Howdy, Stranger!

It looks like you're new here. If you want to get involved, click one of these buttons!

CFA Events Calendar

View full calendar

CFA Events Calendar

View full calendar

Recommended Discussions

See how our partners can help you ace your CFA exams.

CFAI 2014 Mock PM C - Spong Q6

@alta12 @RaviVooda‌


6.) Given Vertex's forecasts in Statement 4, the most appropriate strategy for Vertex is to:
A. shorten duration in the credit sector and lengthen duration in the Treasury sector.
B. lengthen duration in the credit sector and shorten duration in the Treasury sector.
C. lengthen duration in all spread sectors and the Treasury sector.
Answer = B

As spreads tighten the credit sector will benefit from increased exposure to longer duration issues. Because the yield curve is expected to steepen, it would be appropriate for Vertex to shorten duration in Treasuries because rising yields will cause security prices to fall. Ideally, the net effect should be to reduce duration below the benchmark.



Why do we have to lengthen duration in the credit sector? I thought rates are all rising and spreads are tightening? I don't get the explanation of the Treasuries bit as well. Please help.

Comments

  • @vincent‌t, when economy is growing, private companies do well, which implies credit sectors do well. so their spreads contract. Since their ratings get better bonds in that area will perform better. Also we should decrease the treasury sector and move them to credit sector as the duration of credit ones is high and their price increase will be much more than the treasury ones. Hope this helps

    Alta12
  • @RaviVooda‌ if the credit sector has higher duration than the treasury shouldn't you decrease the allocation to the credit sector since higher duration are more sensitive to changes of interest rates and because long term interest rate are expected to increase by 0.75% and short term at 0.50%, wouldn't allocating more to credit reduce your portfolio value due to the increased rate?
  • @vincentt, when economy is improving, short term rates rise gradually leaving further risk on the short end side until the yield curve becomes flat.

    @alta12 what is your view?
  • @RaviVooda‌ this is the bit that confuses me, when the text mentioned expected steeper yield curve (i know it means long term rates increase more than short term rate) but what does it actually implies? Is it just to invest more in short term instead of long?

    On another note, if the current yield is very steep, we should invest in longer duration than shorter to enjoy the higher yield?

    Is my understanding correct?

  • @vincentt‌ , steeper implies that the short term rates are way lower than long term rates. consider short term (3%) and long term (9%). When text says steeper my conclusions would be
    - Fiscal and Monetary policies both are stimulatory
    - Economy is in the early swing stage and is getting back on track and inflation is decreasing.
    - Credit spread will tighten

    So, if yield curve is steep, we should move our money to longer duration as decreasing spread will help to gain more. On the short duration side it is dangerous as short term interest rates increase with economy getting on track. (We can still be on short term side, if our requirement is very very short term and we are managing against liabilities). So moving to longer duration is to get profits and to save losses :)
  • @RaviVooda‌ i get your point on the high long term rates (in the steep yield curve) which might decrease.

    Going back to this question, the expected increase of short and long term rate are forecast, so that means it has not happened, so wouldn't it be better to allocate more on short term?
  • @vincentt‌ , the answer can be overweighting short term duration if we expect interest rates to rise first then later spread is decreased. This contradicts with the answer CFAI has given us. :(
    @alta12, @sophie some help please.
  • @RaviVooda‌ :-O that's why i was stuck when working on this question, though I got it right


    A. shorten duration in the credit sector and lengthen duration in the Treasury sector.
    (Can't be A because tightening spread credit sector will definitely outperform treasury in terms of total return).

    B. lengthen duration in the credit sector and shorten duration in the Treasury sector.

    C. lengthen duration in all spread sectors and the Treasury sector.
    (same reason with A)

    So this leaves us with B, however the explanation does not make any sense. Was this question from a sample or somewhere else?
  • @vincentt , I do not remember doing such question in the text book.
  • @ravivooda @vincentt I did this question by process of elimination as I know I needed to long duration on credit as the spreads are coming down (and B was the only answer that fitted in my mind). Like you guys, I'm a bit confused about the steep yield curve and short duration in the treasury sector. May have to wait for @sophie for this one!
  • SophieSophie Posts: 1,997 Sr Partner
    Hello my dearest L3 candidates :D@vincentt‌ would you mind pasting the full question, esp statement 4? hopefully i can help this discussion
    Alta12vincentt
  • @sophie Vertex evaluates potential trades using total return analysis (TRS). TRS assesses the expected effect of a trade on the total portfolio return based on an interest rate forecast. EG. Vertex recently evaluated the expected total return for a single bond, with a beginning price of $103, a 5% semi annual coupon, an expected price at the end of one year $102.50, and an annual reinvestment rate of 2%.

    Vertex also positions the portfolio to reflect the firm's opinion on the direction of interest rates and credit spreads. Over the next 6 months, Vertex is forecasting:
    1. Low and stable implied interest rate volatility
    2. spreads to narrow across all spread sectors by 25bps, and
    3. A positively slope yield curve with short rates rising 50bps and long rates rising by about 75bps.

    Q: Given Vertex's forecast above, the most appropriate strategy for Vertex is to:

    A) Shorten duration in the credit sector and lengthen duration in the treasury sector.
    B) Lengthen duration in the credit sector and shorten duration in the treasury sector.
    C) Lengthen duration in all spread sectors and the treasury sector.
  • SophieSophie Posts: 1,997 Sr Partner
    Thanks @alta12. Ok I think maybe you guys are over evaluating what the term structure of interest rate implies here.

    Let me try to reason my trail of thought. When I first read the question, and looked at the answer, I knew C was eliminated given the contradictory nature of A and B.

    And then I looked at statement 2 where the (credit?) spreads are expected to narrow across ALL sector. With this information, I knew I had to increase duration in the credit sector as the bond prices are expected to increase, which already points to answer B.

    For treasuries, I'd only reason that it "theoretically" is the best credit rating and therefore credit spreads tightening shouldn't affect it. In relation to point 2 and 3, I'd reallocate my exposure to credit (issuer credit risk) from straight forward Treasuries given the yield curve steepening.

    I hope this makes sense?
  • 1. Low and stable implied interest rate volatility
    2. spreads to narrow across all spread sectors by 25bps, and
    3. A positively slope yield curve with short rates rising 50bps and long rates rising by about 75bps.



    Thanks for your time @sophie. What you mentioned make sense for point #2 as treasuries would not have any spread hence won't be affected by tightening spread.

    However, when we take point #3 into account it complicate things. Since long term rates are expected to increase more than short term (even short term rates are expected to rise more than the tightening 25bps), wouldn't it be right to invest more on shorter duration and less on longer ones? That's as far as I understand from the text.

    The only exception to the above strategy is when the long term rates are already high (current instead of expected) then one should invest into longer duration (expecting it to fall).

    Is that what CFAI text is implying guys? @RaviVooda‌ @alta12






  • @sophie @vincentt @RaviVooda‌

    I'm still confused. Can we break this down.

    Let's say if the question didn't give us 2) the bit about credit spreads and just the following:

    1. Low and stable implied interest rate volatility
    3. A positively slope yield curve with short rates rising 50bps and long rates rising by about 75bps.

    Would you decrease the portfolio's overall duration as the long term rates are rising more than short term rates? That way you are losing less overall on the bond value?
  • @alta12, yes. Then we would move to short term end
  • SophieSophie Posts: 1,997 Sr Partner
    OK @vincentt‌ @Alta12‌ - I think you guys are using the term duration in 2 meanings in these context:

    1) English = a length of period (which in this case it seems like you are using the term duration to mean maturity)
    2) Finance = sensitivity of bond price to yield changes

    With the expected yield curve steepening (interest rate rise), reducing your (finance) duration of Treasuries at all maturity means that you reduce the sensitivity of your bond portfolio to interest rate rise, which means you reduce the impact of fall in value in your bond portfolio when interest rates increase. It is not asking about whether you should reduce exposure to short or long term maturity of Treasuries. Does this make sense?
    Alta12
  • edited June 2014
    Thanks @sophie! Makes sense now! I was thinking how to position the portfolio to take advantage of the higher rise in long term rates vs short term rates. I can see that is not what the question was asking :-/
  • Hi, @sophie i did not mixed up the 2 meanings but i have a couple more questions:

    2. spreads to narrow across all spread sectors by 25bps, and
    3. A positively slope yield curve with short rates rising 50bps and long rates rising by about 75bps.


    Based on the #2 statement, we can conclude that credit sector's spread will be tightened and yield will reduced by 0.25% and no changes to the treasuries.

    Based on #3, with expected rise for short term rates @ 0.5% and long term @ 0.75%, however taking #2 into account the overall is still a rise for short and long rates each at 0.25% and 0.50%.

    Therefore, there forecast were:
    Credit sector -> short & long rise at 25bps and 50bps
    Treasuries -> short & long rise at 50bps and 75bps

    Which means it's still an overall increase to short and long term, wouldn't it be right to try to reduce the duration of treasuries and also credit? but more so for treasuries over credit?


    @sophie your points regarding "...reducing your (finance) duration of Treasuries at all maturity means that you reduce the sensitivity of your bond portfolio to interest rate rise, which means you reduce the impact of fall in value in your bond portfolio when interest rates increase." definitely make sense, but from what i can see the credit sector is still exposed to increasing rate both short and long?
  • SophieSophie Posts: 1,997 Sr Partner
    vincentt said:


    Therefore, there forecast were:
    Credit sector -> short & long rise at 25bps and 50bps
    Treasuries -> short & long rise at 50bps and 75bps

    Which means it's still an overall increase to short and long term, wouldn't it be right to try to reduce the duration of treasuries and also credit? but more so for treasuries over credit?

    Yes that certainly makes sense. But remember you're limited to the choices in your answers. With C eliminated, and A & B remaining, the best course of action is to reallocate to credit more and reduce exposure in treasuries. Your assessment is not wrong, it's just in the context of the answers provided. In the real world one could say you exit both the credit and treasuries play altogether! We are making a relative assessment here in the context of the answer.

    And yes the credit sector is still exposed to the yield curve steepening, but with A & B remaining, I choose the answer that reduces my portfolio losses (or immunise it the most from my interest rate expectations). Hope this helps! This question ain't easy!
  • thanks for the explanation @sophie and sorry for being a pain :P , I just want to get my understanding right because if question like this appears in the morning, they will require me to justify my choice.

    Just a random thought, if I could explain why option A or C isn't right but using the reason of "the process of elimination" and hence B is the right answer, will that be acceptable? lol
    Sophie
  • SophieSophie Posts: 1,997 Sr Partner
    It's call making stuff up @vincentt :)) No worries, just trying my best to help as well, so curiosity and full understanding is fundamental to pass. Good luck for this Sat! Remember to take some time off to nurse the brain before the big day!
    Alta12vincentt
  • haha thank you @sophie for your help through these never ending levels :D
    Alta12
  • So we cannot gain overall just lose less?
  • @vincentt,@alta12, Sorry but I could not still get why should we increase duration of credit sector and decrease duration of treasury.
    I understand that we should decrease our duration to reduce our loss. But how does this happen with the answer selected?
Sign In or Register to comment.