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WIFE Week in Financial Education (2021-05-10)

David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
Welcome to the latest week in financial education (WIFE)! As the May exams have started, we experienced another busy week. We are grateful for some fabulous contributions by members (see links below). At this time of year, many candidates are naturally focused on practice question revision, not just from our database but also other sources like GARP's Practice Exams. This always elicits informative feedback on the issue of question quality. We are constantly reminded that Imprecise or poorly worded questions prove to be debatable (or at least confusing) when they are stress tested. In the worst case, a flawed question can actually reinforce a mental mistake. GARP's question about a repo transaction (link below) is a fine example. This is a question that GARP had already revised twice in 2016-17 due to imprecisions but even their updated version could be improved. My strong belief is that a good question should not make the candidate struggle to interpret any input assumption (e.g., is the given bond price a quote price or an invoice price?); given limited time, it is hard enough to perform the calculation required by the question.

I hope you like this week's new practice questions. The new correlations (Chapter 12) set should give you good coverage on some useful techniques: The Jarque-Bera test of normality, the power law for heavy-tail distributions, and a low-difficulty quiz asking you to find rank (Spearman's and Kendall's tau) correlations. The latter (rank correlations) is also a concept in Topic 5 (Part 2, Market Risk) where we had the pleasure of contributing an edit to FRM author Gunter Meissner's book (see https://trtl.bz/2rseaBT for details). If you happen to be a visual thinker like me, here is how I handle concordant/discordant pairs, it's simple: concordant pairs lie in the first (I) or third (III) quadrant https://trtl.bz/3y76ans. About the portfolio construction question set, I calibrated them as approachable; as we've often observed, the weakness of this reading assignment (Grinold Chapter 14) is the lack of scaffolding: the material presumes you've read prior chapters in the book. Have a good study week!

New Practice Question Sets
In the Forum
Curated Links
 
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David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
Thank you @Jagan.Ganti for the insight! For others who might be interested, Jagan noticed that our question 905.2 asked for a spread to the given spot rate term structure, yet Tuckman defines a spread to forward rates. You (Jagan) asked whether there is a difference. See below.

Inputs in yellow, XLS is here. The given spot rate term structure (TS) is up steep with round numbers: {1.0% @ 0.5 year, 2.0% @ 1.0 year, 3.0% @ 1.5 years, and 4.0% @ 2.0 years}. This would price a 2-year 4.0% s.a. coupon bond at $100.0955 (in blue) regardless of whether we discounted with spots or discounted with the implied forward rate curve: 1.0%, 3.005%, 5.015%, 7.030%}. The spot-discounted bond price must of course match the forward-discounted bond price if the implied forward rates are correctly computed. That's basic bond stuff so far.

My question 905.2 asks for the spread given a traded (aka, observed) bond price of $95.12 (first green cell) and my answer is 2.70% because that's the constant spread added to the spot rate term structure that discounts to this lower price. A spread shifts the term structure to fit an observed price. But if we apply the exact same spread to the forward rate TS and discount those forward rates, we get a very slightly lower price ($95.1197 versus $95.1200). Put another way, the exact, correct spread added to forwards is slightly less than the exact, correct spread added to spots. The difference in spreads (which is not displayed below) is only 0.00015% or just 0.0150 basis points. A true approximation but not an exact match! (There is some rounding in the displayed numbers, so please look at the XLS if you really want fine clarification).

 
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