CFA Level 3 Exam

359 Questions

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Question No. 1

Jerry Edwards is an analyst with DeLeon Analytics. He is currently advising the CFO of Anderson Corp., a multinational manufacturing corporation based in Newark, New Jersey, USA. Jackie Palmer is Edwards's assistant. Palmer is well versed in risk management, having worked at a large multinational bank for the last ten years prior to coming to Anderson.

Anderson has received a $2 million note with a duration of 4.0 from Weaver Tools for a shipment delivered last week. Weaver markets tools and machinery from manufacturers of Anderson's size. Edwards states that in order to effectively hedge the price risk of this instrument, Anderson should sell a series of interest rate calls. Palmer states that an alternative hedge for the note would be to enter an interest rate swap as the fixed-rate payer.
As well as selling products from a Swiss plant in Europe, Anderson sells products in Switzerland itself. As a result, Anderson has quarterly cash flows of 12,000,000 Swiss franc (CHF). In order to convert these cash flows into dollars, Edwards suggests that Anderson enter into a currency swap without an exchange of notional principal. Palmer contacts a currency swap dealer with whom they have dealt in the past and finds the following exchange rate and annual swap interest rates:
Exchange Rate (CHF per dollar) 1.24
Swap interest rate in U.S. dollars 2.80%
Swap interest rate in Swiss franc 6.60%
Discussing foreign exchange rate risk in general, Edwards states that it is transaction exposure that is most often hedged, because the amount to be hedged is contractual and certain. Economic exposure, he states, is less certain and thus harder to hedge.
To finance their U.S. operations, Anderson issued a S10 million fixed-rate bond in the United States five years ago. The bond had an original maturity often years and now has a modified duration of 4.0. Edwards states that Anderson should enter a 5-year semiannual pay floating swap with a notional principal of about $11.4 million to take advantage of falling interest rates. The duration of the fixed-rate side of the swap is equal to 75% of its maturity or 3.75 (= 0.75 x 5). The duration of the floating side of the swap is 0.25. Palmer states that Anderson's position in the swap will have a negative duration.
For another client of DeLeon, Edwards has assigned Palmer the task of estimating the interest rate sensitivity of the client's portfolios. The client's portfolio consists of positions in both U.S. and British bonds. The relevant information for estimating (he duration contribution of the British bond and the portfolio's total duration is provided below.
U.S. dollar bond $275,000
British bond $155,000
British yield beta 1.40
Duration of U.S. bond 4.0
Duration of British bond 8.5
When discussing portfolio management with clients, Edwards recommends the use of emerging market bonds to add value to a core-plus strategy. He explains the characteristics of emerging market debt to Palmer by stating:
1. "The performance of emerging market debt has been quite resilient over time. After crises in the debt markets, emerging market bonds quickly recover after a crisis, so long-term returns can be poor."
2. "Emerging market debt is quite volatile due in part to the nature of political risk in these markets. It is therefore important that the analyst monitor the risk of these markets. I prefer to measure the risk of emerging market bonds with the standard deviation because it provides the best representation of risk in these markets."

Regarding his two statements about the characteristics of emerging market debt, is Edwards correct?
Choose the correct option from the given list.
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