Free CFA Level III: Portfolio Management Liability-Driven & Index-Based Strategies Practice Questions
Liability-driven and index-based fixed income on CFA Level III covers immunization strategies, cash flow matching, contingent immunization, and bond index replication techniques for institutional investors.
Sample Questions
Question 1
Easy
Duration matching in immunization is most analogous to:
Solution
C is correct.
Duration matching is analogous to a balanced seesaw. The liability is at one point (the fulcrum/horizon), and the portfolio's weighted average cash flow timing must balance at the same point. If interest rates change, the asset and liability values change by the same amount (like both sides of a seesaw moving equally), maintaining equilibrium.
Duration matching is analogous to a balanced seesaw. The liability is at one point (the fulcrum/horizon), and the portfolio's weighted average cash flow timing must balance at the same point. If interest rates change, the asset and liability values change by the same amount (like both sides of a seesaw moving equally), maintaining equilibrium.
Question 2
Medium
Measurement risk in immunization refers to the risk that:
Solution
A is correct.
Measurement risk arises when the statistical inputs used for immunization (duration, convexity, present value calculations) are inaccurately estimated. Sources of measurement error include using approximate duration formulas, ignoring optionality in callable bonds, using incorrect yield curve models, or misestimating cash flow timing. These errors can cause the actual immunization to deviate from the intended match.
Measurement risk arises when the statistical inputs used for immunization (duration, convexity, present value calculations) are inaccurately estimated. Sources of measurement error include using approximate duration formulas, ignoring optionality in callable bonds, using incorrect yield curve models, or misestimating cash flow timing. These errors can cause the actual immunization to deviate from the intended match.
Question 3
Hard
Suppose Vasquez acts on the view in Exhibit 3 and sizes the futures overlay to achieve only a 50% hedge ratio (rather than the 75% target). If 10-year yields then rise 25 bps across the liability curve as she expects, the change in the plan's surplus (assets − liabilities) is closest to:
Solution
C is correct. At a 50% hedge ratio the effective asset BPV (physical plus futures) equals 0.50 × $3,600,000 = $1,800,000. For a +25 bp move, the asset side loses $1,800,000 × 25 = $45.0 million, while liabilities fall by $3,600,000 × 25 = $90.0 million. The change in surplus is −$45.0 million − (−$90.0 million) = +$45.0 million.