Level III Review Fixed Income

Study session 10 concludes the material on fixed-income with two more readings (25-26).
Fixed-Income Portfolio Management
Be able to calculate the duration of equity from the duration of assets and liabilities and the total amount of equity. Understand that leverage increases the interest rate sensitivity of portfolio equity.
The list material for repo agreements is easily testable. Be sure to understand how each item affects the repo rate and risk of the instrument. Forms of transfer (in order of most to least costly) include: physical delivery , wire transfer, custodial account, no delivery. The quality of collateral (higheràlower rate), term of repo (longeràhigher), delivery requirement (deliveredàlower), availability of collateral (lower availabilityàlower rate), prevailing funds rate (loweràlower), borrower credit rating (higheràlower), and seasonal factors will determine the repo rate.
Master the material on use of futures contracts for hedging because the concept will show up in equities as well. Working through problems (and reviewing those you missed) work best here. Understand the target dollar duration, number of futures contracts and the hedge ratio.
Understand the three options strategies:

  • Protective put: buying a put option against a long position has limited downside but maintains upside potential.
  • Covered call: Selling call options against a long position has more downside risk and limited upside potential but involves collecting a premium instead of paying for protection. The strategy is best if rates/prices do not change.
  • Collar strategy: Involve the purchase of a cap on rates by selling a floor (or conversely buying a floor funded from selling a cap depending on your original position). Best used for liability management by floating-rate holders.

Understand the types of credit risk (default, credit spread, and downgrade) and the products that transfer risk (options, forwards, and swaps). The quantitative material here isn’t as intense or important as seen in the Level II CFA Program exam so just make sure you have a good grasp of the concepts.
Understand the sources of excess returns in active management: market selection, currency selection, duration/yield curve management, sector selection, issuer credit analysis, and investing in markets outside the benchmark.
Currency risk has often been a focus of the curriculum. Understand how appreciation/depreciation of foreign currency affects the portfolio and the three types of hedging: forward, proxy (domestic currency and another correlated with the foreign), and cross (foreign currency and another correlated with the domestic). Be able to calculate hedged and unhedged returns.
Hedging Mortgage Securities
Understanding convexity (and why MBS and call-option securities have negative convexity) is extremely important. The reason is that debtors have prepayment options that can be exercised when interest rates drop. At lower rates, the increase in price of a bond with this option will be less than a bond with no prepayment/call option. Note: there is no difference in the convexity (price changes) in bonds at higher rates because the prepayment/call option has much less value.
Understand the five principal risks in mortgage securities:

  • Spread risk that the OAS may change and cause the MBS value to decline
  • Rate risk that a change in rates will cause the security value to decline
  • Yield Curve risk where exposure of a portfolio is at risk to nonparallel changes in the curve
  • Prepayment risk is the risk associated with the call option on the security (negative convexity)
  • Volatility risk arises because the option becomes more valuable with heightened volatility in rates (there is a higher chance that rates will drop causing the option to have more value).

One section that many candidates neglect is the calculation behind a two-bond hedge. Do not avoid this just because it may be difficult at first! It has shown up frequently on past exams and knowing how to do the hedge puts you ahead of other candidates. Make up a couple of flash cards and drill the concept until you can do it easily. The process is relatively lengthy so it may take some time but stick with it.
Study session 11 begins the level 3 material on equity portfolio management which is worth 5-15% of your total exam score.
‘til next time, happy studyin’
Joseph Hogue, CFA

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