Liquidity Risk of a Bond

CFA Level III Fixed Income
#1

Can someone pls explain me the following:

Q. Which of the following strategies best addresses the liquidity risk of a less frequently traded bond position in an active manager’s portfolio?

  1. Enter into a receive fixed, pay floating asset swap, unwinding the swap position once the illiquid bond position is sold.
  2. Sell single-name CDS protection on the illiquid bond issuer, unwinding the CDS contract when the bond is sold.
  3. Allocate the illiquid bond to the buy-and-hold portion of the investment portfolio.

According to the solution, both 1 and 2 are long risks and 3 is the correct answer.

When they say long risk, does it mean long liquidity risk? and how putting the bond into buy and hold solves the problem of illiquidity?

#2

In this case, yes.

If you don’t plan to sell it, then its illiquidity doesn’t matter.

#3

and why do we say that receiving fixed and pay floating or selling single name CDS is long liquidity risk? This is where I feel I don’t understand by what it means we are long liquidity

#4

I am not sure if my approach is correct but the way I’m reading is that we don’t know if the bond is floating or fixed so we can’t make a call on the whether we should enter into a receiver or payer swap. Plus all you would be doing is hedging against interest rate risk not liquidity risk.

CDS also doesn’t address liquidity risk. It addresses credit risk - and even if it did that to some extent, selling the CDS would mean you are doubling down on your long exposure to the underlying issuer.