Free CFA Level III: Portfolio Management Credit Strategies Practice Questions

A is correct.

Bottom-up credit analysis focuses on individual issuers: analyzing financial statements, business fundamentals, competitive position, and management quality to assess creditworthiness. The analyst then identifies bonds that are attractively priced relative to their credit risk, seeking to buy undervalued credit and avoid overvalued credit.

C is correct.

Sector rotation in credit is a top-down strategy that adjusts the portfolio's allocation across different credit sectors (e.g., financials, industrials, utilities, consumer) based on relative value analysis and economic outlook. For example, overweighting financials when the banking sector is expected to benefit from rising interest rates, or overweighting utilities when seeking defensive positioning.

A is correct. Ferrer expects spreads to widen, so she must shorten credit exposure. Buying protection on a CDS index is economically short credit: it gains value as spreads widen and therefore contributes negative spread duration to the portfolio. Selling protection would do the opposite.

The required reduction is $4.25 - 3.90 = 0.35$ years. Ferrer's stated sizing convention is that the notional as a fraction of the $850 million portfolio, multiplied by the index spread duration of 4.60, delivers the change in portfolio spread duration:

$$\frac{N}{\$850{,}000{,}000} \times 4.60 = 0.35$$

$$N = \frac{0.35}{4.60} \times \$850{,}000{,}000 = 0.0761 \times \$850{,}000{,}000 \approx \$64.7 \text{ million}$$

Roughly $65 million of bought protection therefore achieves the target while leaving every cash bond weight, and thus the analysts' issuer selection, untouched. The residual exposure Ferrer accepts is basis risk: the index spread and the portfolio's own spreads need not move one for one.