CFA Mock Exam 2017: Q26

CFA Level III
#1

Hi all,

Has anyone found Question 26 (CFA 2017 Mock AM) misleading, too?

Here it goes…

"…she needs to be aware of interest rate linkages between these economies, and mentions three points that he should consider:

1 Since the Chilean peso appears to be undervalued relative to the British pound and is likely to rise, Chilean bond yields may be lower than they should be relative to British bonds.

2 The peg linking Denmark’s currency to the euro is considered to be at risk and likely to break. Therefore, Danish bond yields are expected to drop if the Danish krone weakens relative to the euro.

3 After removing expected inflation, the real bond yield is likely to be similar in Singapore and Sweden."

Question: Of Kumar’s three points regarding interest rate linkages between countries proposed for the new fund, she is least likely correct with respect to bond yields in:

A Chile.

B Denmark.

C Singapore and Sweden.

Correct answer: B.

I mean, I can see why B is the correct answer, no doubt about it. However, answer C seems correct for me too: We cannot consciously assume in real life that real bonds in Singapore trade similarly to Swedish ones. It’s like assuming that US 10y cash govies trade like German 10y Bunds after we’ve removed expected inflation, it’s just difficult to imagine in real life…or am I missing a CFA ‘generalization’ here?

Thank you!

#2

isn’t that the PPP assumption ? I agree does not seem realistic…

#3

It is pegging currency assumption. Bonds denominated in weaker currency will have higher yields if peg is going to break.

#4

I choose C too somehow… I can only guess the point is whichever two countries, after removing the inflation difference, the real yield would be the same in this case which is consistent with PPP taught in CFA…

for me it`s hard to consider DKK as a weak currency at first, but in CFA context in terms of pegging, it is the same as all the other eastern European countries currency, so investors need a risk premium if they lose confidence that the peg would be maintained, and if there is no peg, these countries would have higher inflation, lower real yield and weak currency as a result…

not sure whether my understanding is correct…

#5

^ DKK is not an Eastern European currency not even similar to this.:slight_smile:

#6

Thanks so far for the responses. Could somebody make a concrete example of why C is incorrect based on PPP?

#7

Singapore and Sweden are both among top countries regarding the standard of living in the world. Why we wouldn’t assume that both countries bonds have similar real yields?

#8

Hi Flashback, thanks for your answer! They are both developed market economies, true. However, why shall standard of living be a price determinant? This makes little sense to me. In fact, 10y real yields in Sweden trade right now at -1.4% and those in Singapore at +0.43%…a wide spread indeed in this low yield environment.

#9

I meant same economic determinants as both are wealthy countries. If you proceed with comparing actual data with information in CFAI Curriculum, you will also find that many currency rates stated in CFAI are quite different than actual. However, the point in this question was currency pegging and this concept was tested. You may find it in this key sentence “the peg linking Denmark’s currency to the euro is considered to be at risk and likely to break.”. More Tricks Than Kicks…

#10

I checked once again and I agree with you that is difficult to clearly answer which is the best solution between B and C. C may be doubtful regarding real yields but I would go with assumption as I stated above. This one is also one of those…Hopefully such solution would be more clear on real exam.

#11

This has to do with the peg.

From schweser:

A peg is unilateral declaration by the pegging country to maintain the exchange rate. Generally, the IR of the pegged currency to which it is linked, and the IR differential will fluctuate with the market’s confidence in the peg. If confidence is high, the rate differential can be small. A common problem arises if investors begin to lose confidence in the pegged currency and it begins to decline in value. The pegging country must then increase short term rates to attract capital and maintain the value of the currency at the peg.

#12

I got this one correct, only because I knew B was definitely false. I was fine with eliminating C as choice but am I the only one who doesn’t understand A? Economics is my weak spot.

#13

Actually nevermind I got it. Just had to think it through a minute. Peso is going to appreciate so rates need to be lower relative to pound.

#14

Hi flashback, yes I agree. I def got why B is be the right answer (it is the ‘more wrong’ answer), though C kept me thinking through… well guys, thank you to all of you. We are almost there :slight_smile:

#15

I think the answer is very weirdly worded and very confusing. I got this wrong but if you think about IRP, weaker currency has higher yield, it makes sense.