CFA Level 3 Exam

359 Questions

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Question No. 1

Jean Sims, CFA and Ellie Hayes, CFA are advisors for Eagle Fixed Income Investors. Eagle makes recommendations on bonds, mortgages, and other fixed income investments for wealthy individuals and institutions.

Eagle has a client, Parker Portfolio Managers, which has a large holding of mortgages. Due to a projected decline in the housing market in the United States, the yields on mortgages are expected to increase over the next year. The largest mortgage position for Parker is currently priced at 98.80. Given the projected increase in yields, Sims has calculated an expected price of the mortgage of 95.50 in one year. For the same magnitude of yield change, she projects a price of 101.20 if yields instead fall. Hayes states that Parker should hedge the mortgage by shorting a 10-year Treasury bond futures contract.
Discussing the performance of mortgages in general with Parker officers, Hayes states that they are market directional investments. Hayes's reasoning is that mortgages tend to follow the general direction of the fixed income market, where mortgages should be avoided when interest rates are expected to rise and favored when they are expected to fall.
Commenting on hedging mortgages in general, Sims states that a two Treasury bond futures hedge is usually more effective than a single Treasury bond futures hedge. Furthermore, she states, a mortgage can be hedged dynamically by adjusting the hedge through time, or by buying interest rate options. An option hedge would be used when its implied volatility is low, she states.
Examining the Parker portfolio in more detail, Sims gathers the following details on mortgages they hold.
Sims gathers the following details on mortgages they hold.
Later that day Sims and Hayes discuss the appropriate hedging of mortgages and make the following statements:
• Sims: "To hedge the duration exposure of a mortgage and maintain a constant duration, the investor should sell Treasury bond futures when interest rates fall and buy Treasury bond futures when interest rates rise."
• Hayes: "Mortgage investors face model risk where using a poor model increases the investor's risk. For example, if prepayments increase faster than expected, the investor faces greater risk. Unfortunately, there is no easy way to hedge model risk."
Examining the properties of principal only (PO) and interest only (10) strips, Sims determines that the key rate durations for a client's PO strip are negative before year 8 but turn positive thereafter. The client's 10 strip has key rate durations that are positive up until year 10 but turn negative thereafter. Overall, the duration is positive for the PO strip and negative for the 10 strip. Sims is examining the effect of a yield curve change on the mortgages. Her assumption is that the short end of the yield curve increases while the Long end of the curve is unchanged.
Regarding comments of Sims and Hayes on hedging mortgages and model risk, are the comments correct?
Choose the correct option from the given list.
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