Sample Question 3 for Collection

Gobeil’s Collection of 1,000 Questions™

Sample Question 3

Esther is in her late 50s and plans to retire in a few years. She has accumulated a
substantial amount of capital. She has invested most of her money in medium to longterm
government bonds. You have concluded that a passive investment strategy is most
suited to Esther's investment needs.

Which of the following are passive investment strategies?

1. A matching strategy
2. Bond swapping
3. Riding the yield curve
4. Immunization

(A) 1 and 2
(B) 1 and 4
(C) 2 and 3
(D) 3 and 4

(Concepts) A passive investment strategy is a strategy of holding securities for a
relatively long period with a minimum of changes made in the portfolio's composition.
Passive bond strategies include the ladder approach, the barbell approach, immunization,
and purchasing strip bonds that will be held until maturity. This type of strategy is
geared towards the conservative investor. In contrast, an active investment strategy
involves frequent trading of the portfolio's securities in an effort to earn a superior
return.

A matching strategy is a strategy of matching the term to maturity of the selected bonds
to the investor's need for future income. For example, if the investor believes that he
would need a lump-sum of $20,000 to purchase a new car in 5 years, he would purchase
a bond with a face value of $20,000 and term to maturity of 5 years.
Bond swapping is a strategy of switching from one bond to another to take advantage of
changing yield curves. Because interest rates can be volatile in the short run, an investor
pursuing a bond swapping strategy is prepared to make frequent trades in his bond
portfolio.

The strategy of riding the yield curve is an active bond strategy that involves buying a
long-term bond, holding it for a year, selling it at a premium and then using the proceeds
to purchase another long-term bond and repeating the process. To be successful, the
yield curve must be positively sloped and remain constant.

A bond's duration is a measure of the average time it takes for the bondholder to receive
the present value of the interest and principal payments. An immunization strategy is a
strategy to reduce gains and losses resulting from interest rate changes. It involves
matching a bond's duration to the bondholder's holding period, instead of matching it
with the term to maturity. According to this strategy, regardless of the changes in interest
rates, the cash or wealth received by the bondholder at the end of the duration period will
remain constant.

An interest rate risk is a risk that arises from an increase in interest rates. When interest
rates rise, bond prices fall. Fixed-rate investments, such as term deposits, lock-in a set
interest rate and the investor is protected from interest rate risk. Long-term marketable
bonds carry a high level of interest rate risk.

A reinvestment risk is a risk that arises from a decrease in interest rates when payments
of interest and principal need to be reinvested. A decrease in interest rates may leave the
investor with a lower return than had been anticipated when the investment was first
purchased.

To successfully implement an immunization strategy, an investor must hold the bond for
its duration and reinvest the coupon payments. A bond immunization strategy is
designed to minimize interest rate risk and reinvestment rate risk.

Answer is (B). (Statement 1 is true.) A matching strategy involves matching the term to
maturity of the selected bonds to the investor's need for future income.

So, a matching strategy is a passive investment strategy.

(Statement 2 is false.) Bond swapping involves switching from one bond to another to
take advantage of changing yield curves. Because interest rates can be volatile in the
short run, an investor pursuing a bond swapping strategy is prepared to make frequent
trades in his bond portfolio.

So, bond swapping is not a passive investment strategy.

(Statement 3 is false.) Riding the yield curve is an active bond strategy that involves
buying a long-term bond, holding it for a year, selling it at a premium and then using the
proceeds to purchase another long-term bond and repeating the process. To be
successful, the yield curve must be positively sloped and remain constant.

So, riding the yield curve is not a passive investment strategy.

(Statement 4 is true.) To successfully implement an immunization strategy, an investor
must hold the bond for its duration and reinvest the coupon payments.

So, immunization is a passive investment strategy.