CFA Exam Question of the Day

Level I | Level II | Level III

2024-06-12

Vignette:
Natasha Jorgen is a financial engineer with the firm CDC Analytics Inc. Her main task is to assist in the modeling of credit derivatives.

Her boss, Toshi Yamato, has asked her to put together a presentation on credit risk for several of their top institutional clients.

Question:
Natasha wants to include an example of a credit forward payoff calculation in her presentation. She collects the following data:
  • Notional principal = $10 million
  • Spread = 300 bps
  • Strike = 250 bps
  • Risk factor = 2
The answer that is closest to the payoff the buyer will pay/receive is:

Select an Answer:
receive $25,000
pay $100,000
pay $25,000
receive $100,000
Rationale:
To calculate the forward payoff:

Forward Valuet = (RSt − SS) × Notional principal × Risk factor

Where RSt is the actual or real spread and SS is the strike spread over the benchmark.

Thus, we get:

FVt = (.03 − .025) × $10 million × 2
FVt = $100,000

Since the FVt is positive, then the buyer of the credit forward receives the $100,000.

Remember that forwards are symmetrical; thus, there will always be a winner and a loser in the transaction.

2024-06-11

Vignette:
Raymond Quinn is employed with Schooner Capital. Raymond is the head of the derivatives department of the firm. Raymond's mandate is to ensure the use of derivatives to compliment the portfolio management of the assets the firm manages. Raymond works with the portfolio managers in using equity and debt derivatives to lower risk and take advantage of opportunities that are available.

Schooner serves both individual and institutional clients and aims to provide the best return for a specified risk level for each client. The following is a situation that Raymond faces regularly in performing his duties and responsibilities.

Question:
Which of the following would best explain credit spread risk the firm may be exposed to?

Select an Answer:
the increase in return volatility
a widening of the spread between the return from an asset and the return from the benchmark asset
the option adjusted spread widening
a credit upgrade
Rationale:
Credit spread risk is the risk of a widening of the spread between the return from an asset and the return from the benchmark asset.

2024-06-10

Vignette:
Cindy Long is employed with Vector Capital. Cindy is responsible for monitoring the portfolio managers of the firm with regard to risk considerations.

Vector serves both individual and institutional clients and aims to provide the best return for a specified risk level for each client. The following is a situation that Cindy faces regularly in performing her duties and responsibilities.

Question:
Cindy is planning to use VAR for controlling market risk. This would be ineffective in which of the following applications?

Select an Answer:
if VAR is used to predict potential losses
all of these answers
if the firm does not have proper risk management infrastructure in place
if VAR is used to compare portfolio performance versus a benchmark
Rationale:
Using VAR in isolation without a proper risk management infrastructure is not an effective strategy for controlling risks. VAR needs to be presented along with the corresponding expected return whenever the strategy actively pursues risk. Otherwise, the magnitude of the risk cannot be evaluated in the context of the potential returns.

2024-06-09

Vignette:
Cindy Long is employed with Vector Capital. Cindy is responsible for monitoring the portfolio managers of the firm with regard to risk considerations.

Vector serves both individual and institutional clients and aims to provide the best return for a specified risk level for each client.

The following is a situation that Cindy faces regularly in performing her duties and responsibilities.

Question:
Cindy currently monitors the variance/covariance VAR and is considering using stress testing as well.

Which of the following are reasons Cindy should use stress testing?

I. Accounts for delta risks
II. Accounts for gamma risks
III. Provides for the probability of a loss
IV. Accounts for beta risk

Select an Answer:
I, III
IV
II, III
I, II, III, IV
Rationale:
Stress testing would give Cindy a measure of gamma risks. Gamma risks are not measured by the variance/covariance method. Stress testing would allow Cindy to estimate the worst case loss and VAR would complement this with the measure of the probability of the loss when gamma risks are considered.

2024-06-08

Vignette:
Raymond Quinn is employed with Schooner Capital. Raymond is the head of the derivatives department of the firm.

Raymond's mandate is to ensure the use of derivatives to compliment the portfolio management of the assets the firm manages. Raymond works with the portfolio managers in using equity and debt derivatives to lower risk and take advantage of opportunities that are available.

Schooner serves both individual and institutional clients and aims to provide the best return for a specified risk level for each client. The following is a situation that Raymond faces regularly in performing his duties and responsibilities.

Question:
One of Schooners fund managers has a $10 million par value position in an option free 8.5%, 10-year corporate bond that is trading at 124.55 and has a yield of 5.28%. The portfolio manager has asked Raymond how he can hedge the position for three months using 3-month futures that are trading at a price of 115. The CTD issue is the 7.80%, 10-year issue that is trading at 121.45 and yielding 5.02%. Par value for the futures contracts are $100,000. The conversion factor for the CTD is 1.05 and the yield spread between the bond and the CTD is expected to stay constant at 26 for the next three months.

If the duration of the corporate bond on the settlement date is 8.25 and assuming that yields stay constant, what is the target price for the CTD?

Select an Answer:
$120.75
$135.00
$148.32
$154.41
Rationale:
The target price for the CTD = Futures price × Conversion factor = 115 × 1.05 = 120.75.

The duration of the futures contract and the duration of the corporate bond only are relevant to calculating the number of futures contracts needed to hedge the position.