1 Each of the following is a step in the risk management process EXCEPT: A) filing taxes. 2 B) identify and price the appropriate tools for achieving ...
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Each of the following is a step in the risk management process EXCEPT: A) filing taxes.
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The final step in the implementation phase of the risk management process is to: B) identify and price the appropriate tools for achieving the objectives. Yoshi Chu and Ryan Dobson have been tasked with creating an enterprise-wide risk management (ERM) system for Reliant Financial Services. After creating a centralized data warehousing facility, their next step is creating a useful analytics system. Which of the following features would be least likely included in their system?
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A)
Derivative valuation models.
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One goal of all risk management systems should be to: A) bring the level of risk to a desired level of risk, which may exceed zero.
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Risk management has evolved into: A) a broad set of interrelated activities.
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Which of the following is the final step in the risk management process? A) Monitoring the process and taking any necessary corrective actions.
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Which of the following operations applies to the monitoring and evaluation systems of an enterprise-wide risk management (ERM) system? B) Performing diagnostics on the pricing, value at risk (VAR) computations, and data quality.
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Which of the following is the most difficult step in establishing an enterprise-wide risk management (ERM) system for a large firm? C) Creating a centralized data warehousing system.
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Risk management is best addressed: daily. C) Peter Weatherford and Paul Washington are discussing the characteristics of an effective enterprise risk management system for their firm, Supra Portfolio Managers. Weatherford states that Supra should have a committee in place to respond to violations of risk management guidelines. Washington adds that each asset Supra holds must be investigated thoroughly in isolation so that management can better understand the asset’s risk and return characteristics. Which of the following regarding Weatherford’s and Washington’s statements is CORRECT?
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C)
Weatherford is correct; Washington is incorrect.
Tom Andrews is in charge of the risk management committee for Sigma Portfolio Managers. Interest rates have recently increased and the firm’s model has predicted a substantial decline in the value of the firm’s bond portfolio. However, the actual value of the bond portfolio has not decreased as much as expected because the firm has large holdings of callable bonds. Which of the following is the best action for Andrews to take? Andrews should advise the risk management committee that they should:
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B)
revise the model in light of its shortcomings.
Frank Meinrod is in charge of the risk management committee for Alpha Portfolio Managers. Recently, the value of one of the company’s bond positions has decreased due to a potential steep rate hike by the Federal Reserve. Meinrod believes that the rate hike will be moderate and that the decline in the bond portfolio value is temporary. Which of the following is the best action for Meinrod to take? Meinrod should advise the risk management committee that they should: 9
B)
take no action at all.
Which of the following would NOT be a characteristic of an effective enterprise risk management system? 10
A)
Allocating capital according to the returns generated.
Which of the following would NOT be a characteristic of an effective enterprise risk management system? 11
B)
Decentralization of risk monitoring and control procedures.
Which of the following regarding an effective risk management model is least accurate? 12
B)
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Duration and delta are sufficient for modeling the risk of bonds and options.
When describing the risk exposures that an analyst should examine as part of an enterprise risk management system, what terms describe the risks pertaining to the factors that directly affect firm or portfolio values and the risks associated with external capital markets? Firm/Portfolio Value - External Capital Market B)
Market risk - Financial Risk
The LDC Bank specializes in foreign exchange transactions and lending to emerging market countries. They have provided a loan to the country of Tinia so that Tinia can install a water irrigation system in the interior of the country. The LDC Bank is very careful with their lending practices, calculating the probability of a country’s default through the use of simulation. They have also entered into a currency swap that allows them to receive Mexican pesos in exchange for paying U.S. dollars. Which of the following risk is NOT explicitly mentioned in these series of transactions by the LDC Bank?
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A)
Regulatory risk.
A manager wishes to lower the financial risk of a portfolio. She looks at the risks of her portfolio associated with currencies and commodities. In attempting to lower the financial risk associated with her portfolio, she should hedge: 15
B)
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the risk associated with both currencies and commodities.
A company has a portfolio composed of several securities with large bid/ask spreads. This is an indication that the portfolio has: high liquidity risk, which means high financial risk. A) Increasing the relative weight on OTC derivatives relative to the weight on exchange-traded derivatives in a portfolio will:
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A)
increase credit risk and financial risk.
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All of the following are sources of non-financial risk EXCEPT: commodity prices. B)
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All of the following are types of financial risk EXCEPT: accounting risk. B)
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Which of the following is a source of financial risk? Commodity prices. C) Suppose that in a currency swap, counterparty A makes a payment to counterparty B who, unbeknownst to A, defaults on the payment that is due at the same time to A. This is called:
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A)
settlement risk.
A property that is usually necessary for a risk source to be considered financial is that it involves: 22
A) 23
a transaction with a party outside the firm.
All of the following are sources of non-financial risk EXCEPT: credit risk. A)
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If the one-day value at risk of a portfolio is $50,000 at a 95 percent probability level, this means that we should expect that in one day out of: 20 days, the portfolio will decline by $50,000 or more. C)
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The minimum amount of money that one could expect to lose with a given probability over a specific period of time is the definition of: value at risk (VAR). A) Value at risk (VAR) is a benchmark associated with a given probability. The actual loss:
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B)
may be much greater.
All of the following are considered to be strengths of the historical value at risk (VAR) methodology EXCEPT: 27
B)
minimal data is needed.
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All of the following are considered to be weaknesses of the variance/covariance value at risk (VAR) methodology EXCEPT: market data necessary to compute VAR is often not available. B)
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Which of the following factors is the common weakness in historical and Monte Carlo Simulation approach to VAR estimation? For some assets you may face model risk. A) The method for calculating value at risk that is the simplest and rests heavily on means and variances is the:
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C)
delta-normal method.
The method for calculating value at risk that uses the fewest assumed inputs is the: 31
A)
historical method.
Which of the following statements exhibits a weakness of historical value at risk (VAR)? 32
A)
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The manager of the Matrix Small Cap Index Fund calculates a historical daily VAR at the 95% confidence level of $4,080 using Russell 2000 Index returns from 1987-2001. The manager of the Smith Small Cap Index Fund, which is the same size as the Matrix Small Cap Index Fund, calculates a historical daily VAR at the 95% confidence level of $4,210 using Russell 2000 Index returns from 1990-2001.
Assuming that adequate daily data is available, a criticism of the Monte Carlo value at risk (VAR) methodology, but not the other VAR methodologies is that it: is exposed to model risk. A)
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A disadvantage of the Monte Carlo method for calculating value at risk is that: it is computationally intensive. B) All of the following are advantages in Monte Carlo simulation approach to VAR estimation EXCEPT:
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C) 36
no model risk
Which value at risk methodology is most subject to model risk? Monte Carlo simulation. B) Which of the methods for calculating Value At Risk (VAR) do asset managers most commonly use?
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B)
Variance/covariance.
Which methodology for computing value at risk (VAR) relies on the assumption of normally distributed returns? 38
B)
Variance/Covariance VAR.
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Value at risk (VAR) is attractive because it: is a single and easily understood measure. B)
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Which of the following is NOT a practical benefit of the value at risk framework? Hedging. A) As a risk measurement, value at risk may be superior to standard deviation because:
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A) 42
VAR may capture market participant's attitudes towards risk more completely.
With respect to value at risk (VAR), regulatory agencies: in some industries require its computation and reporting. B) Which of the following is NOT an appropriate application of VAR for portfolio managers?
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C)
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Peer group risk evaluation.
Regarding the practical application of value at risk (VAR) for portfolio managers, which of the following statements is least accurate? VAR can: not be used to set risk limits relative to a benchmark. A) Which of the following statements describes the most unique and practical application of value at risk (VAR) for comparing risky assets? VAR can be used to compare risk:
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A)
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across asset classes such as bonds and stocks.
An investor hires a portfolio manager and stipulates a maximum value at risk for the portfolio. This is an example of the use of the value at risk framework to: set risk limits. B)
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The accuracy of a value at risk (VAR) measure: can only be ascertained after the fact. C)
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Which of the following statements best describes the uses of stress analysis? A)
Stress analysis can be used to enhance VAR analysis by focusing on the extent of loss in an extreme event.
John Nicholson is in charge of the risk management committee for Beta Portfolio Managers. Beta has a variety of bonds in their portfolio of differing durations, call features, and coupons. He is worried about the impact on the firm’s bond portfolio from simultaneous changes in interest rates, the shape of the yield curve, and interest rate volatilities. Which of the following forms of stress testing is he most likely to utilize? 49
B)
Stylized scenarios.
Which of the following describes the form of stress testing referred to as factor push analysis? 50
B)
The impact on the portfolio is measured by examining an input at an extreme level.
Which of the following is NOT a disadvantage of using stress testing? Stress testing: 51
B) 52
reflects only normal circumstances.
Which of the following is NOT a use of stress testing? It enables the risk manager to eliminate all risk from a portfolio. B) Paula Flox, global risk manager for Green Asset Management, wants to implement a stress testing program. She asks Richard Volk, a junior analyst, to prepare a report on stress testing. When she receives the completed report, Flox is extremely unhappy because it includes only one true conclusion. Which of Volk’s conclusions regarding stress testing is CORRECT? Stress analysis:
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B)
is not useful for determining the probability of an expected loss.
Which of the following is NOT a damaging consequence of not conducting proper stress analysis? 54
B)
Exposure to risk of being taken over.
The long position of a forward contract bears the credit risk if the market price of the underlying is: 55
A)
greater than the exercise price.
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Which of the following will have the least amount of credit risk? A(n): short option position. A)
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Prior to expiration, the long position in a European option would have: only potential credit risk. C)
Using the following information from a firm that uses enterprise risk management, which portfolio manager has superior performance and why? Manager A Manager B Capital $150,000,000 - $590,000,000 VAR $7,500,000 - $21,000,000 Manager B because their return is higher in a risk budgeting context. C) 58
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Which of the following is the most widely accepted definition of market risk? The potential change of value in an asset or derivative in response to a change in some basic source of uncertainty. C)
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Which of the following is a type of market risk? Interest rate risk. A) For a firm that uses enterprise risk management, what type of limit should be used to ensure firm diversification?
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B)
Position limit.
For a firm that uses enterprise risk management, how should a deviation from a risk budget be dealt with? 62
C) 63
The deviation should be reported immediately to upper management.
Which of the following is a source of market risk? Equity prices. B) When two counterparties have obligations to each other, the process that potentially reduces the credit risk of one counterparty to zero and lowers the credit risk of the other is known as:
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A)
netting.
A subsidiary of a parent company that is capitalized in a way that results in a high credit rating, with the objective of allowing the subsidiary to engage in activities where a high credit rating is an advantage would be called: 65
C) 66
a special purpose vehicle.
he practice that imposes current credit risk on a periodic basis to lower potential credit risk is called: C)
marking to market.
Jenny Rouse has been a portfolio manager for Theta Advisors for the last five years. The performance of her portfolio has had few returns below its benchmarks since its inception. Which of the following risk measures best measures Rouse’s performance? 67
B)
Sortino ratio.
Which of the following risk measures does NOT assume a normal distribution of returns? 68
B) 69
RoMAD.
In the Sortino ratio, the excess return is divided by the: standard deviation using only the returns below a minimum level A) Which of the following most accurately describes the relationship between computing internal capital requirements using a stress testing approach versus a value at risk (VAR) capital strength approach? Stress testing approaches:
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A)
complement VAR approaches since they account for scenarios that may not be properly considered in VAR approaches.
Stress testing approaches are not constrained by many of the constraints associated with the traditional distribution based value at risk (VAR) approaches. Which of the following is an example of a constraint associated with the traditional VAR approach but NOT the stress testing approach? The traditional VAR approach: 71
B)
places too small a probability on extreme events.
Which of the following describes the best way to resolve the differences between the stress testing approach to computing capital requirements and the value at risk (VAR) approach? 72
A) 73
Use both approaches and then use the larger of the two capital requirements.
What is the value at risk (VAR) for the portfolio at the 99% probability level? -$19,800. C) VAR = (portfolio value)[expected Rp - Z(σ)] ($1,000,000)[0.12 - (2.33)(0.06)]
= -$19,800
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What may be the lowest value of portfolio Z within the next one year according to value at risk, at 95% probability given the standard deviation of portfolio Z is 22%? $1,499,000. A) Expected return = (0.25)(12) + (0.25)(14) + (0.25)(5) + (0.25)(14) = 11.25% VAR = 2,000,000[0.1125 − (1.65)(0.22)] = −501,000 2,000,000 − 501,000 = 1,499,000 John Dumas is in charge of $100 million of equity portfolio. He expects a return of 10% with a standard deviation of 8%. What will be the minimum value of portfolio at 95% probability. Z scores from standard normal distribution are: 10% = 1.28 5% = 1.65 2.5% = 1.96 1% = 2.33 Maximum possible loss at 95% probability = 10 − 1.65 × 8 = −3.2 million. Minimum value of portfolio at 95% probability = 100 − 3.2 = 96.80 million.
Gregory Chambers is interested in estimating the daily VAR (with 99% probability) of bank's fixed income portfolio, currently valued at $30 million. The portfolio has the following returns over the past 200 days (ranked from high to low). 1.9%, 1.87%, 1.85%, 1.79%......-1.78%, -1.81%, -1.84%, -1.87%, -1.91% What will be the VAR estimate using the historical method? VAR = (-0.0187)(30,000,000) = -$561,000 therefore the 1% daily value at risk is $561,000. A portfolio manager determines that his portfolio has an expected return of $20,000 and a standard deviation of $45,000. Given a 95% confidence level, what is the portfolio's VAR? $54,250. A) The expected outcome is $20,000. Given the standard deviation of $45,000 and a z-score of 1.65 (95% confidence level for a one-tailed test), the VAR is –54,250 [= 20,000 – 1.65 (45,000)].
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Consider a portfolio that has the following characteristics: An expected return of 12%. $1,000,000 portfolio value. Annual standard deviation equal to 6%. What is the value at risk (VAR) for the portfolio at the 99% probability level? -$19,800. C) VAR = (portfolio value)[expected Rp - Z(σ)] ($1,000,000)[0.12 - (2.33)(0.06)] = -$19,800 The manager of a large, multi-currency portfolio is investigating methods to hedge the portfolio. If she regresses the return of the portfolio on several major currencies, she is most likely trying to solve the problem of:
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B)
illiquid forward and futures markets for some currencies.
Which of the following equations represents the net profit/loss on a hedged position, in domestic currency terms? 80
C)
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( V t S t - V 0 S 0 ) – V 0 (F t - F 0 ) .
A U.S.-based investor has purchased a 15,000,000 peso office building in Mexico. He has hedged his investment by selling forward futures at $0.1098/peso. Two months later, the futures exchange rate has fallen to $0.0921/peso. The investor’s net change in the futures position is: B)
$265,500.
V0 (-Ft + F0) = 15,000,000 pesos × (-$0.0921/peso + $0.1098/peso) = $265,500
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A U.S. investor who holds a £2,000,000 investment wishes to hedge the portfolio against currency risk. The investor should: sell £2,000,000 worth of futures for U.S. dollars C)
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A basic strategy for hedging a portfolio against currency risk, where the investor hedges the foreign currency value of the foreign asset, is called: hedging the principal. A)
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The basic underlying goal of a currency hedge is to minimize a portfolio’s exposure to changes in: exchange rates. B) The manager of a single-currency portfolio is investigating methods to hedge the portfolio. If he regresses the return of the portfolio on the return of the currency, the: slope coefficient of the regression represents the economic risk C) One issue addressed in a minimum-variance hedge over a hedge of the principal strategy is: the covariance of the local return (in the foreign market) and the exchange rate. C) An analyst is exploring methods to hedge the return of a foreign asset in a foreign country as well as hedge the foreign exchange risk of the hedged amount. To implement a minimum-variance hedge over a hedge of the principal strategy a portfolio manager needs to set the hedge ratio for: B)
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In managing the risk of a portfolio denominated in a foreign currency, which of the following is not a reason for using a minimum-variance hedge over a hedge of the principal strategy? A minimum variance hedge: avoids having to perform a regression analysis with its associated statistical error. A) An analyst is managing a portfolio denominated in a foreign currency. In her analysis, she estimates that the hedge ratio of the portfolio is equal to one, and she implements the appropriate hedge. She also forecasts that there will be a negative correlation between the interest rate in her country and the interest rate associated with the foreign currency. This relationship of the interest rates: C)
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translation risk equal to one.
will introduce basis risk to the hedged position.
In the hedging of currency risk, the issue of basis risk is: a concern when using futures contracts and not options. A) An analyst is managing a portfolio denominated in a foreign currency, and he plans to hold the portfolio one year. The analyst computes the hedge ratio of the portfolio to be equal to one, and he plans to implement the appropriate hedge. Which of the following actions will reduce basis risk? A)
Taking a futures position that matures in one year.
An analyst in Europe manages a portfolio denominated in yen. The hedge ratio for the portfolio is equal to one, but the futures exchange rate is greater than the spot exchange rate, where the exchange rate is Euro/yen. If there is an increase in the European interest rate relative to the Japanese interest rate, then according to interest rate parity: 92
A)
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the basis will widen.
A manager plans to the hedge currency risk of a portfolio. The manager will take positions in futures which he plans to close with offsetting contracts at a later date. In choosing among currency futures contracts of various maturities, the manager should recognize that using the strategy of closing contracts with offsetting contracts rather than making delivery is: B)
possible with both short and long-term contracts.
Bill Chapman, CFA, has been hedging the currency of his portfolio using long-term futures contracts. He uses the futures as part of the strategic allocation of the portfolio. If Chapman were to decide to start using short-term contracts for the same purpose then, compared to the long-term contracts, he would find the short-term contracts: 94
B)
more liquid and using them more costly with respect to commissions
A manager wants to hedge the risk of a portfolio that meets a one-time liability in the near future. If the manager wishes to use a hedging instrument that tracks the behavior of the spot exchange rate, then the manager should choose: 95
B)
short-term forward contracts.
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In managing international, multi-currency portfolios, cross-hedging: refers to using the forward contracts on one currency to hedge the currency risk of another currency. C)
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One of the problems in hedging the currency risk of a portfolio that has assets in many currencies is: some of the currencies in which assets are denominated may not have liquid contracts that can provide adequate hedges B)
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Jill Pope, CFA, manages a large multinational portfolio that includes assets denominated in over 20 currencies. Pope is planning to hedge this portfolio for currency risk. Composing: a perfect hedge may not be possible, but she may be able to compose an effective hedge with futures on a few major currencies A) Jill Pope, CFA, is a portfolio manager in the United States that will begin managing a portfolio denominated only in Euros. Her supervisor asks her to hedge the portfolio against currency fluctuations using an instrument that will effectively be an insurance policy against downside risk while offering upside potential. To do this, Pope:
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C) 100
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should buy put options on the $/€ exchange rate
Compared to options on currencies, futures contracts on currencies offer a: more perfect hedge at a lower initial cost A) Phil Johnson, CFA, is a portfolio manager in the United States and manages a portfolio denominated in yen. Johnson has been using forward contracts on the yen to hedge this portfolio, but now he is considering using put options. Johnson: B)
may choose to use put options if he wishes to allow for upside potential on currency changes while hedging downside risk
Phil Johnson, CFA, is a portfolio manager in the United States and has implemented a delta hedge strategy using put contracts on his ₤2,000,000 security portfolio. The delta is -0.667, and Johnson used this value in composing his delta hedge using put contracts. The value of the pound increases from $2.00/₤ to $2.10/₤. If the delta hedge works perfectly, then the change in the value of each put on each British pound will be closest to a/an: 102
decrease of $0.07. A) Delta = Change in option premium / Change in exchange rate So, delta × change in exchange rate = change in option premium -0.667 × $0.10 = -$0.07
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Phil Johnson, CFA, is a portfolio manager in the United States and has been using a delta hedge strategy using $/€ put contracts on his €5,000,000 security portfolio. Johnson estimates the delta of the put contract to be -0.40, and Johnson used this value in composing his delta hedge. The $/€ exchange rate decreases from $1.25/€ to $1.2/€. The price of the put per Euro increases by $0.01. Based on this information, Johnson’s net position would: decline by $125,000. B) Johnson would have purchased -1 / -0.4 = 2.5 put contracts for each Euro. The value of the portfolio would have declined by $250,000 = (1.25 − 1.2)($/€)(€5,000,000). The value of the put contract position will increase by $125,000 = ($0.01)(5,000,000)(2.5). Thus, the net change is a decline of $125,000.
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Jill Pope, CFA, is a portfolio manager in the United States and has been using a delta hedge strategy using $/yen put conracts on her 10,000,000 yen security portfolio. The delta is -0.80. Other things equal, in dollar terms, a 0.100% decrease in the $/yen exchange rate would produce a: B)
0.1% decrease in the security portfolio and a 0.080% increase in each put purchased
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When adding exposure to equities in a foreign market to your portfolio, which of the following strategies would offer the lowest amount of currency risk? In: your domestic derivatives market going long call options on an index on the foreign market. A)
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When adding exposure to equities in a foreign market to your portfolio, which of the following strategies would offer the lowest amount of currency risk? In: your domestic futures market going long index futures on an index on the foreign market. B)
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Jill Pope, CFA, has been managing a stock portfolio denominated in a foreign currency and has set a particular nominal return goal for the portfolio. She wishes to investigate ways to achieve the goal while lowering the currency risk. Which of the following strategies is most appropriate? B)
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In the management of currency exposure, the one approach that would most likely explicitly include a benchmark for returns on currency positions would be associated with: a separate asset allocation approach. C) Rob Johnson, CFA, manages a large portfolio of international assets for a client. He and the client had agreed upon a well-defined IPS, which specified that an outside expert would manage the currency risk as part of the overall portfolio strategy. Recently Johnson and the client changed the IPS so that the expert manages currency positions using a strategy distinct from the security portfolio and distinct benchmarks. The move that Johnson and the client have agreed upon would be best described as moving from: C)
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Increasing the beta of the stock portfolio
an overlay approach to a separate asset allocation approach
Jill Pope, CFA, manages a large portfolio of international assets for a client. She and the client had agreed upon a welldefined IPS, which specified that Pope was responsible for managing currency exposure as one of the risks of the portfolio. Recently Pope and the client changed the IPS so that they now have hired a separate manager, who is an expert in currency risk, and that manager will be responsible for currency risk. The move that Pope and the client have agreed upon would be best described as moving from: B)
a strategic hedge ratio approach to a currency overlay approach
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If the value of a stock portfolio equals 16 times the futures price of the appropriate equity index contract and beta of the equity portfolio and futures price were equal, how many contracts would it take to reduce the beta of the equity index to zero? A short position in 16 contracts C) Number of contracts = -16 = (0 − beta) × (16 × futures price) / (beta × futures price)
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A manager of a $20,000,000 portfolio wants to decrease beta from the current value of 0.9 to 0.5. The beta on the futures contract is 1.1 and the futures price is $105,000. Using futures contracts, what strategy would be appropriate? Short 69 contracts. C) Number of contracts = -69.26 = (0.5 − 0.9) × ($20,000,000) / (1.1 × $105,000), and this rounds down to 69 (absolute value). Since the goal is to decrease beta, the manager should go short which is also indicated by the negative sign.
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A manager of a $10,000,000 portfolio wants to increase beta from the current value of 0.9 to 1.1. The beta on the futures contract is 1.2 and the futures price is $245,000. Using futures contracts, what strategy would be appropriate? Long 7 contracts C)
Number of contracts = 6.80 = (1.1 − 0.9) × ($10,000,000) / (1.2 × $245,000), and this rounds up to seven. Since the goal is to increase beta, the manager should go long.
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Michael Hallen, CFA, manages an equity portfolio with a current market value of $78 million and a beta of 0.95. Convinced the market is poised for a significant upward movement, Hallen would like to increase the beta of the portfolio by 40 percent, using S&P 500 futures currently trading at 856. The multiplier is 250. What is the number of futures contracts, rounded up to the nearest whole number, that will be needed to achieve Hallen’s objective? 139 C) First determine the new target beta by multiplying the current beta of the portfolio which is .95 by 1.4 to achieve a new target beta that is 40% greater than the current portfolio beta: (.95)(1.4) = 1.33 Then use the equation: [(BetaT - Betap)/Betaf][Vp/(Pf x multiplier)] [(1.33-.95)/1](78,000,000)/(856)(250) = (.38)(364.49) = 138.50, rounded to 139.
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An investor has a $100 million stock portfolio with a beta of 1.2. He would like to alter his portfolio beta using S&P 500 futures contracts. The contracts are currently trading at 596.90. The futures contract has a multiple of 250. Which of the following is the CORRECT trade required to double the portfolio beta? Buy 804 contracts. B) The number of futures contracts required to double the portfolio beta is computed as follows: Number of contracts = [(target beta - portfolio beta)/futures beta] x (Portfolio value / Futures contract An investor has an $80 million stock portfolio with a beta of 1.1. He would like to partially hedge his portfolio using S&P 500 futures contracts. The contracts are currently trading at 596.70. The futures contract has a multiple of 250. Which of the following is the CORRECT trade to reduce the portfolio beta by 50 percent? Sell 295 contracts A) The number of futures contracts required for the 100% risk-minimizing hedge (or to reduce the beta to zero) is computed as follows: Number of contracts = Portfolio value / Futures contract value × beta $80 million / (596.70 × $250) × 1.1 = 590 contracts Therefore, to reduce the by 50% we simply use half this number of contracts or 295 contracts.
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Robert Zorn, CFA, manages an equity portfolio with a current market value of $150 million. The beta of the portfolio is 1.23 and Zorn is forecasting a short-term market adjustment that will significantly lower equity values and will occur in the near future. Zorn has decided to use S&P 500 futures, currently trading at 1260, to reduce the portfolio’s systematic risk exposure by 30 percent. The multiplier is 250. What is the number of futures contracts, rounded up to the nearest whole number, that will be needed to achieve Zorn’s objective? Sell 176 A) First determine the new target beta by multiplying the current beta of the portfolio which is 1.23 by .7 to achieve a new target beta that is 30% less than the current portfolio beta: (1.23)(.7) = 0.861 Then use the equation: [(BetaT - Betap)/Betaf][Vp/(Pf x multiplier)] [(0.861-1.23)/1](150,000,000)/(1260)(250) = (-.369)(476.19) = -175.71, rounded to -176 Tom Corser is the manager of the $140,000,000 Intrepid Growth Fund. Corser’s long-term view of the equity market is negative, and as a result, his portfolio is allocated defensively with a beta of 0.85. Despite his negative long-term outlook, Corser thinks the market is temporarily mispriced, and could rise significantly over the next few weeks. Corser has implemented tactical asset allocation measures in his fund sporadically over the years, and thinks now is another time to do so. Because he likes his long-term holdings, he decides to use a futures overlay rather than trading assets to implement his view of the market. Corser decides he wants to increase the beta of his portfolio to 1.25. The appropriate futures contract has a beta of 1.03 and the total futures price is $310,000. What is the appropriate tactical allocation strategy for Corser to accomplish his objective? Buy 175 equity futures contracts B) Number of contracts = Portfolio value / Futures contract value × beta $100 million / (596.70 × $250) × 1.1 = 737 contracts An investor has a cash position currently invested in T-Bills but would like to "equitize" it by using S&P futures contracts. Which of the following trades will create the desired synthetic equity position?
A)
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Buying S&P 500 futures contracts.
A manager has a position in Treasury bills worth $175 million with a yield of 2%. For the next 6 months, the manager wishes to have a synthetic equity position approximately equal to this value. The manager chooses S&P 500 index futures, which has a dividend yield of 3%. The futures price is 1,050 and the multiplier is $250. How many contracts will this take? 673 contracts. C) Number of contracts = 673.3 = $175,000,000 × (1.02) 0.5/(1050 × 250 When using stock index futures contracts and cash to create a synthetic stock index, the larger the index multiplier:
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B) 122
the fewer the number of needed contracts
To synthetically create the risk/return profile of an underlying common equity security: C)
Buy the corresponding futures contract and invest in a T-bill.
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To create a synthetic cash position: buy the common equity and sell short the corresponding futures contract B)
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Which of the following statements about portfolio hedging is least accurate?
C)
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To synthetically create the risk/return profile of an underlying common equity security, buy the corresponding futures contract, sell the common short, and invest in a T-bill.
A portfolio holds $20 million of its assets in an index fund that mimics the return of the Dow Jones Industrial Average (DJIA). The dividend yield on the DJIA index is 2.8%. The manager of the portfolio would like to synthetically convert half of the position to cash for a one month period. The futures contract on the DJIA that expires in a month is priced at 14520.01. It has a multiplier equal to $10. The risk-free rate is 3.85%. The number of contracts the fund needs to use is closest to: 69 B) The negative sign indicates the need to take a short position.
An investment of $240,000,000 in T-bills earning 3 percent is combined with 886 stock index futures that have a price of 1,100 and a multiplier of 250. In three months, when the futures mature and the index value is 1,120, what will be the value of the position at that time? $246,210,097. C) Payoff of futures plus T-bill = 886 × $250 × (1,120 − 1,100) + $240,000,000 × 1.03 0.25 Payoff of futures plus T-bill = $246,210,097 A manager wants to synthetically convert to cash $45 million of a diversified stock portfolio for three months. The manager will use the CME E-mini S&P stock index futures contract, which has a multiplier equal to $50, and the price of the three month contract is 1610.50. The dividend yield on the portfolio is 2.4%. The risk-free rate is 4.04%. The number of contracts the fund needs to use is closest to: 564 B)
The negative sign indicates the need to take a short position.
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A manager wants to synthetically convert to cash $12 million of a diversified stock portfolio for three months. The manager will use the CME E-mini S&P stock index futures contract, which has a multiplier equal to $50, and the price of the three month contract is 1598.80. The dividend yield on the portfolio is 2.8%. The risk-free rate is 3.96%. To accomplish this, the best choice would be to:
take a short position in 152 contracts C) The negative sign indicates the need to take a short position.
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A manager has a 70/30 stock and bond portfolio. To synthetically create a portfolio that is 60 percent stock and 40 percent bonds, the manager should: go long the bond futures and short the stock index futures B)
A manager has a $100 million portfolio that consists of 50% stock and 50% bonds. The beta of the stock position is 1. The modified duration of the bond position is 5. The manager wishes to achieve an effective mix of 60% stock and 40% bonds. The price and beta of the stock index futures contracts are $277,000 and 1.1 respectively. (The futures price includes the effect of the index multiplier.) The price, modified duration, and yield beta of the futures contracts are $98,000, 6, and 1 respectively. What is the appropriate strategy? Short 85 bond futures and go long 33 stock index futures C) number of bond futures = -85.03 = [(0 − 5) / 6]($10,000,000 / $98,000) number of stock futures = 32.82 = [(1 − 0) / 1.1]($10,000,000 / $277,000) An S&P500 index manager knows that he will have $60,000,000 in funds available in three months. He is very bullish on the stock market and would like to hedge the cash inflow using S&P 500 futures contracts. The S&P 500 futures contract stands at 1100.00 and one contract is worth 250 times the index. Which of the following is the most accurate hedge for this portfolio? Buy 218 contracts. B) contracts = (beta)(Portfolio value) ÷ (futures price)(contract multiplier) = (1)(60,000,000) ÷ (1100)(250) @ 218.18 = 218 contracts Redden Capital Management manages an intermediate, high-quality bond portfolio with a value of $12 million dollars. The modified duration of the portfolio is 4.4 years with a yield beta of 1.0. Scott Stuart, the manager of the portfolio is concerned about rising interest rates over the next few months and wants to make a tactical adjustment and cut the duration of the portfolio in half. Stuart asks Amy Swemba, a junior portfolio manager with Redden, to accomplish this task. Swemba is aware that a Treasury bond futures contract exists with a value of $102,000, with a modified duration of 8.2 years. Swemba replies to Stuart’s comments with the following statements:
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Statement 1: The fastest and most cost-effective way to reduce the duration of the portfolio by half would be to sell $6 Statement 2: The portfolio’s duration could also be adjusted by selling 40 of the Treasury bond futures contracts. After listening to Swemba’s statements, Stuart should: disagree with both Statement 1 and Statement 2. B)
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The performance of a synthetically reallocated portfolio, e.g., a synthetic adjustment from stocks to bonds, would not exactly match the target position for all of the following reasons EXCEPT: the risk free rate is not zero. C)
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A manager wishes to make a synthetic adjustment of a mid-cap stock portfolio. The goal is to increase the beta of the portfolio by 0.5. The beta of the futures contract the manager will use is one. If the value of the portfolio is 10 times the futures price, then the futures contract position needed is a: long position in 5 contracts A) number of contracts = 5 = 0.5 × 10 × (futures price) / (1 × futures price).
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An investor has a $100 million stock portfolio with a beta of 1.1. He would like to hedge his portfolio using S&P 500 futures contracts, which are currently trading at 596.70. The futures contract has a multiple of 250. Which of the following is the CORRECT trade required to create a synthetic T-bill? Sell 737 contracts B) A manager of $40 million of mid-cap equities would like to move $5 million of the position to large-cap equities. The beta of the mid-cap position is 1.1, and the average beta of large-cap stocks is 0.9. The betas of the corresponding mid and large-cap futures contracts are 1.1 and 0.95 respectively. The mid and large-cap futures prices are $252,000 and $98,222 respectively. What is the appropriate strategy? Short:
20 mid-cap futures and go long 48 large-cap futures. C) -19.84 = (0 − 1.1) × ($5,000,000) / (1.1 × $252,000) The manager should short 20 of the futures on the mid-cap index. Then the manager should take a long position in the following number of contracts on the large-cap index: 48.23 = (0.9 − 0) × ($5,000,000) / (0.95 × $98,222)
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A manager of $30 million in mid-cap equities would like to move half of the position to an exposure resembling small-cap equities. The beta of the mid-cap position is 1.0, and the average beta of small-cap stocks is 1.6. The betas of the corresponding mid and small-cap futures contracts are 1.05 and 1.5 respectively. The mid and small-cap futures prices are $260,000 and $222,222 respectively. What is the appropriate strategy? Short 55 mid-cap futures and go long 72 small-cap futures. B) In this case, for the first step where we convert the mid-cap position to cash, V=$15 million, and the target beta is 0. The current beta is 1.0, and the futures beta is 1.05: -54.95 = (0 − 1) × ($15,000,000) / (1.05 × $260,000) The manager should short 55 of the futures on the mid-cap index. Then the manager should take a long position in the following number of contracts on the small-cap index: 72.00 = (1.6 − 0) × ($15,000,000) / (1.5 × $222,222)
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The practice of taking long positions in futures contracts to create an exposure that converts a yet-to be received cash position into a synthetic equity or bond position is: called pre-investing. A) A portfolio manager knows that a $10 million inflow of cash will be received in a month. The portfolio under management is 70% invested in stock with an average beta of 0.8 and 30% invested in bonds with a duration of 5. The most appropriate stock index futures contract has a price of $233,450 and a beta of 1.1. The most appropriate bond index futures has a duration of 6 and a price of $99,500. How can the manager pre-invest the $10 million in the appropriate proportions? Take a: long position in 22 of the stock futures and 25 of the bond futures. A) The goal is to create a $7 million equity position with a beta of 0.8 and a $3 million bond position with a duration of 5: number of stock futures = 21.8 = (0.8 − 0) × ($7,000,000) / (1.1 × $233,450) number of bond futures = 25.13 = (5 − 0) × ($3,000,000) / (6 × $99,500)
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A portfolio manager has a net long position in both stocks and bonds and no cash. When pre-investing a future cash inflow, to replicate the existing portfolio, using bond and stock futures, which of the following statements is most accurate? The manager will: go long both stock and bond futures. B) The risk associated with a fall in demand for a firm’s product caused by an appreciation of the home currency of the firm is called: economic exposure. C) Derivatives are most often used to hedge which type of exchange-rate risk? Transaction exposure. B) The exchange-rate risk associated with falling asset values in foreign subsidiaries caused by currency fluctuations is called: translation exposure B) With respect to the practice of using forward contracts to eliminate the exchange-rate risk associated with a receiving a future payment in a foreign currency, which of the following is correct? A firm that expects to receive a foreign-currency payment is: A)
“long” the currency and should short the forward contract on the foreign currency
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A maker of large computers has just received an order for some of its products. The agreed upon price is in British pounds: ₤8 million. The firm will receive the pounds in 60 days. The current exchange rate is $1.32/₤ and the 60-day forward rate is $1.35/₤. If the firm uses the forward contract to hedge the corresponding exchange rate risk, how many dollars will it expect to receive? $10,800,000 A) $10,800,000 = (₤8,000,000) × $1.35/₤ When expecting to make a future payment in a foreign currency, a firm should take a: long forward position in the currency to hedge an appreciation of that currency B)
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An asset manager says he has perfectly hedged an equity portfolio that is denominated in a foreign currency by only using forward currency contracts. We know then that the: asset manager is not telling the truth B)
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If a manager plans to use currency forwards to hedge a long position in foreign equities, then which of the following would represent a strategy that would prevent over-hedging? Short an amount that is less than the current equity position B)
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If a manager shorts a forward currency contract to hedge the expected value of a foreign-equity portfolio in one year. The worst-case scenario is if the portfolio’s return is: less than the expected value and the currency appreciates C)
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When hedging the exchange-rate risk of a foreign currency-denominated equity portfolio, a manager must recognize that the position has: both equity risk and foreign exchange risk. B)
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In order to perfectly hedge an investment in foreign equities, a manager would most likely have to use: both currency forwards and equity futures A)
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When investing in foreign equity assets, the exchange-rate dimension of the investment generally: increases the total risk C)