Mock Exam Question -Fixed Income Part I

CFA Level III
#1

I am doing the Mock Exam from CFA website, there is one question I got wrong, but do not understand even after reading the answer, can someone help me out on this? Thanks a lot!!!

Text from the Question:

Norris then asks Whitney, “What sectors are you currently recommending for client portfolios?” Whitney responds: “I recommend investing 25% of the portfolio in mortgage-backed securities because they are trading at attractive valuations. I would not, however, buy floating-rate securities because these do not hedge liabilities appropriately.”

What are the two risks that Whitney is most likely exposed to, given his recommendations on sectors?

Interest rate risk and cap risk

Interest rate risk and contingent claim risk

Contingent claim risk and cap risk

I choose C “Contingent claim risk and cap risk”, but solution says it is incorrect. It explains as follow:

Incorrect.

When such assets as mortgage-backed securities have a contingent claim provision, explicit or implicit, there is an associated risk. As rates fall, the security might have coupons halted and principal repaid, which results in reinvestment risk and also limits any potential upside as would be generated by a non-callable security. In addition, all fixed-income securities that have fixed rather than floating interest rates are exposed to interest rate risk because prices move in the opposite direction of rates.

CFA Level III

“Fixed-Income Portfolio Management – Part I,” H. Gifford Fong and Larry D. Guin

Section 4.1.2.2

I am so confused, it seems the solution is explaining my answer. I am understand it incorrectly?

#2

Hey Teresa - I also picked C on this one. But looking at it…

We get the contingent claims risk in the MBS, and maybe we were thinking of this as a kind of cap risk, so picked C

Floaters are particularly sensitive to cap risk, since they will only adjust to a certain level and then be capped. She says she doesn’t like flosters now, so likely isn’t exposing herself to this.

regular interest rate risk will apply to the MBS, and not the floaters, so turns out B is the best answer.

Hope that helps

#3

I interpreted the statement differently and arrived at B.

"I would not, however, buy floating-rate securities because these do not hedge liabilities appropriately.”

The question asks “What are the two risks that Whitney is most likely exposed to…”

Contingent claim is obvious. When Whitney says that floating rate securities do not hedge liabilites appropriately I interpreted that to mean that Whitney has fixed rate liability exposure which is therefore exposed to interest rate risk.

#4

Thank you so much guys! :slight_smile:

#5

There is no cap risk for MBS. Contingent claims only happen when interest rate falls. Upwards movement of Interest rates for an MBS is not capped.