inflation than bonds.
Are Luna’s statements accurate?
| Yes. Both statements are correct. | ||
| No. Both statements are not correct. | ||
| No. Only statement 1 is correct. | ||
| No. Only statement 2 is correct. |
Luna Canutti is discussing the characteristics of attractive target companies for LBOs.
Statement 1: The intrinsic value of the company is less than its market price. Private equity firms try to buy companies like this one that are out of favor in the public markets and have stock prices that reflect this perception.
Statement 2: Private equity firms seek to generate attractive returns on equity by identifying companies that are efficiently managed and are performing well.
Are Luna’s statements accurate?
| Yes. Both statements are correct. | ||
| No. Both statements are not correct. | ||
| No. Only statement 1 is correct. | ||
| No. Only statement 2 is correct. |
Luna Canutti is discussing characteristics of infrastructure investments.
Statement 1: Brownfield investments are usually less risky than greenfield investments.
Statement 2: Because infrastructure provides essential services, government generally will regulate their operations and financial decisions.
Are Luna’s statements accurate?
| Yes. Both statements are correct. | ||
| No. Both statements are not correct. | ||
| No. Only statement 1 is correct. | ||
| No. Only statement 2 is correct. |
Which of the following is not a good criteria for a bond benchmark?
| Investible | ||
| Ambiguous | ||
| Measurable | ||
| Specified in advance |
In the event of default, the recovery rate of which of the following bonds would most likely be highest?
| First mortgage debt | ||
| Senior unsecured debt | ||
| Junior subordinate debt |
Securitization benefits financial markets by:
| increasing the role of intermediaries. | ||
| establishing a barrier between investors and originating borrowers. | ||
| allowing investors to tailor credit risk and interest rate risk exposures to meet their individual needs. |
If a mortgage borrower makes prepayments without penalty to take advantage of falling interest rates, the lender will most likely experience:
| extension risk. | ||
| contraction risk. | ||
| yield maintenance. |
Which of the following best describes the cash flow that owners of credit card receivable asset-backed securities receive during the lockout period?
| No cash flow | ||
| Only principal payments collected | ||
| Only finance charges collected and fees |
In a liquid bond market, a bond owner should be able to sell a bond at a price
| Close to fair market value. | ||
| above the original purchase price | ||
| close to par value |
The spot price of a three year zero coupon bond is 0.8950 and the forward price of a one-year zero-coupon bond beginning in three years is 0.9350. What is the four-year spot rate?
| 7.21% | ||
| 6.37% | ||
| 5.43% | ||
| 4.55% |
Instead of buying all of the bonds in a bond index, the bond manager uses a sampling approach in an attempt to match the primary index risk factors and achieve a higher return than the index. This style is called:
| Enhanced indexing by matching primary risk factors. | ||
| Active management with larger risk factor mismatches | ||
| Full-blown active management. |
Potential challenges with using indexes as benchmarks can include the following:
Challenge 1: Compared to equities, bonds have less active secondary markets.
Challenge 2: Index composition tends to change infrequently.
Challenge 3: Indexes are subject to the “bums” problem.
Which of the above are legitimate challenges?
| 1 and 2 | ||
| 2 and 3 | ||
| 1 and 3 |
Joseph Kennedy is discussing tracking risk.
Comment 1: The portfolio’s active return is the portfolio return minus the benchmark return. The tracking risk is the standard deviation of the active return.
Comment 2: Tracking risk arises primarily from mismatches between a portfolio’s risk profile and the benchmark risk profile.
Are Joseph’s comments correct?
| Both comments are correct. | ||
| Both comments are not correct. | ||
| Only comment 1 is correct. | ||
| Only comment 2 is correct. |
Two dedicated, fixed-income strategies designed to accommodate specific funding needs of an investor are:
| Immunization and cash flow matching. | ||
| Immunization and cushion optimization. | ||
| Cushion optimization and cash flow matching. |
Fixed income analysis multiple choice