AIP Investment Products & Financial Instruments 5 — Questions and Answers
Question 1: A total return swap (TRS) allows one party to receive the total economic return of a reference asset while paying a floating rate. Which investor would MOST likely use a TRS to gain exposure to a bond without owning it?
- A pension fund seeking to immunize its liabilities
- A hedge fund seeking leveraged exposure to a high-yield bond index without purchasing the bonds (Correct answer)
- A corporation hedging its foreign exchange receivables
- An insurance company seeking to reduce credit risk on existing bond holdings
Correct answer: A hedge fund seeking leveraged exposure to a high-yield bond index without purchasing the bonds
Total return swaps allow hedge funds to gain leveraged economic exposure to an asset's total return (income + price change) without owning it, making them efficient for accessing hard-to-obtain bonds or adding leverage.
Question 2: Which of the following describes a key difference between a traditional mutual fund and a separately managed account (SMA)?
- SMAs pool investor assets together to achieve economies of scale
- In an SMA, the investor directly owns the individual securities, enabling tax-loss harvesting and customization (Correct answer)
- Mutual funds allow direct security ownership, while SMAs hold pooled shares
- SMAs are only available for bond strategies, not equity strategies
Correct answer: In an SMA, the investor directly owns the individual securities, enabling tax-loss harvesting and customization
In an SMA, the investor holds individual securities directly in their own account, allowing for personalized tax management (e.g., tax-loss harvesting) and customization not available in pooled mutual funds.
Question 3: A convertible bond's conversion premium is calculated as:
- The bond's coupon rate minus the stock's dividend yield
- The percentage by which the bond's market price exceeds its conversion value (parity) (Correct answer)
- The difference between the bond's par value and its current market price
- The number of shares received upon conversion multiplied by the stock price
Correct answer: The percentage by which the bond's market price exceeds its conversion value (parity)
The conversion premium represents how much more investors pay for the convertible bond relative to its immediate conversion value, reflecting the value of optionality and the bond floor protection.
Question 4: Under the Investment Company Act of 1940, a mutual fund classified as 'diversified' must meet the '75-5-10' rule. Which statement correctly describes this rule?
- At least 75% of assets must be in cash and government securities
- At least 75% of assets must be invested such that no single issuer exceeds 5% of total assets and represents no more than 10% of the issuer's outstanding voting securities (Correct answer)
- The fund must hold at least 75 different securities with no sector exceeding 10%
- No more than 5% of assets can be in any single security, with a 10% cash reserve requirement
Correct answer: At least 75% of assets must be invested such that no single issuer exceeds 5% of total assets and represents no more than 10% of the issuer's outstanding voting securities
The 75-5-10 diversification rule requires that 75% of assets be diversified such that no single position exceeds 5% of total assets and no more than 10% of any issuer's voting shares are held.
Question 5: An investor seeking income with tax advantages in a high tax bracket would MOST likely prefer which fixed-income instrument?
- Corporate high-yield bonds rated BB
- U.S. Treasury bonds exempt from state and local taxes
- Municipal bonds, whose interest is generally exempt from federal income tax (Correct answer)
- Agency mortgage-backed securities backed by Fannie Mae
Correct answer: Municipal bonds, whose interest is generally exempt from federal income tax
Municipal bond interest is generally exempt from federal income tax (and often state/local taxes for in-state bonds), making them particularly attractive to high-bracket investors whose after-tax yield advantage is greatest.
Question 6: What is the primary function of the Options Clearing Corporation (OCC) in the U.S. options market?
- To set strike prices and expiration dates for all listed options contracts
- To act as the central counterparty guaranteeing all listed options contracts, eliminating counterparty risk for buyers and sellers (Correct answer)
- To regulate options dealers and enforce position limits
- To provide price discovery for over-the-counter options transactions
Correct answer: To act as the central counterparty guaranteeing all listed options contracts, eliminating counterparty risk for buyers and sellers
The OCC serves as the central counterparty and guarantor for all listed U.S. options contracts — becoming the buyer to every seller and seller to every buyer — eliminating individual counterparty risk.
Question 7: A 'barbell' bond portfolio strategy involves holding:
- Only intermediate-term bonds to balance income and price stability
- Bonds concentrated at both short and long maturities, with little in intermediate maturities (Correct answer)
- Only investment-grade bonds at the highest and lowest credit ratings
- Equal weights across all maturity buckets from 1 to 30 years
Correct answer: Bonds concentrated at both short and long maturities, with little in intermediate maturities
A barbell strategy concentrates holdings at the short and long ends of the yield curve, combining the liquidity of short-term bonds with the higher yields of long-term bonds, while avoiding intermediate maturities.
AIP Investment Products & Financial Instruments 5
A total return swap (TRS) allows one party to receive the total economic return of a reference asset while paying a floating rate.
Which investor would MOST likely use a TRS to gain exposure to a bond without owning it?