HOFIS Ch2

Question 1

Describe Interest Rate Risk.

Answer 1

Interest rate risk captures the risk of adverse changes in interest rates.
The two types of interest rate risk are:
1. Level Risk - the exposure to level (i.e. parallel) interest rate changes
Ÿ As interest rates rise, the price of fixed income securities will fall
Ÿ Common measure used: Duration
2. Yield Curve Risk - the exposure of a portfolio to changes in the shape of the yield
curve
Ÿ Common measure used: Key Rate Duration

Question 2

Define bid/ask spread and market bid/ask spread.

Answer 2

Bid/ask spread is the amount by which the ask price exceeds the bid price

The market bid/ask spread is the difference between the best (highest) bid price
and the lowest ask price

Question 3

Describe Liquidity Risk.

Answer 3

Liquidity risk - risk that the investor will have to sell a bond below its “true value”,
where the true value is indicated by a recent transaction

The bid/ask spread is a measure of liquidity risk, and wider bid/ask spreads are
associated with higher liquidity risk

Liquid markets have small bid/ask spreads that do not materially increase for
large transactions

Question 4

State how to compute active return and tracking error volatility

Answer 4

Active return = Portfolio’s actual return - Benchmark’s return

Can calculate the standard deviation of the active return to measure tracking error
risk/volatility