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b. On July 21, 1993, Disney issued, at par, \$300 million of 100-year bonds with a coupon rate of
7.55 percent. The bonds are callable in 30 years at 103.02. From Disneyâ€™s point of view, state
three disadvantages of calling the zero coupon notes and effectively replacing part of that debt
capital with the issue of 100-year bonds. [8 minutes]
7. CFA Examination Level II
CFA
Â®
Table 18.1 shows prices as a function of yields for four tranches of a collateralized mortgage obliga-
tion (CMO).

Table 18.1 Prices for Four CMO Tranches at Selected Yields

YIELD (%)

CMO Tranche 6.0 6.5 7.0 7.5 8.0

T-1 111.5 105.5 100.0 95.0 90.5
T-2 107.5 104.0 100.0 95.5 90.5
T-3 112.0 105.5 100.0 95.5 92.0
T-4 104.5 102.0 100.0 98.5 97.5

a. Calculate the effective duration of Tranche T-3. Assume that the relevant current yield is 7.0 per-
cent. Show your work. [5 minutes]
b. Identify the tranche with the negative convexity. Calculate the effective convexity of this tranche.
Table 18.2 shows the option-adjusted spread for four different mortgage pass-through securities.

Volatility of 8 Percent)

Security (in Basis Points)

A 43
B 70
C 89
D 99

c. Identify which of the patterns of option-adjusted spreads shown in Table 18.3 is plausible if the
assumed interest rate volatility is 12 percent rather than the 8 percent assumed in Table 18.2. Jus-
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32 Web Problems

Volatility of 12 Percent)

Security Pattern A Pattern B

213
A 103
B 20 120
C 49 129
D 69 129

CHAPTER 19

1. CFA Examination Level III (adapted)
CFA
Â®
Hans Kaufmann is a global fixed-income portfolio manager based in Switzerland. His clients are
primarily U.S.-based pension funds. He allocates investments in the United States, Japan, Germany,
and the United Kingdom. His approach is to make investment allocation decisions among these four
countries based on his global economic outlook. To develop this economic outlook, Kaufmann ana-
lyzes the following five factors for each country: real economic growth, inflation, monetary policy,
interest rates, and exchange rates.
When Kaufmann believes that the four economies are equally attractive for investment purposes,
he equally weights investments in the four countries. When the economies are not equally attractive,
he overweights the country or countries where he sees the largest potential returns.
Table 19.1 through Table 19.5 present relevant economic data and forecasts.
a. Indicate, before taking into account currency hedging, whether Kaufmann should overweight or
underweight investments in each country. Justify your position. [15 minutes]
b. Briefly describe how your answer to Part a might change with the use of currency-hedging tech-
niques. [5 minutes]

Table 19.1 Real GDP (Annual Changes)

1996 1997 1998 1999E

United States 3.0% 2.9% 2.4% 2.7%
Japan 4.7 2.4 3.2 3.4
Germany 2.0 2.5 1.5 2.1
United Kingdom 3.4 3.0 3.4 2.3

Table 19.2 GDP Deflator (Annual Changes)

1996 1997 1998 1999E

United States 3.2% 2.6% 3.3% 3.8%
Japan 1.5 2.8 3.0 3.0
Germany 2.2 3.1 2.5 2.2
United Kingdom 6.0 3.5 4.5 4.8
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33
Chapter 19

Table 19.3 Narrow Money (MI) (Annual Changes)

1996 1997 1998 1999E

United States 9.2% 13.4% 5.5% 7.0%
Japan 5.0 6.9 9.9 10.0
Germany 4.3 8.5 7.5 8.5
United Kingdom 7.0 8.0 6.7 5.5

Table 19.4 Long-Term Interest Rates (Annual Rates)

1996 1997 1998 1999E

United States 10.6% 7.7% 8.8% 9.0%
Japan 5.5 4.1 4.7 4.7
Germany 9.9 5.9 6.1 7.0
United Kingdom 10.6 9.9 9.8 9.5

Table 19.5 Exchange Rates (Currency per U.S. Dollars)

1996 1997 1998 1999E

United States (dollars) 1.00 1.00 1.00 1.00
Japan (yen) 130.10 121.50 111.40 108.35
Germany (marks) 1.95 1.80 1.60 1.52
United Kingdom (pounds) 0.67 0.60 0.58 0.59

Sources: International Monetary Fund.

2. CFA Examination Level III
CFA
Â®
PTCâ€™s Investment Committee has decided to allocate 50 percent of the pension plan portfolioâ€™s
fixed-income investment to non-U.S. government bonds (i.e., bonds representing non-U.S. sover-
eign credits). For a number of reasons, BAGâ€”the Committeeâ€™s consultantâ€”has recommended
against using a pure dedication approach to management of the bonds. Instead, it has presented the
committee with three alternative strategies for consideration, accompanied by the 15-year historical
performance data for each strategy shown in Table 19.6.
a. Based on the management strategy characteristics set forth in Table 19.6, as well as your general
knowledge, identify and explain three advantages of each strategy as an alternative for the In-
vestment Committee to consider. In developing your response, regard yourself as a strong advo-
cate as you explain the advantages of each of the three alternatives. [15 minutes]
b. Identify and explain one key disadvantage of each of the three strategies. [5 minutes]
PTC has now decided to index the segment of the fixed-income portfolio to be invested in non-U.S.
government bonds, using the Salomon Brothers World Government Bond Index as the benchmark
portfolio. Assume this index includes the sovereign credits of nine major countries in the following
proportions:
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34 Web Problems

Country Weighting

Australia 2%
Denmark 2
France 11
Germany 19
Japan 37
The Netherlands 8
Switzerland 2
United Kingdom 11

Table 19.6 15-Year Historical Universe Performance

Average Average Top Average Bottom Standard
Decile Returnsa Decile Returnsb
Returns Deviation
Annualized Annualized Annualized of Returns

Strategy Characteristics
Active management 12.9% 15.6% 6.8% 18.6%
Duration shifts + or â€“ 40% of
Salomon WGB Indexc
Deviations from country allocation
benchmarks in Index are
unrestricted
Transactions permitted for any
management purpose
Fee: 35 basis points/year
Passive management 11.8% 12.8% 10.7% 16.0%
Duration shifts + or â€“ 5% of
Salomon WGB Indexc
Country allocation deviations limited
relative to index proportions
Transactions permitted only for
replacement of deteriorating credits
Fee: 15 basis points/year
Indexed management 11.3% 12.0% 11.0% 14.9%
Match return of Salomon WGB Indexc
No duration shifts permitted
Transactions allowed only for
portfolio rebalancing
Fee: 6 basis points/year

aTop decile returns are simple average of the 10 best manager records in BAGâ€™s 100-manager universe.
bBottom decile returns are a simple average of the 10 worst manager records in BAGâ€™s 100-manager universe.
cSalomon Brothers World Government Bond Index (WGB)

Several members of the Investment Committee favor use of the full replication approach to indexing
the non-U.S. government bonds, while the chairman favors use of the stratified sampling approach.
As the BAG representative assigned to the PTC account, you have been asked to assist the commit-
tee in choosing between the two indexing methods.
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Chapter 19

c. Describe and evaluate each of these two indexing alternatives for the purpose of creating and
managing a bond portfolio intended to represent the Salomon Brothers World Government Bond
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