Currently Alpha’s portfolio consists of large cap U.S. stocks, bonds, and adjustable-rate mortgage-backed securities. John Wortek and Jack Benson are advisors with Pheifer Advisors, located in New York. Pheifer provides investment advice to wealthy investors and institutional investors and has been doing so for over ten years.
Sumner (Portfolio Manager) would also like to keep the fixed income portfolio structured so that it is dedicated to the firm’s obligations and is immunized against interest rate risk. Benson states that a barbell strategy exploits a flattening of the yield curve but can immunize a portfolio against interest rate risk in a manner similar to a bullet bond portfolio. Discussing mortgages, Wortek states that the effective duration will drop precipitously when interest rates fall and that the convexity properties are different from a traditional fixed income instrument.
Ques) Regarding Wortek’s and Benson’s statements concerning mortgages and portfolio immunization:
The chief economist is Paul Worthington. Based on the Federal Reserve’s latest Federal Open Market Committee meeting minutes and a decrease in purchases of U.S. bonds by Chinese investors, Worthington is forecasting an increase in U.S. interest rates. At the same time, Worthington is also forecasting a slowdown in the economy, because he believes that the Federal Reserve has been too aggressive in fighting inflation through increases in interest rates.
Ques) Suppose Worthington’s forecast of interest rates and the economy is correct; which of the following strategies would be most applicable?
A. Total return analysis.
B. Wortek’s strategy that is based on quality-spread analysis.
C. Benson’s strategy that is based on percentage yield spread analysis.
This is a typical Schweser question. I think C is the answer to the first question…ARM still bears interest rate risk, and it could be called if the rate FALLS.
“Benson states that a barbell strategy exploits a flattening of the yield curve”
I think this part is incorrect. If you are short the barbell structure, you could make money from the yield curve flattening. However, this is not the strategy’s intent (which seems to be what the question is trying to ask).
The part about MBS is correct. So, the answer to the first question is A.
I have no idea about the second question. Wtf is this…?
the first question has something to do with cuspy coupon? I know that not all interest rate drops are equal as far as duration changes are concerned . I think the cuspy coupon number is an inflexion point between steep and no-so-steep-all-of-a-sudden
Ques) Regarding Wortek’s and Benson’s statements concerning mortgages and portfolio immunization:
A. one is correct.
B. both are incorrect.
C. both are correct.
ans: C : Both are correct -
W** ortek is correct . The effective duration of a mortgage will drop precipitously when interest rates drop because the effective maturity of the bond decreases sharply as the bond is more likely to be called. Benson is also correct.** A barbell strategy exploits a flattening of the yield curve but can immunize the duration of a portfolio just as a bullet bond portfolio could. The barbell invests in both a short-term and a long-term bond. When the yield curve flattens, the decrease in the long-term yield results in a stronger price increase than the decrease in the short-term bond’s price because the long-term bond has a longer duration.
for Second ques Ans (A)
If Worthington is correct, there will be an increase in interest rates and a slowdown in the economy. In this case, short duration bonds should be purchased and long duration bonds should be sold. Furthermore, if the economy slows, the spreads on credit risky bonds should increase. Bond trading based only on yields, such as Wortek’s and Benson’s strategies, will ignore the potential price decrease from an increase in credit spreads. Total return analysis examines both the yield and the potential price change and is most appropriate in this situation where spreads are projected to increase.
