Question

A long-term investor who searches for protection against rising consumer prices would most likely purchase a:

		a. U.S. Treasury bond
		b. Mortgage-backed security
		c. U.S. Treasury inflation protection security
		d. Equity shares in a financial institutio

Uncle Robbie, who does not have a margin account, bought a Treasury bond on the secondary market that has 10 years until maturity and a 2% coupon payment, paid semi-annually. Which of the following risks is he subject to?

		a. Financial risk
		b. Exchange rate risk
		c. Default risk
		d. Reinvestment rate risk

A commercial bank owns a portfolio of fixed income securities with a market value of $810 million. The bank is concerned about a spike in inflation during the coming month, citing a potential energy shortage. A surge in oil and natural gas price would place significant downward pressure on the value of the portfolio. The risk management tool most likely to help the bank is:

		a. Beta
		b. Standard deviation
		c. Value at risk
		d. Correlation coefficient

Answer 1

Q1: if the investor is worried about the increasing consumer prices, he needs a protection against inflation. All the other options of bonds give fixed interest and therefore don't hedge against inflation but U.S. Treasury inflation protection security adjusts the par value for inflation for each coupon payment and then calculates the payment on the adjusted par value thereby protecting the investor for the increase in inflation. Equity investment doesn't give a fixed return and it may or may not give ample return to cover inflation. Therefore it is not used as a hedging instrument for inflation explicitly. So c is the correct option

Q2: As the investment is in treasury security, which is backed by the full faith of US government, it is supposed to be default risk free instrument so option c is ruled out. As the investor is not investing in any foreign currency, he is not exposed to exchange rate risk, therefore option b is also ruled out. Financial risk encompasses several risk and can't be defined in any particular manner therefore this option is also ruled out. However, as the investor is unaware of what the interest rates will be at the time of maturity of the instrument, he is exposed to reinvestment risk because maybe at the time of maturity, the interest rate is lower than his current rate making him invest at a lower rate. so option D is correct

Q3. Beta, Standard deviation, Value at risk are all isolated measures. These wont tell us how will a surge in energy prices impact the bond portfolio. They will only be used to analyse the riskiness of portfolio or energy stock in comparison to other related securities. But correlation coefficient of the portfolio to the energy prices is a metric which clearly tells the impact of change in energy prices on the portfolio value so option D is the correct answer