2.Explain why a callable bonds price would be expected to decline less than an otherwise comparable option-free bond when interest rates rise.The price of a callable bond can be expressed as follows: Price of callable bond = Price of option-free bond Price of embedded call optionAn increase in interest rates will reduce the price of the option-free bond. However, to partially offset that price decline of the option-free bond, the price of the embedded call option will decrease. This is because as interest rates rise the value of the embedded call option to the issuer is worth less. Since a lower price for the embedded call option is subtracted from the lower price of the option-free bond, the price of the callable bond does not fall as much as that of an option-free bond.3.A.Short-term investors such as money market mutual funds invest in floating- rate securities having maturities greater than 1 year. Suppose that the coupon rate is reset everyday. Why is the interest rate risk small for such issues?A floating-rate securitys exposure to interest rate risk is affected by the time to the next reset date. The shorter the time, the less likely the issue will offer a below-market interest rate until the next reset date. So, a daily reset will not expose the investor of this floater to interest rate risk due to this factor. However, there is interest rate risk, which we will see in part B.B.Why would it be improper to say that a floating-rate security whose coupon rate resets every day has no interest rate risk?The reason there is still interest rate risk with a daily reset floating-rate security is that the margin required by the market may change. And, if there is a cap on the floater, there is cap risk. 4.John Smith and Jane Brody are assistant portfolio managers. The senior portfolio manager has asked them to consider the acquisition of one of two option-free bond issues with the following characteristics:Issue 1 has a lower coupon rate than Issue 2Issue 1 has a shorter maturity than Issue 2 Both issues have the same credit rating.Smith and Brody are discussing the interest rate risk of the two issues. Smith argues that Issue 1 has greater interest rate risk than Issue 2 because of its lower coupon rate. Brody counters by arguing that Issue 2 has greater interest rate risk because it has a longer maturity than Issue 1.A. Which assistant portfolio manager is correct with respect to their selection to the issue with the greater interest rate risk?While both assistant portfolio managers are correct in that they have identified two features of an issue that will impact interest rate risk, it is the interaction of the two that will affect an issues interest rate risk. From the information provided in the question, it cannot be determined which has the greater interest rate risk.B. Suppose that you are the senior portfolio manager. How would you suggest that Smith and Brody determine which issue has the greater interest rate risk?The reason there is still interest rate risk with a daily reset floating-rate security is that the margin required by the market may change. And, if there is a cap on the floater, there is cap risk.5.A portfolio manager wants to estimate the interest rate risk of a bond using duration. The current price of the bond is 82. A valuation model found that if interest rates decline by 30 basis points, the price will increase to 83.50 and if interest rates increase by 30 basis points, the price will decline to 80.75. What is the duration of this bond?The information for computing duration: Price if yields decline by 30 basis points = 83.50 Price if yields rise by 30 basis points = 80.75Initial price = 82.00Change in yield in decimal = 0.0030 Then,Duration =83.50 80.75= 5.59 2(82.00)(0.00306.A portfolio manager purchased $8 million in market value of a bond with a duration of 5. For this bond, determine the estimated change in its market value for the change in interest rates shown below:A.100 basis points. B.50 basis points. C.25 basis points. D.10 basis points.Since the duration is the approximate percentage price change for a 100 basis point change in interest rates, a bond with a duration of 5 will change by approximately 5% for a 100 basis point change in interest rates. Since the market value of the bond is $8 million, the change in the market value for a 100 basis point change in interest rates is found by multiplying 5% by $8 million. Therefore, the change in market value per 100 basis point change in interest rates is $400,000. To get an estimate of the change in the market value for any other change in interest rates, it is only necessary to scale the change in market value accordingly.A.For 100 basis points = $400,000. B.For 50 basis points = $200,000 (=$400,000/2). C.For 25 basis points = $100,000 ($400,000/4). D.For 10 basis points = $40,000 ($400,000/10).7. A portfolio manager of a bond fund is considering the acquisition of an extremely complex bond issue. It is complex because it has multiple embedded options. The manager wants to estimate the interest rate risk of the bond issue so that he can determine the impact of including it in his current portfolio. The portfolio manager contacts the dealer who created the bond issue to obtain an estimate for the issues duration. The dealer estimates the duration to be 7. The portfolio manager solicited his firms in-house quantitative analyst and asked her to estimate the issues duration. She estimated the duration to be 10. Explain why there is such a dramatic difference in the issues duration as estimated by the dealers analysts and the firms in-house analyst.To calculate duration, the price must be estimated for an increase and decrease (i.e., a rate shock) of the same number of basis points. A valuation model must be employed to obtain the two prices. With an extremely complex bond issue, the valuation models by different analysts can produce substantially different prices when rates are shocked. This will result in differences in estimates of duration.8. Duration is commonly used as a measure of interest rate risk. However, duration does not consider yield curve risk. Why?For an individual bond, duration is an estimate of the price sensitivity of a bond to changes in interest rates. A portfolio duration can be estimated from the duration of the individual bond holdings in the portfolio. To use the portfolios duration as an estimate of interest rate risk it is assumed that when interest rates change, the interest rate for all maturities change by the same number of basis points. That is, it does not consider non-parallel changes of the yield curve.9. What measure can a portfolio manager use to assess the interest rate risk of a portfolio to a change in the 5-year yield?The approach briefly discussed in this reading for doing so is rate duration. Specifically, the 5-year rate duration indicates the approximate percentage change in the value of the portfolio if the yield on all maturities are unchanged but the yield for the 5-year maturity changes by 100 basis points. 10.For the investor in a callable bond, what are the two forms of reinvestment risk?The first form of reinvestment risk is due to the likelihood the proceeds from the called issue will be reinvested at a lower interest rate. The second form of reinvestment risk is the typical risk faced by an investor when purchasing a bond with a coupon. It is necessary to reinvest all the coupon payments at the computed yield in order to realize the yield at the time the bond is purchased.11. Investors are exposed to credit risk when they purchase a bond. However, even if an issuer does not default on its obligation prior to its maturity date, there is still a concern about how credit risk can adversely impact the performance of a bond. Why?Credit risk includes default risk, credit spread risk, and downgrade risk. While an investor holds a bond in his or her portfolio, if the issuer does not default there is still 1) the risk that credit spreads in the market will increase (credit spread risk) causing the price of the bond to decline and 2) the risk that the issue will be downgraded by the rating agencies causing the price to decline or not perform as well as other issues (downgrade risk).12. Using the hypothetical rating transition matrix shown in Exhibit 4 of the reading, answer the following questions:A.What is the probability that a bond rated BBB will be downgraded?A.The probability that a bond rated BBB will be downgraded is equal to the sum of the probabilities of a downgrade to BB, B, CCC or D. From the corresponding cells in the exhibit: 5.70% + 0.70% + 0.16% + 0.20% = 6.76%. Therefore, the probability of a downgrade is 6.76%.B.The probability that a bond rated BBB will go into default is the probability that it will fall into the D rating. From the exhibit we see that the probability is 0.20%. B.What is the probability that a bond rated BBB will go into default?C.What is the probability that a bond rated BBB will be upgraded?D.What is the probability that a bond rated B will be upgraded to investment grade?E.What is the probability that a bond rated A will be downgraded to noninvestment grade?F.What is the probability that a AAA rated bond will not be downgraded at the end of one year?14. A portfolio manager is considering the purchase of a new type of bond. The bond is extremely complex in terms of its embedded options. Currently, there is only one dealer making a market in this type of bond. In addition, the manager plans to finance the purchase of this bond by using the bond as collateral. The bond matures in five years and the manager plans to hold the bond for five years. Because the manager plans to hold the bond to its maturity, he has indicated that he is not concerned with liquidity risk. Explain why you agree or disagree with the managers view that he is not concerned with liquidity risk.

If this managers portfolio is marked-to-market, the manager must be concerned with the bid prices provided to mark the position to market. With only one dealer, there is concern that if this dealer decides to discontinue making a market in this issue, bids must be obtained from a different source. Finally, this manager intends to finance the purchase. The lender of the funds (the dealer financing the purchase) will mark the position to market based on the price it determines and this price will reflect the liquidity risk. Consequently, this manager should be concerned with the liquidity risk even if the manager intends to hold the security to the maturity date.Identify the difference in the major risks associated with the following investment alternatives:Practice Problems for Reading 53347A.For an investor who plans to hold a security for one year, purchasing a Treasury security that matures in one year versus purchasing a Treasury security that matures in 30 years.B.For an investor who plans to hold an investment for 10 years, purchasing a Treasury security that matures in 10 years versus purchasing an AAA corporate security that matures in 10 years.C.For an investor who plans to hold an investment for two years, purchasing a zero-coupon Treasury security that matures in one year versus purchasing a zero-coupon Treasury security that matures in two years.The purchase of a 30-year Treasury exposes the investor to interest rate risk since at the end of one year, the security is a 29-year instrument. Its price at the end of one year depends on what happens to interest rates one year later.B.The major difference in risk is with respect to credit risk. Specifically, the AAA issue exposes the investor to credit risk.C.There is reinvestment risk for the 1-year zero-coupon Treasury issue because the principal must be reinvested at the end of one year.D.The major difference is the quantity of credit risk exposure of both issues. The U.S. corporate bond issue has greater credit risk. (Note that the sovereign issue is dollar denominated so that there is no exchange rate risk.)E.The less actively traded issue will have greater liquidity risk.F.There are two differences in risk. First, there is the greater credit risk of investing in Italian government bonds relative to U.S. Treasury bonds. Second, investing in the Italian government bonds denominated in lira exposes a U.S. investor to exchange rate risk.D.For an investor who plans to hold an investment for five years, purchasing an AA sovereign bond (with dollar denominated cash flow payments) versus purchasing a U.S. corporate bond with a B rating.E.For an investor who plans to hold an investment for four years, purchasing a less actively traded 10-year AA rated bond versus purchasing a 10-year AA rated bond that is actively traded.F.For a U.S. investor who plans to hold an investment for six years, purchasing a Treasury security that matures in six years versus purchasing an Italian government security that matures in six years and is denominated in lira.

16.Sam Stevens is the trustee for the Hole Punchers Labor Union (HPLU). He has approached the investment management firm of IM Associates (IMA) to manage its $200 million bond portfolio. IMA assigned Carol Peters as the portfolio manager for the HPLU account. In their first meeting, Mr. Stevens told Ms. Peters:We are an extremely conservative pension fund. We believe in investing in only investment grade bonds so that there will be minimal risk that the principal invested will be lost. We want at least 40% of the portfolio to be held in bonds that will mature within the next three years. I would like your thoughts on this proposed structure for the portfolio.How should Ms. Peters respond?Probably the first thing that Ms. Peters should ask is what the investment objectives are of HPLU. Addressing directly the two statements Mr. Stevens made, consider the first. Mr. Stevens believes that by buying investment grade bonds the portfolio will not be exposed to a loss of principal. However, all bondsinvestment grade and non-investment gradeare exposed to the potential loss of principal if interest rates rise (i.e., interest rate risk) if an issue must be sold prior to its maturity date. If a callable bond is purchased, there can be a loss of principal if the call price is less than the purchase price (i.e., call risk). The issue can also be downgraded (i.e., downgrade risk) or the market can require a higher spread (i.e., credit spread risk), both resulting in a decline in the price of an issue. This will result in a loss of principal if the issue must be sold prior to the maturity date.The request that the bond portfolio have 40% in issues that mature within three years will reduce the interest rate risk of the portfolio. However, it will expose the HPLU to reinvestment risk (assuming the investment horizon for HPLU is greater than three years) since when the bonds mature there is the risk that the proceeds received may have to be reinvested at a lower interest rate than the coupon rate of the maturing issues.17.A. A treasurer of a municipality with a municipal pension fund has required that its in-house portfolio manager invest all funds in the highest investment grade securities that mature in one month or less. The treasurer believes that this is a safe policy. Comment on this investment policy.It is reasonable to assume that the municipality will not need to redeem proceeds from the pension fund to make current payments to beneficiaries. Instead, the investment objective is to have the fund grow in order to meet future payments that must be made to retiring employees. Investing in just high investment grade securities that mature in one month or less exposes the pension fund to substantial reinvestment risk. So, while the fund reduces its interest rate risk by investing in such securities, it increases exposure to reinvestment risk. In the case of a pension fund, it would be expected that it can absorb some level of interest rate risk but would not want to be exposed to substantial reinvestment risk. So, this investment strategy may not make sense for the municipalitys pension fund.B.The same treasurer requires that the in-house portfolio municipalitys operating fund (i.e., fund needed for day-to-day operations of the municipality) follow the same investment policy. Comment on the appropriateness of this investment policy for managing the municipalitys operating fund.The opposite is true for the operating fund. The municipality can be expected to need proceeds on a shorter term basis. It should be less willing to expose the operating fund to interest rate risk but willing to sacrifice investment income (i.e., willing to accept reinvestment risk).

18.In January 1994, General Electric Capital Corporation (GECC) had outstanding $500 million of Reset Notes due March 15, 2018. The reset notes were floating-rate securities. In January 1994, the bonds had an 8% coupon rate for three years that ended March 15, 1997. On January 26, 1994, GECC notified the noteholders that it would redeem the issue on March 15th at par value. This was within the required 30 to 60 day prior notice period. Investors who sought investments with very short-term instruments (e.g., money market investors) bought the notes after GECCs planned redemption announcement. The notes were viewed as short-term because they would be redeemed in six weeks or so. In early February, the Federal Reserve started to boost interest rates and on February 15th, GECC canceled the proposed redemption. Instead, it decided to reset the new interest rate based on the indenture at 108% of the three-year Treasury rate in effect on the tenth day preceding the date of the new interest period of March 15th. The Wall Street Journal reported that the notes dropped from par to 98 ($1,000 to $980 per note) after the cancellation of the proposed redemption.1Why did the price decline?When the proposed redemption was announced, the securities were treated as short-term investments with a maturity of about six weeksfrom the announcement date of January 26th to the redemption date of March 15th. When GECC canceled the proposed redemption issue and set the coupon rate as allowed by the indenture, the price of the issue declined because the new coupon rate was not competitive with market rates for issues with GECCs rating with the same time to the next reset date in three years.19. A British portfolio manager is considering investing in Japanese government bonds denominated in yen. What are the major risks associated with this investment?A major risk is foreign exchange risk. This is the risk that the Japanese yen will depreciate relative to the British pound when a coupon payment or principal repayment is received. There is still the interest rate risk associated with the Japanese government bond that results from a rise in Japanese interest rates. There is reinvestment risk. There is also credit risk, although this risk is minimal. Sovereign risk is also a minimal concern.20. Explain how certain types of event risk can result in downgrade risk.Certain events can impair the ability of an issue or issuer to repay its debt obligations. For example, a corporate takeover that increases the issuers debt can result in a downgrade. Regulatory changes that reduce revenues or increase expenses of a regulated company or a company serving a market that is adversely affected by the regulation will be downgraded if it is viewed by the rating agency that the ability to satisfy obligations has been impaired.21.Comment on the following statement: Sovereign risk is the risk that a foreign government defaults on its obligation.This statement about sovereign risk is incomplete. There are actions that can be taken by a foreign government other than a default that can have an adverse impact on a bonds price. These actions can result in an increase in the credit spread risk or an increase in downgrade risk.22. All else equal, will an increase in expected yield volatility increase the price of a bond with an embedded:call option?put option?A. No No B.NoYes C.YesNoB is correct. An increase in expected yield volatility increases the price of both embedded call and put options. The price of the embedded call option is subtracted from the price of a comparable option-free bond, therefore, the price of the callable bond decreases. In the case of an embedded put option, the price of the embedded option is added to the price of a comparable option- free bond, causing the price of the bond to increase. Whether the value of the option is added to or subtracted from the price of an option-free bond is dependent upon who benefits from the option, the issuer or the holder.An analyst stated that a callable bond has less reinvestment risk and more price appreciation potential than an otherwise identical option-free bond. The analysts statement most likely is:A.incorrect with respect to both reinvestment risk and price appreciation potential.B.incorrect with respect to reinvestment risk, but correct with respect to price appreciation potential.C.correct with respect to reinvestment risk, but incorrect with respect to price appreciation potential.An analyst stated that an amortizing security typically has more reinvestment risk and more interest rate risk than an otherwise identical zero-coupon bond. The analysts statement most likely is:A.correct with respect to both reinvestment risk and interest rate risk. B.incorrect with respect to reinvestment risk, but correct with respect tointerest rate risk.C.correct with respect to reinvestment risk, but incorrect with respect to interest rate risk.An analyst made the following statement: We expect interest rates to be very volatile for the foreseeable future. I think we should buy floating-rate securities because they have less interest rate risk than fixed-rate securities and the price will always reset to par value. Is the analysts statement most likely correct with respect to:relative interest rate risk?price reset?A. No No B.NoYes C.YesNo26.Changes in the slope of the yield curve:A.have little effect on the value of a well-diversified portfolio of bonds.B.highlight the need for risk measures such as rate duration and key rate duration.C.impact the value of floating-rate securities more than they impact the value of fixed-coupon securities.B is correct. Yield curve changes are rarely parallel. Non-parallel shifts in the yield curve affect the various bonds held in a portfolio differently, depending on their coupon rate, time to maturity, embedded options, etc. Therefore, additional risk measures have been developed. Two widely used measures are rate duration, which refers to the duration of a particular maturity (e.g., five- year rate duration), and key rate duration, which is rate duration for the most important (key) rates that impact a portfolio.27.Consider the following statements about credit risk and liquidity risk: Statement 1Investment-grade bonds include bonds rated BBB (by S&P)or Baa (by Moodys) or higher.Statement 2Bonds financed by repurchase agreements have less liquidity risk than bonds held as part of a buy-and-hold strategy.Are the statements most likely correct or incorrect? A.Neither statement is correct. B.Statement 1 is incorrect, but Statement 2 is correct. C.Statement 1 is correct, but Statement 2 is incorrect.28.A bond portfolio manager gathered the following information about a bond issue: Par value Current market value Duration $10,000,000 $9,850,0004.8If yields are expected to decline by 75 basis points, which of the following would provide the most appropriate estimate of the price change for the bond issue?A.3.6% of $9,850,000. B.3.6% of $10,000,000. C.4.8% of $9,850,000.3.A.A floating-rate securitys exposure to interest rate risk is affected by the time to the next reset date. The shorter the time, the less likely the issue will offer a below-market interest rate until the next reset date. So, a daily reset will not expose the investor of this floater to interest rate risk due to this factor. However, there is interest rate risk, which we will see in part B.4.A.While both assistant portfolio managers are correct in that they have identified two features of an issue that will impact interest rate risk, it is the interaction of the two that will affect an issues interest rate risk. From the information provided in the question, it cannot be determined which has the greater interest rate risk.Below par value since the coupon rate is less than the yield required by the market.1.A. B.Below par value since the coupon rate is less than the yield required by themarket.C.Below par value since the coupon rate is less than the yield required by the market.D.Above par value since the coupon rate is greater than the yield required by the market.E.Par value since the coupon rate is equal to the yield required by the market.AA BB CC DD EE514 658 0 578 412IssueCoupon Rate (%)Yield Required by the Market (%)7.25 7.15 6.20 5.00 4.50PriceBelow par Below par Below par Above par Par2.The price of a callable bond can be expressed as follows: Price of callable bond = Price of option-free bond Price of embedded call optionAn increase in interest rates will reduce the price of the option-free bond. However, to partially offset that price decline of the option-free bond, the price of the embedded call option will decrease. This is because as interest rates rise the value of the embedded call option to the issuer is worth less. Since a lower price for the embedded call option is subtracted from the lower price of the option-free bond, the price of the callable bond does not fall as much as that of an option-free bond.B.The reason there is still interest rate risk with a daily reset floating-rate security is that the margin required by the market may change. And, if there is a cap on the floater, there is cap risk.B.You, as the senior portfolio manager, might want to suggest that the two assistant portfolio managers compute the duration of the two issues.5.The information for computing duration: Price if yields decline by 30 basis points = 83.50 Price if yields rise by 30 basis points = 80.75Solutions for Reading 53351Initial price = 82.00Change in yield in decimal = 0.0030 Then,Duration =83.50 80.75= 5.59 2(82.00)(0.0030)6.Since the duration is the approximate percentage price change for a 100 basis point change in interest rates, a bond with a duration of 5 will change by approximately 5% for a 100 basis point change in interest rates. Since the market value of the bond is $8 million, the change in the market value for a 100 basis point change in interest rates is found by multiplying 5% by $8 million. Therefore, the change in market value per 100 basis point change in interest rates is $400,000. To get an estimate of the change in the market value for any other change in interest rates, it is only necessary to scale the change in market value accordingly.A.For 100 basis points = $400,000. B.For 50 basis points = $200,000 (=$400,000/2). C.For 25 basis points = $100,000 ($400,000/4). D.For 10 basis points = $40,000 ($400,000/10).7.To calculate duration, the price must be estimated for an increase and decrease (i.e., a rate shock) of the same number of basis points. A valuation model must be employed to obtain the two prices. With an extremely complex bond issue, the valuation models by different analysts can produce substantially different prices when rates are shocked. This will result in differences in estimates of duration.8.For an individual bond, duration is an estimate of the price sensitivity of a bond to changes in interest rates. A portfolio duration can be estimated from the duration of the individual bond holdings in the portfolio. To use the portfolios duration as an estimate of interest rate risk it is assumed that when interest rates change, the interest rate for all maturities change by the same number of basis points. That is, it does not consider non-parallel changes of the yield curve.9.The approach briefly discussed in this reading for doing so is rate duration. Specifically, the 5-year rate duration indicates the approximate percentage change in the value of the portfolio if the yield on all maturities are unchanged but the yield for the 5-year maturity changes by 100 basis points.10.The first form of reinvestment risk is due to the likelihood the proceeds from the called issue will be reinvested at a lower interest rate. The second form of reinvestment risk is the typical risk faced by an investor when purchasing a bond with a coupon. It is necessary to reinvest all the coupon payments at the computed yield in order to realize the yield at the time the bond is purchased.11.Credit risk includes default risk, credit spread risk, and downgrade risk. While an investor holds a bond in his or her portfolio, if the issuer does not default there is still 1) the risk that credit spreads in the market will increase (credit spread risk) causing the price of the bond to decline and 2) the risk that the issue will be downgraded by the rating agencies causing the price to decline or not perform as well as other issues (downgrade risk).12.A.The probability that a bond rated BBB will be downgraded is equal to the sum of the probabilities of a downgrade to BB, B, CCC or D. From the corresponding cells in the exhibit: 5.70% + 0.70% + 0.16% + 0.20% = 6.76%. Therefore, the probability of a downgrade is 6.76%.B.The probability that a bond rated BBB will go into default is the probability that it will fall into the D rating. From the exhibit we see that the probability is 0.20%.352Reading 53 Risks Associated with Investing in Bonds13.14.15.16.C.The probability that a bond rated BBB will be upgraded is equal to the sum of the probabilities of an upgrade to AAA, AA, or A. From the corresponding cells in the exhibit: 0.04% + 0.30% + 5.20% = 5.54%. Therefore, the probability of an upgrade is 5.54%.D.The probability that a bond rated B will be upgraded to investment grade is the sum of the probabilities that the bond will be rated AAA, AA, A or BBB at the end of the year. (Remember that the first four rating categories are investment grade.) From the exhibit: 0.01% + 0.09% + 0.55% + 0.88% = 1.53%. Therefore, the probability that a bond rated B will be upgraded to investment grade is 1.53%.E.The probability that a bond rated A will be downgraded to noninvestment grade is the sum of the probabilities that the bond will be downgraded to below BBB. From the exhibit: 0.37% + 0.02% + 0.02% + 0.05% = 0.46%, therefore, the probability that a bond rated A will be downgraded to noninvestment grade is 0.46%.F.The probability that a bond rated AAA will not be downgraded is 93.2%.The market bidask spread is the difference between the highest bid price and the lowest ask price. Dealers 3 and 4 have the best bid price (961532). Dealer 2 has the lowest ask price (961732). The market bidask spread is therefore 232.If this managers portfolio is marked-to-market, the manager must be concerned with the bid prices provided to mark the position to market. With only one dealer, there is concern that if this dealer decides to discontinue making a market in this issue, bids must be obtained from a different source. Finally, this manager intends to finance the purchase. The lender of the funds (the dealer financing the purchase) will mark the position to market based on the price it determines and this price will reflect the liquidity risk. Consequently, this manager should be concerned with the liquidity risk even if the manager intends to hold the security to the maturity date.A.The purchase of a 30-year Treasury exposes the investor to interest rate risk since at the end of one year, the security is a 29-year instrument. Its price at the end of one year depends on what happens to interest rates one year later.B.The major difference in risk is with respect to credit risk. Specifically, the AAA issue exposes the investor to credit risk.C.There is reinvestment risk for the 1-year zero-coupon Treasury issue because the principal must be reinvested at the end of one year.D.The major difference is the quantity of credit risk exposure of both issues. The U.S. corporate bond issue has greater credit risk. (Note that the sovereign issue is dollar denominated so that there is no exchange rate risk.)E.The less actively traded issue will have greater liquidity risk.F.There are two differences in risk. First, there is the greater credit risk of investing in Italian government bonds relative to U.S. Treasury bonds. Second, investing in the Italian government bonds denominated in lira exposes a U.S. investor to exchange rate risk.Probably the first thing that Ms. Peters should ask is what the investment objectives are of HPLU. Addressing directly the two statements Mr. Stevens made, consider the first. Mr. Stevens believes that by buying investment grade bonds the portfolio will not be exposed to a loss of principal. However, all bondsinvestment grade and non-investment gradeare exposed to the potential loss of principal if interest rates rise (i.e., interest rate risk) if anSolutions for Reading 5335317.A.B.It is reasonable to assume that the municipality will not need to redeem proceeds from the pension fund to make current payments to beneficiaries. Instead, the investment objective is to have the fund grow in order to meet future payments that must be made to retiring employees. Investing in just high investment grade securities that mature in one month or less exposes the pension fund to substantial reinvestment risk. So, while the fund reduces its interest rate risk by investing in such securities, it increases exposure to reinvestment risk. In the case of a pension fund, it would be expected that it can absorb some level of interest rate risk but would not want to be exposed to substantial reinvestment risk. So, this investment strategy may not make sense for the municipalitys pension fund.The opposite is true for the operating fund. The municipality can be expected to need proceeds on a shorter term basis. It should be less willing to expose the operating fund to interest rate risk but willing to sacrifice investment income (i.e., willing to accept reinvestment risk).issue must be sold prior to its maturity date. If a callable bond is purchased, there can be a loss of principal if the call price is less than the purchase price (i.e., call risk). The issue can also be downgraded (i.e., downgrade risk) or the market can require a higher spread (i.e., credit spread risk), both resulting in a decline in the price of an issue. This will result in a loss of principal if the issue must be sold prior to the maturity date.The request that the bond portfolio have 40% in issues that mature within three years will reduce the interest rate risk of the portfolio. However, it will expose the HPLU to reinvestment risk (assuming the investment horizon for HPLU is greater than three years) since when the bonds mature there is the risk that the proceeds received may have to be reinvested at a lower interest rate than the coupon rate of the maturing issues.18.When the proposed redemption was announced, the securities were treated as short-term investments with a maturity of about six weeksfrom the announcement date of January 26th to the redemption date of March 15th. When GECC canceled the proposed redemption issue and set the coupon rate as allowed by the indenture, the price of the issue declined because the new coupon rate was not competitive with market rates for issues with GECCs rating with the same time to the next reset date in three years.19.A major risk is foreign exchange risk. This is the risk that the Japanese yen will depreciate relative to the British pound when a coupon payment or principal repayment is received. There is still the interest rate risk associated with the Japanese government bond that results from a rise in Japanese interest rates. There is reinvestment risk. There is also credit risk, although this risk is minimal. Sovereign risk is also a minimal concern.20.Certain events can impair the ability of an issue or issuer to repay its debt obligations. For example, a corporate takeover that increases the issuers debt can result in a downgrade. Regulatory changes that reduce revenues or increase expenses of a regulated company or a company serving a market that is adversely affected by the regulation will be downgraded if it is viewed by the rating agency that the ability to satisfy obligations has been impaired.21.This statement about sovereign risk is incomplete. There are actions that can be taken by a foreign government other than a default that can have an adverse impact on a bonds price. These actions can result in an increase in the credit spread risk or an increase in downgrade risk.354Reading 53 Risks Associated with Investing in Bonds22.23.24.25.26.27.28.B is correct. An increase in expected yield volatility increases the price of both embedded call and put options. The price of the embedded call option is subtracted from the price of a comparable option-free bond, therefore, the price of the callable bond decreases. In the case of an embedded put option, the price of the embedded option is added to the price of a comparable option- free bond, causing the price of the bond to increase. Whether the value of the option is added to or subtracted from the price of an option-free bond is dependent upon who benefits from the option, the issuer or the holder.A is correct. Both statements are incorrect. An issuer is more likely to call a bond when rates have declined, thereby increasing the reinvestment risk relative to an option-free bond. Because of the call provision, the callable bond has less price appreciation potential than an identical option-free bond (termed price compression).C is correct. An amortizing security includes payments of both interest and principal that must be reinvested. A zero-coupon bond has no reinvestment risk prior to maturity because no cash flows are received that must be reinvested. Because zero-coupon bonds do not have periodic cash flows, they have the highest interest rate risk for a given maturity and given change in market yields.C is correct. Floating rate securities generally have less interest rate risk than fixed coupon rate securities. Reasons that the security might not reset to par include a change in the required margin that investors demand (spread) or the security may have a cap on the floating interest rate.B is correct. Yield curve changes are rarely parallel. Non-parallel shifts in the yield curve affect the various bonds held in a portfolio differently, depending on their coupon rate, time to maturity, embedded options, etc. Therefore, additional risk measures have been developed. Two widely used measures are rate duration, which refers to the duration of a particular maturity (e.g., five- year rate duration), and key rate duration, which is rate duration for the most important (key) rates that impact a portfolio.C is correct. Statement 1 correctly defines investment-grade bonds. Statement 2 is incorrect because repurchase agreements expose investors to liquidity risk as the collateral used in the repo is marked-to-market periodically.A is correct. A duration of 4.8 means that the approximate percentage price change for a 100 basis point change in yield will be 4.8%. A 75 basis point change would be 4.8(0.75) = 3.6%. The price change would be 3.6% of the market value. (Institute 345-354)Institute, CFA. Level I 2013 Volume 5 Equity and Fixed Income. John Wiley & Sons P&T, 7/3/2012. .