Vignette: Albert and Sara are both bond portfolio managers for different pension fund management firms. Both attended the same college and periodically get together to discuss portfolio management issues. They had recently met to discuss bond indexing, enhanced indexing, tracking error, and bonds with embedded options.
The following question relates to their conversation.
Question: Sara is considering some bond indexing enhancements that could be used to improve her performance. She is considering purchasing some callable bonds and knows that returns can be enhanced when a callable bond moves from being priced to call to being priced to maturity (or visa versa), by increasing a portfolios relative exposure to call risk.
Sara asks Albert which of the following best describes callable bonds' performance for near-term yield changes?
Select an Answer: Bonds that are price to call tend to outperform when rates decline because their observed price sensitivity is less than their effective duration. Bonds that are priced to maturity tend to underperform when rates rise, because their observed duration is greater than their effective duration. When rates rise callable bonds are going to fall more than comparable noncallable bonds because of the callable bonds negative convexity. Bonds that are priced to maturity tend to outperform when rates rise, because their observed duration is greater than their effective duration
Rationale:
Bonds that are priced to maturity tend to underperform when rates rise, because their observed duration is greater than their effective duration. Recall that when rates rise, callable bonds (priced to call) are not going to fall by as much as comparable noncallable bonds (priced to maturity) because of the callable bond's negative convexity (the price flattens out at lower rates).
2025-07-09
Question: If the spread increases by 22 basis points, the contribution of the issue to portfolio duration is 1.7 while the contribution of the issue to index duration is 2.35.
It follows that the basis point change in tracking error is ________.
Select an Answer: -14.3 8.4 14.3 -8.4
Rationale:
Basis point change in tracking error = - Change in spread × (Contribution of issue to portfolio duration − Contribution of issue to index duration)
= -22 × (1.7 − 2.35) = 14.3
2025-07-08
Question: Which of the following suggests that the portfolio and index share similar underlying risk factors?
Select an Answer: Both the bond index and portfolio perform well over the period under consideration. Portfolio performance is greater than total tracking error. The standard deviation of the tracking error remains low and stable over time. Tracking error remains consistently moderate.
Rationale:
If the standard deviation of the tracking error remains low and stable over time, this suggests that both the portfolio and index share similar underlying risk factors.
2025-07-07
Question: Most countries do not have highly developed corporate bond markets.
This increases the risk of ________.
Select an Answer: default illiquidity fraud banking system collapse
Rationale:
Illiquidity is a risk because most countries do not have a highly developed corporate bond market.
2025-07-06
Question: Which of the following is not a reason for secondary market trading?
