EOC: Reading 20 Qns20-Yield Curve Strategies

CFA Level III Fixed Income
#1

Qns 20, Reading 20 yield curve stratgies.
Exhibit 1 Cefrino Sovereign Bond Fund Current Fund Holdings of On- theRun Bonds
Maturity Coupon/YTM Market Value Modified Duration
1- year 0.78% $10,000,000 0.99
3- year 1.40% $10,000,000 2.92
5- year 1.80% $10,000,000 4.74
10- year 2.34% $10,000,000 8.82
30- year 2.95% $10,000,000 19.69
Portfolio 1.85% $50,000,000 7.43
Over the next 12 months, Abram expects a stable yield curve; however, Edgarton
expects a steepening yield curve, with short- term yields rising by 1.00% and long- term yields rising by more than 1.00%.

Exhibit 2 Selected Partial Durations
Maturity Beginning Yield Curve Curve Shift Current Portfolio Partial PVBP Pro Forma Portfolio 1
Partial PVBP
Pro Forma Portfolio 2
Partial PVBP
1- year 0.78% 1.00% 0.0020 0.0018 0.0021
3- year 1.40% 1.00% 0.0058 0.0044 0.0061
5- year 1.80% 1.25% 0.0095 0.0114 0.0095
10- year 2.34% 1.60% 0.0177 0.0212 0.0159
30- year 2.95% 1.75% 0.0394 0.0374 0.0394

Based on exhibits 1 & 2, which of the following portfolios is most likely to have the best performance given Edgarton’s yield curve expectation.
A Current Portfolio
B. Pro Forma Portfolio 1
C. Pro Forma Portfolio 2

The given answer is C. Given Edgarton’s expectation for steeping yield curve, the best strategy is to shorten portfolio duration by more heavily weighting shorter maturities.

Can anyone kindly explain why C is the answer as I thought B might be the answer given that pro forma portoflio 1 has it’s more partial durations in 5-year and 10-year partial PVBP (look like a bullet structure and bullet outperform in steeping yield curve).

Thanks in advance

#2

Given the partial PVBP and curve shift, it’s more accurate to calculate the change in portfolio value using the formula.

If I assume a par value of $10,000,000, the change in value of portfolio 1 is -$119.82 while the change in value of portfolio 2 is -$114.47, so that tells us that Portfolio 2 outperforms Portfolio 1 if a steepening yield curve scenario occurs.

If you don’t calculate the change and want to compare the difference in the PVBP, you will notice that the partial PVBP for the 10-year point in Portfolio 1 heavily outweighs Portfolio 2. While the 30-year partial PVBP is lower in Portfolio 1 than Portfolio 2, the impact it has is smaller (for the 1.75% shift) as compared to the impact from the 10-year point (given a 1.6% shift).

#3

Thanks once again fino_abama!!

If we have a flatten yield curve and assuming the changes of value for both portfolio remains, portfolio 1 will be outperforming portfolio 2 or portfolio 2 will still outperform given that the change in value of portfolio is lesser than portfolio 1?

Thanks,

#4

If we assume all values remain the same except that the curve shifts are in negative signs (i.e. flattening), then portfolio 1 will outperform portfolio 2 (+$119.82 vs +$114.47).