Deck 13: Liability-Driven and Index-Based Strategies

Question 1

The following information relates to Questions
Serena Soto is a risk management specialist with Liability Protection advisors. trey hudgens,
CFo of Kiest Manufacturing, enlists Soto's help with three projects. The first project is to
defease some of Kiest's existing fixed-rate bonds that are maturing in each of the next three
years. The bonds have no call or put provisions and pay interest annually. exhibit 1 presents
the payment schedule for the bonds.
The second project for Soto is to help hudgens immunize a $20 million portfolio of
liabilities. The liabilities range from 3.00 years to 8.50 years with a Macaulay duration of 5.34
years, cash flow yield of 3.25%, portfolio convexity of 33.05, and basis point value (bPv) of
$10,505. Soto suggested employing a duration-matching strategy using one of the three aaa
rated bond portfolios presented in exhibit 2.
Soto explains to hudgens that the underlying duration-matching strategy is based on the
following three assumptions.
1. yield curve shifts in the future will be parallel.
2. bond types and quality will closely match those of the liabilities.
3. The portfolio will be rebalanced by buying or selling bonds rather than using derivatives.
The third project for Soto is to make a significant direct investment in broadly diversified
global bonds for Kiest's pension plan. Kiest has a young workforce, and thus, the plan has a
long-term investment horizon. hudgens needs Soto's help to select a benchmark index that is
appropriate for Kiest's young workforce and avoids the "bums" problem. Soto discusses three
benchmark candidates, presented in exhibit 3.
With the benchmark selected, hudgens provides guidelines to Soto directing her to (1)
use the most cost-effective method to track the benchmark and (2) provide low tracking error.
after providing hudgens with advice on direct investment, Soto offered him additional
information on alternative indirect investment strategies using (1) bond mutual funds, (2)
exchange-traded funds (etFs), and (3) total return swaps. hudgens expresses interest in using
bond mutual funds rather than the other strategies for the following reasons.
reason 1 total return swaps have much higher transaction costs and initial cash outlay than
bond mutual funds.
reason 2 Unlike bond mutual funds, bond etFs can trade at discounts to their underlying
indexes, and those discounts can persist.
reason 3 bond mutual funds can be traded throughout the day at the net asset value of the
underlying bonds.
based on exhibit 2, relative to Portfolio C, Portfolio b:

A) has higher cash flow reinvestment risk.
B) is a more desirable portfolio for liquidity management.
C) provides less protection from yield curve shifts and twists.

Answer 1

B

Question 2

The following information relates to Questions
Doug Kepler, the newly hired chief financial officer for the City of radford, asks the dep-
uty financial manager, hui ng, to prepare an analysis of the current investment portfolio
and the city's current and future obligations. The city has multiple liabilities of different
amounts and maturities relating to the pension fund, infrastructure repairs, and various
other obligations.
ng observes that the current fixed-income portfolio is structured to match the duration of
each liability. Previously, this structure caused the city to access a line of credit for temporary
mismatches resulting from changes in the term structure of interest rates.
Kepler asks ng for different strategies to manage the interest rate risk of the city's
fixed-income investment portfolio against one-time shifts in the yield curve. ng considers two
different strategies:
Strategy 1: immunization of the single liabilities using zero-coupon bonds held to maturity.
Strategy 2: immunization of the single liabilities using coupon-bearing bonds while
continuously matching duration.
The city also manages a separate, smaller bond portfolio for the radford School District.
During the next five years, the school district has obligations for school expansions and ren-
ovations. The funds needed for those obligations are invested in the bloomberg barclays US
aggregate index. Kepler asks ng which portfolio management strategy would be most efficient
in mimicking this index.
a radford School board member has stated that she prefers a bond portfolio structure
that provides diversification over time, as well as liquidity. in addressing the board member's
inquiry, ng examines a bullet portfolio, a barbell portfolio, and a laddered portfolio.
an upward shift in the yield curve on Strategy 2 will most likely result in the:

A) price effect canceling the coupon reinvestment effect.
B) price effect being greater than the coupon reinvestment effect.
C) coupon reinvestment effect being greater than the price effect.

Answer 2

A

Question 3

The following information relates to Questions
SD&r Capital (SD&r), a global asset management company, specializes in fixed-income
investments. Molly Compton, chief investment officer, is meeting with a prospective client,
Leah Mowery of DePuy Financial Company (DFC).
Mowery informs Compton that DFC's previous fixed income manager focused on the
interest rate sensitivities of assets and liabilities when making asset allocation decisions. Comp-
ton explains that, in contrast, SD&r's investment process first analyzes the size and timing
of client liabilities, then builds an asset portfolio based on the interest rate sensitivity of those
liabilities.
Compton notes that SD&r generally uses actively managed portfolios designed to earn
a return in excess of the benchmark portfolio. For clients interested in passive exposure to
fixed-income instruments, SD&r offers two additional approaches.
approach 1 Seeks to fully replicate the bloomberg barclays US aggregate bond index.
approach 2 Follows a stratified sampling or cell approach to indexing for a subset of the
bonds included in the bloomberg barclays US aggregate bond index. approach
2 may also be customized to reflect client preferences.
to illustrate SD&r's immunization approach for controlling portfolio interest rate risk,
Compton discusses a hypothetical portfolio composed of two non-callable, investment-grade
bonds. The portfolio has a weighted average yield-to-maturity of 9.55%, a weighted average
coupon rate of 10.25%, and a cash flow yield of 9.85%.
Mowery informs Compton that DFC has a single $500 million liability due in nine years,
and she wants SD&r to construct a bond portfolio that earns a rate of return sufficient to pay
off the obligation. Mowery expresses concern about the risks associated with an immunization
strategy for this obligation. in response, Compton makes the following statements about lia-
bility-driven investing:
Statement 1 although the amount and date of SD&r's liability is known with certainty,
measurement errors associated with key parameters relative to interest rate
changes may adversely affect the bond portfolios.
Statement 2 a cash flow matching strategy will mitigate the risk from non-parallel shifts in
the yield curve.
Compton provides the four US dollar-denominated bond portfolios in exhibit 1 for consid-
eration. Compton explains that the portfolios consist of non-callable, investment-grade corporate
and government bonds of various maturities because zero-coupon bonds are unavailable.

The discussion turns to benchmark selection. DFC's previous fixed-income manager used
a custom benchmark with the following characteristics:
Characteristic 1 The benchmark portfolio invests only in investment-grade bonds of US
corporations with a minimum issuance size of $250 million.
Characteristic 2 valuation occurs on a weekly basis, because many of the bonds in the index
are valued weekly.
Characteristic 3 historical prices and portfolio turnover are available for review.
Compton explains that, in order to evaluate the asset allocation process, fixed-income port-
folios should have an appropriate benchmark. Mowery asks for benchmark advice regarding
DFC's portfolio of short-term and intermediate-term bonds, all denominated in US dollars.
Compton presents three possible benchmarks in exhibit 2.

The investment process followed by DFC's previous fixed-income manager is best described as:

A) asset-driven liabilities.
B) liability-driven investing.
C) asset-liability management.

Answer 3

C

Question 4

The following information relates to Questions
SD&r Capital (SD&r), a global asset management company, specializes in fixed-income
investments. Molly Compton, chief investment officer, is meeting with a prospective client,
Leah Mowery of DePuy Financial Company (DFC).
Mowery informs Compton that DFC's previous fixed income manager focused on the
interest rate sensitivities of assets and liabilities when making asset allocation decisions. Comp-
ton explains that, in contrast, SD&r's investment process first analyzes the size and timing
of client liabilities, then builds an asset portfolio based on the interest rate sensitivity of those
liabilities.
Compton notes that SD&r generally uses actively managed portfolios designed to earn
a return in excess of the benchmark portfolio. For clients interested in passive exposure to
fixed-income instruments, SD&r offers two additional approaches.
approach 1 Seeks to fully replicate the bloomberg barclays US aggregate bond index.
approach 2 Follows a stratified sampling or cell approach to indexing for a subset of the
bonds included in the bloomberg barclays US aggregate bond index. approach
2 may also be customized to reflect client preferences.
to illustrate SD&r's immunization approach for controlling portfolio interest rate risk,
Compton discusses a hypothetical portfolio composed of two non-callable, investment-grade
bonds. The portfolio has a weighted average yield-to-maturity of 9.55%, a weighted average
coupon rate of 10.25%, and a cash flow yield of 9.85%.
Mowery informs Compton that DFC has a single $500 million liability due in nine years,
and she wants SD&r to construct a bond portfolio that earns a rate of return sufficient to pay
off the obligation. Mowery expresses concern about the risks associated with an immunization
strategy for this obligation. in response, Compton makes the following statements about lia-
bility-driven investing:
Statement 1 although the amount and date of SD&r's liability is known with certainty,
measurement errors associated with key parameters relative to interest rate
changes may adversely affect the bond portfolios.
Statement 2 a cash flow matching strategy will mitigate the risk from non-parallel shifts in
the yield curve.
Compton provides the four US dollar-denominated bond portfolios in exhibit 1 for consid-
eration. Compton explains that the portfolios consist of non-callable, investment-grade corporate
and government bonds of various maturities because zero-coupon bonds are unavailable.

The discussion turns to benchmark selection. DFC's previous fixed-income manager used
a custom benchmark with the following characteristics:
Characteristic 1 The benchmark portfolio invests only in investment-grade bonds of US
corporations with a minimum issuance size of $250 million.
Characteristic 2 valuation occurs on a weekly basis, because many of the bonds in the index
are valued weekly.
Characteristic 3 historical prices and portfolio turnover are available for review.
Compton explains that, in order to evaluate the asset allocation process, fixed-income port-
folios should have an appropriate benchmark. Mowery asks for benchmark advice regarding
DFC's portfolio of short-term and intermediate-term bonds, all denominated in US dollars.
Compton presents three possible benchmarks in exhibit 2.

based on exhibit 1, which of the portfolios will best immunize SD&r's single liability?

A) Portfolio 1
B) Portfolio 2
C) Portfolio 3

Question 5

The following information relates to Questions
SD&r Capital (SD&r), a global asset management company, specializes in fixed-income
investments. Molly Compton, chief investment officer, is meeting with a prospective client,
Leah Mowery of DePuy Financial Company (DFC).
Mowery informs Compton that DFC's previous fixed income manager focused on the
interest rate sensitivities of assets and liabilities when making asset allocation decisions. Comp-
ton explains that, in contrast, SD&r's investment process first analyzes the size and timing
of client liabilities, then builds an asset portfolio based on the interest rate sensitivity of those
liabilities.
Compton notes that SD&r generally uses actively managed portfolios designed to earn
a return in excess of the benchmark portfolio. For clients interested in passive exposure to
fixed-income instruments, SD&r offers two additional approaches.
approach 1 Seeks to fully replicate the bloomberg barclays US aggregate bond index.
approach 2 Follows a stratified sampling or cell approach to indexing for a subset of the
bonds included in the bloomberg barclays US aggregate bond index. approach
2 may also be customized to reflect client preferences.
to illustrate SD&r's immunization approach for controlling portfolio interest rate risk,
Compton discusses a hypothetical portfolio composed of two non-callable, investment-grade
bonds. The portfolio has a weighted average yield-to-maturity of 9.55%, a weighted average
coupon rate of 10.25%, and a cash flow yield of 9.85%.
Mowery informs Compton that DFC has a single $500 million liability due in nine years,
and she wants SD&r to construct a bond portfolio that earns a rate of return sufficient to pay
off the obligation. Mowery expresses concern about the risks associated with an immunization
strategy for this obligation. in response, Compton makes the following statements about lia-
bility-driven investing:
Statement 1 although the amount and date of SD&r's liability is known with certainty,
measurement errors associated with key parameters relative to interest rate
changes may adversely affect the bond portfolios.
Statement 2 a cash flow matching strategy will mitigate the risk from non-parallel shifts in
the yield curve.
Compton provides the four US dollar-denominated bond portfolios in exhibit 1 for consid-
eration. Compton explains that the portfolios consist of non-callable, investment-grade corporate
and government bonds of various maturities because zero-coupon bonds are unavailable.

The discussion turns to benchmark selection. DFC's previous fixed-income manager used
a custom benchmark with the following characteristics:
Characteristic 1 The benchmark portfolio invests only in investment-grade bonds of US
corporations with a minimum issuance size of $250 million.
Characteristic 2 valuation occurs on a weekly basis, because many of the bonds in the index
are valued weekly.
Characteristic 3 historical prices and portfolio turnover are available for review.
Compton explains that, in order to evaluate the asset allocation process, fixed-income port-
folios should have an appropriate benchmark. Mowery asks for benchmark advice regarding
DFC's portfolio of short-term and intermediate-term bonds, all denominated in US dollars.
Compton presents three possible benchmarks in exhibit 2.

relative to approach 1 of gaining passive exposure, an advantage of approach 2 is that it:

A) minimizes tracking error.
B) requires less risk analysis.
C) is more appropriate for socially responsible investors.

Question 6

The following information relates to Questions
Serena Soto is a risk management specialist with Liability Protection advisors. trey hudgens,
CFo of Kiest Manufacturing, enlists Soto's help with three projects. The first project is to
defease some of Kiest's existing fixed-rate bonds that are maturing in each of the next three
years. The bonds have no call or put provisions and pay interest annually. exhibit 1 presents
the payment schedule for the bonds.
The second project for Soto is to help hudgens immunize a $20 million portfolio of
liabilities. The liabilities range from 3.00 years to 8.50 years with a Macaulay duration of 5.34
years, cash flow yield of 3.25%, portfolio convexity of 33.05, and basis point value (bPv) of
$10,505. Soto suggested employing a duration-matching strategy using one of the three aaa
rated bond portfolios presented in exhibit 2.
Soto explains to hudgens that the underlying duration-matching strategy is based on the
following three assumptions.
1. yield curve shifts in the future will be parallel.
2. bond types and quality will closely match those of the liabilities.
3. The portfolio will be rebalanced by buying or selling bonds rather than using derivatives.
The third project for Soto is to make a significant direct investment in broadly diversified
global bonds for Kiest's pension plan. Kiest has a young workforce, and thus, the plan has a
long-term investment horizon. hudgens needs Soto's help to select a benchmark index that is
appropriate for Kiest's young workforce and avoids the "bums" problem. Soto discusses three
benchmark candidates, presented in exhibit 3.
With the benchmark selected, hudgens provides guidelines to Soto directing her to (1)
use the most cost-effective method to track the benchmark and (2) provide low tracking error.
after providing hudgens with advice on direct investment, Soto offered him additional
information on alternative indirect investment strategies using (1) bond mutual funds, (2)
exchange-traded funds (etFs), and (3) total return swaps. hudgens expresses interest in using
bond mutual funds rather than the other strategies for the following reasons.
reason 1 total return swaps have much higher transaction costs and initial cash outlay than
bond mutual funds.
reason 2 Unlike bond mutual funds, bond etFs can trade at discounts to their underlying
indexes, and those discounts can persist.
reason 3 bond mutual funds can be traded throughout the day at the net asset value of the
underlying bonds.
Soto's three assumptions regarding the duration-matching strategy indicate the presence of:

A) model risk.
B) spread risk.
C) counterparty credit risk.

Question 7

The following information relates to Questions
Serena Soto is a risk management specialist with Liability Protection advisors. trey hudgens,
CFo of Kiest Manufacturing, enlists Soto's help with three projects. The first project is to
defease some of Kiest's existing fixed-rate bonds that are maturing in each of the next three
years. The bonds have no call or put provisions and pay interest annually. exhibit 1 presents
the payment schedule for the bonds.
The second project for Soto is to help hudgens immunize a $20 million portfolio of
liabilities. The liabilities range from 3.00 years to 8.50 years with a Macaulay duration of 5.34
years, cash flow yield of 3.25%, portfolio convexity of 33.05, and basis point value (bPv) of
$10,505. Soto suggested employing a duration-matching strategy using one of the three aaa
rated bond portfolios presented in exhibit 2.
Soto explains to hudgens that the underlying duration-matching strategy is based on the
following three assumptions.
1. yield curve shifts in the future will be parallel.
2. bond types and quality will closely match those of the liabilities.
3. The portfolio will be rebalanced by buying or selling bonds rather than using derivatives.
The third project for Soto is to make a significant direct investment in broadly diversified
global bonds for Kiest's pension plan. Kiest has a young workforce, and thus, the plan has a
long-term investment horizon. hudgens needs Soto's help to select a benchmark index that is
appropriate for Kiest's young workforce and avoids the "bums" problem. Soto discusses three
benchmark candidates, presented in exhibit 3.
With the benchmark selected, hudgens provides guidelines to Soto directing her to (1)
use the most cost-effective method to track the benchmark and (2) provide low tracking error.
after providing hudgens with advice on direct investment, Soto offered him additional
information on alternative indirect investment strategies using (1) bond mutual funds, (2)
exchange-traded funds (etFs), and (3) total return swaps. hudgens expresses interest in using
bond mutual funds rather than the other strategies for the following reasons.
reason 1 total return swaps have much higher transaction costs and initial cash outlay than
bond mutual funds.
reason 2 Unlike bond mutual funds, bond etFs can trade at discounts to their underlying
indexes, and those discounts can persist.
reason 3 bond mutual funds can be traded throughout the day at the net asset value of the
underlying bonds.
to meet both of hudgens's guidelines for the pension's bond fund investment, Soto should recommend:

A) full replication.
B) stratified sampling.
C) active management.

Question 8

The following information relates to Questions
Doug Kepler, the newly hired chief financial officer for the City of radford, asks the dep-
uty financial manager, hui ng, to prepare an analysis of the current investment portfolio
and the city's current and future obligations. The city has multiple liabilities of different
amounts and maturities relating to the pension fund, infrastructure repairs, and various
other obligations.
ng observes that the current fixed-income portfolio is structured to match the duration of
each liability. Previously, this structure caused the city to access a line of credit for temporary
mismatches resulting from changes in the term structure of interest rates.
Kepler asks ng for different strategies to manage the interest rate risk of the city's
fixed-income investment portfolio against one-time shifts in the yield curve. ng considers two
different strategies:
Strategy 1: immunization of the single liabilities using zero-coupon bonds held to maturity.
Strategy 2: immunization of the single liabilities using coupon-bearing bonds while
continuously matching duration.
The city also manages a separate, smaller bond portfolio for the radford School District.
During the next five years, the school district has obligations for school expansions and ren-
ovations. The funds needed for those obligations are invested in the bloomberg barclays US
aggregate index. Kepler asks ng which portfolio management strategy would be most efficient
in mimicking this index.
a radford School board member has stated that she prefers a bond portfolio structure
that provides diversification over time, as well as liquidity. in addressing the board member's
inquiry, ng examines a bullet portfolio, a barbell portfolio, and a laddered portfolio.
Which duration measure should be matched when implementing Strategy 2?

A) Key rate
B) Modified
C) Macaulay

Question 9

The following information relates to Questions
Serena Soto is a risk management specialist with Liability Protection advisors. trey hudgens,
CFo of Kiest Manufacturing, enlists Soto's help with three projects. The first project is to
defease some of Kiest's existing fixed-rate bonds that are maturing in each of the next three
years. The bonds have no call or put provisions and pay interest annually. exhibit 1 presents
the payment schedule for the bonds.
The second project for Soto is to help hudgens immunize a $20 million portfolio of
liabilities. The liabilities range from 3.00 years to 8.50 years with a Macaulay duration of 5.34
years, cash flow yield of 3.25%, portfolio convexity of 33.05, and basis point value (bPv) of
$10,505. Soto suggested employing a duration-matching strategy using one of the three aaa
rated bond portfolios presented in exhibit 2.
Soto explains to hudgens that the underlying duration-matching strategy is based on the
following three assumptions.
1. yield curve shifts in the future will be parallel.
2. bond types and quality will closely match those of the liabilities.
3. The portfolio will be rebalanced by buying or selling bonds rather than using derivatives.
The third project for Soto is to make a significant direct investment in broadly diversified
global bonds for Kiest's pension plan. Kiest has a young workforce, and thus, the plan has a
long-term investment horizon. hudgens needs Soto's help to select a benchmark index that is
appropriate for Kiest's young workforce and avoids the "bums" problem. Soto discusses three
benchmark candidates, presented in exhibit 3.
With the benchmark selected, hudgens provides guidelines to Soto directing her to (1)
use the most cost-effective method to track the benchmark and (2) provide low tracking error.
after providing hudgens with advice on direct investment, Soto offered him additional
information on alternative indirect investment strategies using (1) bond mutual funds, (2)
exchange-traded funds (etFs), and (3) total return swaps. hudgens expresses interest in using
bond mutual funds rather than the other strategies for the following reasons.
reason 1 total return swaps have much higher transaction costs and initial cash outlay than
bond mutual funds.
reason 2 Unlike bond mutual funds, bond etFs can trade at discounts to their underlying
indexes, and those discounts can persist.
reason 3 bond mutual funds can be traded throughout the day at the net asset value of the
underlying bonds.
Which portfolio in exhibit 2 fails to meet the requirements to achieve immunization for multiple liabilities?

A) Portfolio a
B) Portfolio b
C) Portfolio C

Question 10

The following information relates to Questions
Doug Kepler, the newly hired chief financial officer for the City of radford, asks the dep-
uty financial manager, hui ng, to prepare an analysis of the current investment portfolio
and the city's current and future obligations. The city has multiple liabilities of different
amounts and maturities relating to the pension fund, infrastructure repairs, and various
other obligations.
ng observes that the current fixed-income portfolio is structured to match the duration of
each liability. Previously, this structure caused the city to access a line of credit for temporary
mismatches resulting from changes in the term structure of interest rates.
Kepler asks ng for different strategies to manage the interest rate risk of the city's
fixed-income investment portfolio against one-time shifts in the yield curve. ng considers two
different strategies:
Strategy 1: immunization of the single liabilities using zero-coupon bonds held to maturity.
Strategy 2: immunization of the single liabilities using coupon-bearing bonds while
continuously matching duration.
The city also manages a separate, smaller bond portfolio for the radford School District.
During the next five years, the school district has obligations for school expansions and ren-
ovations. The funds needed for those obligations are invested in the bloomberg barclays US
aggregate index. Kepler asks ng which portfolio management strategy would be most efficient
in mimicking this index.
a radford School board member has stated that she prefers a bond portfolio structure
that provides diversification over time, as well as liquidity. in addressing the board member's
inquiry, ng examines a bullet portfolio, a barbell portfolio, and a laddered portfolio.
a disadvantage of Strategy 1 is that:

A) price risk still exists.
B) interest rate volatility introduces risk to effective matching.
C) there may not be enough bonds available to match all liabilities.

Question 11

The following information relates to Questions
SD&r Capital (SD&r), a global asset management company, specializes in fixed-income
investments. Molly Compton, chief investment officer, is meeting with a prospective client,
Leah Mowery of DePuy Financial Company (DFC).
Mowery informs Compton that DFC's previous fixed income manager focused on the
interest rate sensitivities of assets and liabilities when making asset allocation decisions. Comp-
ton explains that, in contrast, SD&r's investment process first analyzes the size and timing
of client liabilities, then builds an asset portfolio based on the interest rate sensitivity of those
liabilities.
Compton notes that SD&r generally uses actively managed portfolios designed to earn
a return in excess of the benchmark portfolio. For clients interested in passive exposure to
fixed-income instruments, SD&r offers two additional approaches.
approach 1 Seeks to fully replicate the bloomberg barclays US aggregate bond index.
approach 2 Follows a stratified sampling or cell approach to indexing for a subset of the
bonds included in the bloomberg barclays US aggregate bond index. approach
2 may also be customized to reflect client preferences.
to illustrate SD&r's immunization approach for controlling portfolio interest rate risk,
Compton discusses a hypothetical portfolio composed of two non-callable, investment-grade
bonds. The portfolio has a weighted average yield-to-maturity of 9.55%, a weighted average
coupon rate of 10.25%, and a cash flow yield of 9.85%.
Mowery informs Compton that DFC has a single $500 million liability due in nine years,
and she wants SD&r to construct a bond portfolio that earns a rate of return sufficient to pay
off the obligation. Mowery expresses concern about the risks associated with an immunization
strategy for this obligation. in response, Compton makes the following statements about lia-
bility-driven investing:
Statement 1 although the amount and date of SD&r's liability is known with certainty,
measurement errors associated with key parameters relative to interest rate
changes may adversely affect the bond portfolios.
Statement 2 a cash flow matching strategy will mitigate the risk from non-parallel shifts in
the yield curve.
Compton provides the four US dollar-denominated bond portfolios in exhibit 1 for consid-
eration. Compton explains that the portfolios consist of non-callable, investment-grade corporate
and government bonds of various maturities because zero-coupon bonds are unavailable.

The discussion turns to benchmark selection. DFC's previous fixed-income manager used
a custom benchmark with the following characteristics:
Characteristic 1 The benchmark portfolio invests only in investment-grade bonds of US
corporations with a minimum issuance size of $250 million.
Characteristic 2 valuation occurs on a weekly basis, because many of the bonds in the index
are valued weekly.
Characteristic 3 historical prices and portfolio turnover are available for review.
Compton explains that, in order to evaluate the asset allocation process, fixed-income port-
folios should have an appropriate benchmark. Mowery asks for benchmark advice regarding
DFC's portfolio of short-term and intermediate-term bonds, all denominated in US dollars.
Compton presents three possible benchmarks in exhibit 2.

The two-bond hypothetical portfolio's immunization goal is to lock in a rate of return equal to:

A) 9.55%.
B) 9.85%.
C) 10.25%.

Question 12

The following information relates to Questions
SD&r Capital (SD&r), a global asset management company, specializes in fixed-income
investments. Molly Compton, chief investment officer, is meeting with a prospective client,
Leah Mowery of DePuy Financial Company (DFC).
Mowery informs Compton that DFC's previous fixed income manager focused on the
interest rate sensitivities of assets and liabilities when making asset allocation decisions. Comp-
ton explains that, in contrast, SD&r's investment process first analyzes the size and timing
of client liabilities, then builds an asset portfolio based on the interest rate sensitivity of those
liabilities.
Compton notes that SD&r generally uses actively managed portfolios designed to earn
a return in excess of the benchmark portfolio. For clients interested in passive exposure to
fixed-income instruments, SD&r offers two additional approaches.
approach 1 Seeks to fully replicate the bloomberg barclays US aggregate bond index.
approach 2 Follows a stratified sampling or cell approach to indexing for a subset of the
bonds included in the bloomberg barclays US aggregate bond index. approach
2 may also be customized to reflect client preferences.
to illustrate SD&r's immunization approach for controlling portfolio interest rate risk,
Compton discusses a hypothetical portfolio composed of two non-callable, investment-grade
bonds. The portfolio has a weighted average yield-to-maturity of 9.55%, a weighted average
coupon rate of 10.25%, and a cash flow yield of 9.85%.
Mowery informs Compton that DFC has a single $500 million liability due in nine years,
and she wants SD&r to construct a bond portfolio that earns a rate of return sufficient to pay
off the obligation. Mowery expresses concern about the risks associated with an immunization
strategy for this obligation. in response, Compton makes the following statements about lia-
bility-driven investing:
Statement 1 although the amount and date of SD&r's liability is known with certainty,
measurement errors associated with key parameters relative to interest rate
changes may adversely affect the bond portfolios.
Statement 2 a cash flow matching strategy will mitigate the risk from non-parallel shifts in
the yield curve.
Compton provides the four US dollar-denominated bond portfolios in exhibit 1 for consid-
eration. Compton explains that the portfolios consist of non-callable, investment-grade corporate
and government bonds of various maturities because zero-coupon bonds are unavailable.

The discussion turns to benchmark selection. DFC's previous fixed-income manager used
a custom benchmark with the following characteristics:
Characteristic 1 The benchmark portfolio invests only in investment-grade bonds of US
corporations with a minimum issuance size of $250 million.
Characteristic 2 valuation occurs on a weekly basis, because many of the bonds in the index
are valued weekly.
Characteristic 3 historical prices and portfolio turnover are available for review.
Compton explains that, in order to evaluate the asset allocation process, fixed-income port-
folios should have an appropriate benchmark. Mowery asks for benchmark advice regarding
DFC's portfolio of short-term and intermediate-term bonds, all denominated in US dollars.
Compton presents three possible benchmarks in exhibit 2.

Which of the custom benchmark's characteristics violates the requirements for an appro- priate benchmark portfolio?

A) Characteristic 1
B) Characteristic 2
C) Characteristic 3

Question 13

The following information relates to Questions
SD&r Capital (SD&r), a global asset management company, specializes in fixed-income
investments. Molly Compton, chief investment officer, is meeting with a prospective client,
Leah Mowery of DePuy Financial Company (DFC).
Mowery informs Compton that DFC's previous fixed income manager focused on the
interest rate sensitivities of assets and liabilities when making asset allocation decisions. Comp-
ton explains that, in contrast, SD&r's investment process first analyzes the size and timing
of client liabilities, then builds an asset portfolio based on the interest rate sensitivity of those
liabilities.
Compton notes that SD&r generally uses actively managed portfolios designed to earn
a return in excess of the benchmark portfolio. For clients interested in passive exposure to
fixed-income instruments, SD&r offers two additional approaches.
approach 1 Seeks to fully replicate the bloomberg barclays US aggregate bond index.
approach 2 Follows a stratified sampling or cell approach to indexing for a subset of the
bonds included in the bloomberg barclays US aggregate bond index. approach
2 may also be customized to reflect client preferences.
to illustrate SD&r's immunization approach for controlling portfolio interest rate risk,
Compton discusses a hypothetical portfolio composed of two non-callable, investment-grade
bonds. The portfolio has a weighted average yield-to-maturity of 9.55%, a weighted average
coupon rate of 10.25%, and a cash flow yield of 9.85%.
Mowery informs Compton that DFC has a single $500 million liability due in nine years,
and she wants SD&r to construct a bond portfolio that earns a rate of return sufficient to pay
off the obligation. Mowery expresses concern about the risks associated with an immunization
strategy for this obligation. in response, Compton makes the following statements about lia-
bility-driven investing:
Statement 1 although the amount and date of SD&r's liability is known with certainty,
measurement errors associated with key parameters relative to interest rate
changes may adversely affect the bond portfolios.
Statement 2 a cash flow matching strategy will mitigate the risk from non-parallel shifts in
the yield curve.
Compton provides the four US dollar-denominated bond portfolios in exhibit 1 for consid-
eration. Compton explains that the portfolios consist of non-callable, investment-grade corporate
and government bonds of various maturities because zero-coupon bonds are unavailable.

The discussion turns to benchmark selection. DFC's previous fixed-income manager used
a custom benchmark with the following characteristics:
Characteristic 1 The benchmark portfolio invests only in investment-grade bonds of US
corporations with a minimum issuance size of $250 million.
Characteristic 2 valuation occurs on a weekly basis, because many of the bonds in the index
are valued weekly.
Characteristic 3 historical prices and portfolio turnover are available for review.
Compton explains that, in order to evaluate the asset allocation process, fixed-income port-
folios should have an appropriate benchmark. Mowery asks for benchmark advice regarding
DFC's portfolio of short-term and intermediate-term bonds, all denominated in US dollars.
Compton presents three possible benchmarks in exhibit 2.

based on DFC's bond holdings and exhibit 2, Compton should recommend:

A) benchmark 1.
B) benchmark 2.
C) benchmark 3.

Question 14

The following information relates to Questions
Serena Soto is a risk management specialist with Liability Protection advisors. trey hudgens,
CFo of Kiest Manufacturing, enlists Soto's help with three projects. The first project is to
defease some of Kiest's existing fixed-rate bonds that are maturing in each of the next three
years. The bonds have no call or put provisions and pay interest annually. exhibit 1 presents
the payment schedule for the bonds.
The second project for Soto is to help hudgens immunize a $20 million portfolio of
liabilities. The liabilities range from 3.00 years to 8.50 years with a Macaulay duration of 5.34
years, cash flow yield of 3.25%, portfolio convexity of 33.05, and basis point value (bPv) of
$10,505. Soto suggested employing a duration-matching strategy using one of the three aaa
rated bond portfolios presented in exhibit 2.
Soto explains to hudgens that the underlying duration-matching strategy is based on the
following three assumptions.
1. yield curve shifts in the future will be parallel.
2. bond types and quality will closely match those of the liabilities.
3. The portfolio will be rebalanced by buying or selling bonds rather than using derivatives.
The third project for Soto is to make a significant direct investment in broadly diversified
global bonds for Kiest's pension plan. Kiest has a young workforce, and thus, the plan has a
long-term investment horizon. hudgens needs Soto's help to select a benchmark index that is
appropriate for Kiest's young workforce and avoids the "bums" problem. Soto discusses three
benchmark candidates, presented in exhibit 3.
With the benchmark selected, hudgens provides guidelines to Soto directing her to (1)
use the most cost-effective method to track the benchmark and (2) provide low tracking error.
after providing hudgens with advice on direct investment, Soto offered him additional
information on alternative indirect investment strategies using (1) bond mutual funds, (2)
exchange-traded funds (etFs), and (3) total return swaps. hudgens expresses interest in using
bond mutual funds rather than the other strategies for the following reasons.
reason 1 total return swaps have much higher transaction costs and initial cash outlay than
bond mutual funds.
reason 2 Unlike bond mutual funds, bond etFs can trade at discounts to their underlying
indexes, and those discounts can persist.
reason 3 bond mutual funds can be traded throughout the day at the net asset value of the
underlying bonds.
Which of hudgens's reasons for choosing bond mutual funds as an investment vehicle is correct?

A) reason 1
B) reason 2
C) reason 3

Question 15

The following information relates to Questions
Serena Soto is a risk management specialist with Liability Protection advisors. trey hudgens,
CFo of Kiest Manufacturing, enlists Soto's help with three projects. The first project is to
defease some of Kiest's existing fixed-rate bonds that are maturing in each of the next three
years. The bonds have no call or put provisions and pay interest annually. exhibit 1 presents
the payment schedule for the bonds.
The second project for Soto is to help hudgens immunize a $20 million portfolio of
liabilities. The liabilities range from 3.00 years to 8.50 years with a Macaulay duration of 5.34
years, cash flow yield of 3.25%, portfolio convexity of 33.05, and basis point value (bPv) of
$10,505. Soto suggested employing a duration-matching strategy using one of the three aaa
rated bond portfolios presented in exhibit 2.
Soto explains to hudgens that the underlying duration-matching strategy is based on the
following three assumptions.
1. yield curve shifts in the future will be parallel.
2. bond types and quality will closely match those of the liabilities.
3. The portfolio will be rebalanced by buying or selling bonds rather than using derivatives.
The third project for Soto is to make a significant direct investment in broadly diversified
global bonds for Kiest's pension plan. Kiest has a young workforce, and thus, the plan has a
long-term investment horizon. hudgens needs Soto's help to select a benchmark index that is
appropriate for Kiest's young workforce and avoids the "bums" problem. Soto discusses three
benchmark candidates, presented in exhibit 3.
With the benchmark selected, hudgens provides guidelines to Soto directing her to (1)
use the most cost-effective method to track the benchmark and (2) provide low tracking error.
after providing hudgens with advice on direct investment, Soto offered him additional
information on alternative indirect investment strategies using (1) bond mutual funds, (2)
exchange-traded funds (etFs), and (3) total return swaps. hudgens expresses interest in using
bond mutual funds rather than the other strategies for the following reasons.
reason 1 total return swaps have much higher transaction costs and initial cash outlay than
bond mutual funds.
reason 2 Unlike bond mutual funds, bond etFs can trade at discounts to their underlying
indexes, and those discounts can persist.
reason 3 bond mutual funds can be traded throughout the day at the net asset value of the
underlying bonds.
based on exhibit 2, the portfolio with the greatest structural risk is:

A) Portfolio a. b. Portfolio b.
C) Portfolio C.

Question 16

The following information relates to Questions
Serena Soto is a risk management specialist with Liability Protection advisors. trey hudgens,
CFo of Kiest Manufacturing, enlists Soto's help with three projects. The first project is to
defease some of Kiest's existing fixed-rate bonds that are maturing in each of the next three
years. The bonds have no call or put provisions and pay interest annually. exhibit 1 presents
the payment schedule for the bonds.
The second project for Soto is to help hudgens immunize a $20 million portfolio of
liabilities. The liabilities range from 3.00 years to 8.50 years with a Macaulay duration of 5.34
years, cash flow yield of 3.25%, portfolio convexity of 33.05, and basis point value (bPv) of
$10,505. Soto suggested employing a duration-matching strategy using one of the three aaa
rated bond portfolios presented in exhibit 2.
Soto explains to hudgens that the underlying duration-matching strategy is based on the
following three assumptions.
1. yield curve shifts in the future will be parallel.
2. bond types and quality will closely match those of the liabilities.
3. The portfolio will be rebalanced by buying or selling bonds rather than using derivatives.
The third project for Soto is to make a significant direct investment in broadly diversified
global bonds for Kiest's pension plan. Kiest has a young workforce, and thus, the plan has a
long-term investment horizon. hudgens needs Soto's help to select a benchmark index that is
appropriate for Kiest's young workforce and avoids the "bums" problem. Soto discusses three
benchmark candidates, presented in exhibit 3.
With the benchmark selected, hudgens provides guidelines to Soto directing her to (1)
use the most cost-effective method to track the benchmark and (2) provide low tracking error.
after providing hudgens with advice on direct investment, Soto offered him additional
information on alternative indirect investment strategies using (1) bond mutual funds, (2)
exchange-traded funds (etFs), and (3) total return swaps. hudgens expresses interest in using
bond mutual funds rather than the other strategies for the following reasons.
reason 1 total return swaps have much higher transaction costs and initial cash outlay than
bond mutual funds.
reason 2 Unlike bond mutual funds, bond etFs can trade at discounts to their underlying
indexes, and those discounts can persist.
reason 3 bond mutual funds can be traded throughout the day at the net asset value of the
underlying bonds.
based on exhibit 1, Kiest's liabilities would be classified as:

Question 17

The following information relates to Questions
Serena Soto is a risk management specialist with Liability Protection advisors. trey hudgens,
CFo of Kiest Manufacturing, enlists Soto's help with three projects. The first project is to
defease some of Kiest's existing fixed-rate bonds that are maturing in each of the next three
years. The bonds have no call or put provisions and pay interest annually. exhibit 1 presents
the payment schedule for the bonds.
The second project for Soto is to help hudgens immunize a $20 million portfolio of
liabilities. The liabilities range from 3.00 years to 8.50 years with a Macaulay duration of 5.34
years, cash flow yield of 3.25%, portfolio convexity of 33.05, and basis point value (bPv) of
$10,505. Soto suggested employing a duration-matching strategy using one of the three aaa
rated bond portfolios presented in exhibit 2.
Soto explains to hudgens that the underlying duration-matching strategy is based on the
following three assumptions.
1. yield curve shifts in the future will be parallel.
2. bond types and quality will closely match those of the liabilities.
3. The portfolio will be rebalanced by buying or selling bonds rather than using derivatives.
The third project for Soto is to make a significant direct investment in broadly diversified
global bonds for Kiest's pension plan. Kiest has a young workforce, and thus, the plan has a
long-term investment horizon. hudgens needs Soto's help to select a benchmark index that is
appropriate for Kiest's young workforce and avoids the "bums" problem. Soto discusses three
benchmark candidates, presented in exhibit 3.
With the benchmark selected, hudgens provides guidelines to Soto directing her to (1)
use the most cost-effective method to track the benchmark and (2) provide low tracking error.
after providing hudgens with advice on direct investment, Soto offered him additional
information on alternative indirect investment strategies using (1) bond mutual funds, (2)
exchange-traded funds (etFs), and (3) total return swaps. hudgens expresses interest in using
bond mutual funds rather than the other strategies for the following reasons.
reason 1 total return swaps have much higher transaction costs and initial cash outlay than
bond mutual funds.
reason 2 Unlike bond mutual funds, bond etFs can trade at discounts to their underlying
indexes, and those discounts can persist.
reason 3 bond mutual funds can be traded throughout the day at the net asset value of the
underlying bonds.
The global bond benchmark in exhibit 3 that is most appropriate for Kiest to use is the:

A) global aggregate index.
B) global high yield index.
C) global aggregate gDP Weighted index.

Question 18

The following information relates to Questions
SD&r Capital (SD&r), a global asset management company, specializes in fixed-income
investments. Molly Compton, chief investment officer, is meeting with a prospective client,
Leah Mowery of DePuy Financial Company (DFC).
Mowery informs Compton that DFC's previous fixed income manager focused on the
interest rate sensitivities of assets and liabilities when making asset allocation decisions. Comp-
ton explains that, in contrast, SD&r's investment process first analyzes the size and timing
of client liabilities, then builds an asset portfolio based on the interest rate sensitivity of those
liabilities.
Compton notes that SD&r generally uses actively managed portfolios designed to earn
a return in excess of the benchmark portfolio. For clients interested in passive exposure to
fixed-income instruments, SD&r offers two additional approaches.
approach 1 Seeks to fully replicate the bloomberg barclays US aggregate bond index.
approach 2 Follows a stratified sampling or cell approach to indexing for a subset of the
bonds included in the bloomberg barclays US aggregate bond index. approach
2 may also be customized to reflect client preferences.
to illustrate SD&r's immunization approach for controlling portfolio interest rate risk,
Compton discusses a hypothetical portfolio composed of two non-callable, investment-grade
bonds. The portfolio has a weighted average yield-to-maturity of 9.55%, a weighted average
coupon rate of 10.25%, and a cash flow yield of 9.85%.
Mowery informs Compton that DFC has a single $500 million liability due in nine years,
and she wants SD&r to construct a bond portfolio that earns a rate of return sufficient to pay
off the obligation. Mowery expresses concern about the risks associated with an immunization
strategy for this obligation. in response, Compton makes the following statements about lia-
bility-driven investing:
Statement 1 although the amount and date of SD&r's liability is known with certainty,
measurement errors associated with key parameters relative to interest rate
changes may adversely affect the bond portfolios.
Statement 2 a cash flow matching strategy will mitigate the risk from non-parallel shifts in
the yield curve.
Compton provides the four US dollar-denominated bond portfolios in exhibit 1 for consid-
eration. Compton explains that the portfolios consist of non-callable, investment-grade corporate
and government bonds of various maturities because zero-coupon bonds are unavailable.

The discussion turns to benchmark selection. DFC's previous fixed-income manager used
a custom benchmark with the following characteristics:
Characteristic 1 The benchmark portfolio invests only in investment-grade bonds of US
corporations with a minimum issuance size of $250 million.
Characteristic 2 valuation occurs on a weekly basis, because many of the bonds in the index
are valued weekly.
Characteristic 3 historical prices and portfolio turnover are available for review.
Compton explains that, in order to evaluate the asset allocation process, fixed-income port-
folios should have an appropriate benchmark. Mowery asks for benchmark advice regarding
DFC's portfolio of short-term and intermediate-term bonds, all denominated in US dollars.
Compton presents three possible benchmarks in exhibit 2.

relative to approach 2 of gaining passive exposure, an advantage of approach 1 is that it:

A) reduces the need for frequent rebalancing.
B) limits the need to purchase bonds that are thinly traded.
C) provides a higher degree of portfolio risk diversification.

Question 19

The following information relates to Questions
SD&r Capital (SD&r), a global asset management company, specializes in fixed-income
investments. Molly Compton, chief investment officer, is meeting with a prospective client,
Leah Mowery of DePuy Financial Company (DFC).
Mowery informs Compton that DFC's previous fixed income manager focused on the
interest rate sensitivities of assets and liabilities when making asset allocation decisions. Comp-
ton explains that, in contrast, SD&r's investment process first analyzes the size and timing
of client liabilities, then builds an asset portfolio based on the interest rate sensitivity of those
liabilities.
Compton notes that SD&r generally uses actively managed portfolios designed to earn
a return in excess of the benchmark portfolio. For clients interested in passive exposure to
fixed-income instruments, SD&r offers two additional approaches.
approach 1 Seeks to fully replicate the bloomberg barclays US aggregate bond index.
approach 2 Follows a stratified sampling or cell approach to indexing for a subset of the
bonds included in the bloomberg barclays US aggregate bond index. approach
2 may also be customized to reflect client preferences.
to illustrate SD&r's immunization approach for controlling portfolio interest rate risk,
Compton discusses a hypothetical portfolio composed of two non-callable, investment-grade
bonds. The portfolio has a weighted average yield-to-maturity of 9.55%, a weighted average
coupon rate of 10.25%, and a cash flow yield of 9.85%.
Mowery informs Compton that DFC has a single $500 million liability due in nine years,
and she wants SD&r to construct a bond portfolio that earns a rate of return sufficient to pay
off the obligation. Mowery expresses concern about the risks associated with an immunization
strategy for this obligation. in response, Compton makes the following statements about lia-
bility-driven investing:
Statement 1 although the amount and date of SD&r's liability is known with certainty,
measurement errors associated with key parameters relative to interest rate
changes may adversely affect the bond portfolios.
Statement 2 a cash flow matching strategy will mitigate the risk from non-parallel shifts in
the yield curve.
Compton provides the four US dollar-denominated bond portfolios in exhibit 1 for consid-
eration. Compton explains that the portfolios consist of non-callable, investment-grade corporate
and government bonds of various maturities because zero-coupon bonds are unavailable.

The discussion turns to benchmark selection. DFC's previous fixed-income manager used
a custom benchmark with the following characteristics:
Characteristic 1 The benchmark portfolio invests only in investment-grade bonds of US
corporations with a minimum issuance size of $250 million.
Characteristic 2 valuation occurs on a weekly basis, because many of the bonds in the index
are valued weekly.
Characteristic 3 historical prices and portfolio turnover are available for review.
Compton explains that, in order to evaluate the asset allocation process, fixed-income port-
folios should have an appropriate benchmark. Mowery asks for benchmark advice regarding
DFC's portfolio of short-term and intermediate-term bonds, all denominated in US dollars.
Compton presents three possible benchmarks in exhibit 2.

Which of the portfolios in exhibit 1 best minimizes the structural risk to a single-liability immunization strategy?

A) Portfolio 1
B) Portfolio 3
C) Portfolio 4

Question 20

The following information relates to Questions
SD&r Capital (SD&r), a global asset management company, specializes in fixed-income
investments. Molly Compton, chief investment officer, is meeting with a prospective client,
Leah Mowery of DePuy Financial Company (DFC).
Mowery informs Compton that DFC's previous fixed income manager focused on the
interest rate sensitivities of assets and liabilities when making asset allocation decisions. Comp-
ton explains that, in contrast, SD&r's investment process first analyzes the size and timing
of client liabilities, then builds an asset portfolio based on the interest rate sensitivity of those
liabilities.
Compton notes that SD&r generally uses actively managed portfolios designed to earn
a return in excess of the benchmark portfolio. For clients interested in passive exposure to
fixed-income instruments, SD&r offers two additional approaches.
approach 1 Seeks to fully replicate the bloomberg barclays US aggregate bond index.
approach 2 Follows a stratified sampling or cell approach to indexing for a subset of the
bonds included in the bloomberg barclays US aggregate bond index. approach
2 may also be customized to reflect client preferences.
to illustrate SD&r's immunization approach for controlling portfolio interest rate risk,
Compton discusses a hypothetical portfolio composed of two non-callable, investment-grade
bonds. The portfolio has a weighted average yield-to-maturity of 9.55%, a weighted average
coupon rate of 10.25%, and a cash flow yield of 9.85%.
Mowery informs Compton that DFC has a single $500 million liability due in nine years,
and she wants SD&r to construct a bond portfolio that earns a rate of return sufficient to pay
off the obligation. Mowery expresses concern about the risks associated with an immunization
strategy for this obligation. in response, Compton makes the following statements about lia-
bility-driven investing:
Statement 1 although the amount and date of SD&r's liability is known with certainty,
measurement errors associated with key parameters relative to interest rate
changes may adversely affect the bond portfolios.
Statement 2 a cash flow matching strategy will mitigate the risk from non-parallel shifts in
the yield curve.
Compton provides the four US dollar-denominated bond portfolios in exhibit 1 for consid-
eration. Compton explains that the portfolios consist of non-callable, investment-grade corporate
and government bonds of various maturities because zero-coupon bonds are unavailable.

The discussion turns to benchmark selection. DFC's previous fixed-income manager used
a custom benchmark with the following characteristics:
Characteristic 1 The benchmark portfolio invests only in investment-grade bonds of US
corporations with a minimum issuance size of $250 million.
Characteristic 2 valuation occurs on a weekly basis, because many of the bonds in the index
are valued weekly.
Characteristic 3 historical prices and portfolio turnover are available for review.
Compton explains that, in order to evaluate the asset allocation process, fixed-income port-
folios should have an appropriate benchmark. Mowery asks for benchmark advice regarding
DFC's portfolio of short-term and intermediate-term bonds, all denominated in US dollars.
Compton presents three possible benchmarks in exhibit 2.

Which of Compton's statements about liability-driven investing is (are) correct?

A) Statement 1 only.
B) Statement 2 only.
C) both Statement 1 and Statement 2.

Question 21

The following information relates to Questions
Doug Kepler, the newly hired chief financial officer for the City of radford, asks the dep-
uty financial manager, hui ng, to prepare an analysis of the current investment portfolio
and the city's current and future obligations. The city has multiple liabilities of different
amounts and maturities relating to the pension fund, infrastructure repairs, and various
other obligations.
ng observes that the current fixed-income portfolio is structured to match the duration of
each liability. Previously, this structure caused the city to access a line of credit for temporary
mismatches resulting from changes in the term structure of interest rates.
Kepler asks ng for different strategies to manage the interest rate risk of the city's
fixed-income investment portfolio against one-time shifts in the yield curve. ng considers two
different strategies:
Strategy 1: immunization of the single liabilities using zero-coupon bonds held to maturity.
Strategy 2: immunization of the single liabilities using coupon-bearing bonds while
continuously matching duration.
The city also manages a separate, smaller bond portfolio for the radford School District.
During the next five years, the school district has obligations for school expansions and ren-
ovations. The funds needed for those obligations are invested in the bloomberg barclays US
aggregate index. Kepler asks ng which portfolio management strategy would be most efficient
in mimicking this index.
a radford School board member has stated that she prefers a bond portfolio structure
that provides diversification over time, as well as liquidity. in addressing the board member's
inquiry, ng examines a bullet portfolio, a barbell portfolio, and a laddered portfolio.
ng's response to Kepler's question about the most efficient portfolio management strategy should be:

A) full replication.
B) active management.
C) a stratified sampling approach to indexing.

Question 22

The following information relates to Questions
Chaopraya av is an investment advisor for high-net-worth individuals. one of her clients,
Schuylkill Cy, plans to fund her grandson's college education and considers two options:
option 1 Contribute a lump sum of $300,000 in 10 years.
option 2 Contribute four level annual payments of $76,500 starting in 10 years.
The grandson will start college in 10 years. Cy seeks to immunize the contribution today.
For option 1, av calculates the present value of the $300,000 as $234,535. to immunize
the future single outflow, av considers three bond portfolios given that no zero-coupon govern-
ment bonds are available. The three portfolios consist of non-callable, fixed-rate, coupon-bearing
government bonds considered free of default risk. av prepares a comparative analysis of the
three portfolios, presented in exhibit 1.

av evaluates the three bond portfolios and selects one to recommend to Cy.
Determine the most appropriate immunization portfolio in exhibit 2. Justify your
decision. after selecting a portfolio to immunize Cy's multiple future outflows, av prepares a report on how this immunization strategy would respond to various interest rate scenarios. The sce-
nario analysis is presented in exhibit 3.

Question 23

The following information relates to Questions
Chaopraya av is an investment advisor for high-net-worth individuals. one of her clients,
Schuylkill Cy, plans to fund her grandson's college education and considers two options:
option 1 Contribute a lump sum of $300,000 in 10 years.
option 2 Contribute four level annual payments of $76,500 starting in 10 years.
The grandson will start college in 10 years. Cy seeks to immunize the contribution today.
For option 1, av calculates the present value of the $300,000 as $234,535. to immunize
the future single outflow, av considers three bond portfolios given that no zero-coupon govern-
ment bonds are available. The three portfolios consist of non-callable, fixed-rate, coupon-bearing
government bonds considered free of default risk. av prepares a comparative analysis of the
three portfolios, presented in exhibit 1.

av evaluates the three bond portfolios and selects one to recommend to Cy.
Discuss the effectiveness of av's immunization strategy in terms of duration gaps.

Question 24

The following information relates to Questions
Chaopraya av is an investment advisor for high-net-worth individuals. one of her clients,
Schuylkill Cy, plans to fund her grandson's college education and considers two options:
option 1 Contribute a lump sum of $300,000 in 10 years.
option 2 Contribute four level annual payments of $76,500 starting in 10 years.
The grandson will start college in 10 years. Cy seeks to immunize the contribution today.
For option 1, av calculates the present value of the $300,000 as $234,535. to immunize
the future single outflow, av considers three bond portfolios given that no zero-coupon govern-
ment bonds are available. The three portfolios consist of non-callable, fixed-rate, coupon-bearing
government bonds considered free of default risk. av prepares a comparative analysis of the
three portfolios, presented in exhibit 1.

av evaluates the three bond portfolios and selects one to recommend to Cy.
Recommend the portfolio in exhibit 1 that would best achieve the immunization. Justify
your response.
Template for Question 24
Recommend the portfolio in exhibit 1 that would best achieve the
immunization. (circle one) Justify your response.
Portfolio a
Portfolio b
Portfolio C
Cy and av now discuss option 2.
av estimates the present value of the four future cash flows as $230,372, with a money
duration of $2,609,700 and convexity of 135.142. She considers three possible portfolios to
immunize the future payments, as presented in exhibit 2.

Question 25

The following information relates to Questions
Doug Kepler, the newly hired chief financial officer for the City of radford, asks the dep-
uty financial manager, hui ng, to prepare an analysis of the current investment portfolio
and the city's current and future obligations. The city has multiple liabilities of different
amounts and maturities relating to the pension fund, infrastructure repairs, and various
other obligations.
ng observes that the current fixed-income portfolio is structured to match the duration of
each liability. Previously, this structure caused the city to access a line of credit for temporary
mismatches resulting from changes in the term structure of interest rates.
Kepler asks ng for different strategies to manage the interest rate risk of the city's
fixed-income investment portfolio against one-time shifts in the yield curve. ng considers two
different strategies:
Strategy 1: immunization of the single liabilities using zero-coupon bonds held to maturity.
Strategy 2: immunization of the single liabilities using coupon-bearing bonds while
continuously matching duration.
The city also manages a separate, smaller bond portfolio for the radford School District.
During the next five years, the school district has obligations for school expansions and ren-
ovations. The funds needed for those obligations are invested in the bloomberg barclays US
aggregate index. Kepler asks ng which portfolio management strategy would be most efficient
in mimicking this index.
a radford School board member has stated that she prefers a bond portfolio structure
that provides diversification over time, as well as liquidity. in addressing the board member's
inquiry, ng examines a bullet portfolio, a barbell portfolio, and a laddered portfolio.
The effects of a non-parallel shift in the yield curve on Strategy 2 can be reduced by:

A) minimizing the convexity of the bond portfolio.
B) maximizing the cash flow yield of the bond portfolio.
C) minimizing the difference between liability duration and bond-portfolio duration.

Question 26

The following information relates to Questions
Doug Kepler, the newly hired chief financial officer for the City of radford, asks the dep-
uty financial manager, hui ng, to prepare an analysis of the current investment portfolio
and the city's current and future obligations. The city has multiple liabilities of different
amounts and maturities relating to the pension fund, infrastructure repairs, and various
other obligations.
ng observes that the current fixed-income portfolio is structured to match the duration of
each liability. Previously, this structure caused the city to access a line of credit for temporary
mismatches resulting from changes in the term structure of interest rates.
Kepler asks ng for different strategies to manage the interest rate risk of the city's
fixed-income investment portfolio against one-time shifts in the yield curve. ng considers two
different strategies:
Strategy 1: immunization of the single liabilities using zero-coupon bonds held to maturity.
Strategy 2: immunization of the single liabilities using coupon-bearing bonds while
continuously matching duration.
The city also manages a separate, smaller bond portfolio for the radford School District.
During the next five years, the school district has obligations for school expansions and ren-
ovations. The funds needed for those obligations are invested in the bloomberg barclays US
aggregate index. Kepler asks ng which portfolio management strategy would be most efficient
in mimicking this index.
a radford School board member has stated that she prefers a bond portfolio structure
that provides diversification over time, as well as liquidity. in addressing the board member's
inquiry, ng examines a bullet portfolio, a barbell portfolio, and a laddered portfolio.
Which portfolio structure should ng recommend that would satisfy the school board member's preference?

A) bullet portfolio
B) barbell portfolio
C) Laddered portfolio