THE FORWARD CONTRACTS USED TO HEDGE POSITIONS IN THE EMO FUND A...

24. The forward contracts used to hedge positions in the EMO fund are most likely to exhibit roll

yield that is:

A. negative.

B. positive.

Portfolio Management—Fixed Income

Question 5

Use the following information to answer the next six questions.

Jethro Mullins is a college graduate who has recently joined the graduate trainee scheme of a large

buy-side multi-asset investment manager. The scheme will involve Mullins spending time in all of the

major divisions of the firm, the first of which is the fixed-income division.

Mullins initially works alongside Ryusaki Tsurayaki, a bond fund manager who specializes in dedication

strategies designed to ensure that portfolios meet the future liabilities of investors. One of the manager’s

clients is Ali Gug, a high net worth individual who is aiming to meet a personal liability due in 10 years’

time, the present value of which is equal to $2,951,100.

The current Gug portfolio consists of three bonds, details of which are displayed in Exhibit 1. Each

holding is of size $1 million par value.

Exhibit 1

Gug Fixed-Income Portfolio

Security

Price

Macaulay Duration

Modified Duration

Bond 1

102.36

3.7

3.6

Bond 2

97.61

9.9

9.7

Bond 3

95.14

16.9

16.6

Tsurayaki also runs a portfolio for a client called Haydee Yesenia. This portfolio is engaged in a

dedication strategy known as contingent immunization. Details of the strategy are given in Exhibit 2:

Exhibit 2

Yesenia Contingent Immunization Strategy

Current portfolio value

$30 million

Portfolio modified duration

5.5

Liability to be paid in 8 years

$40 million

Effective annual discount rate applied to liabilities

5%

Tsurayaki demonstrates to Mullins how a derivatives overlay could be used to close the current duration

gap on the portfolio run for Yesenia. He collates information on a relevant futures contract, which is

displayed in Exhibit 3:

Exhibit 3

Futures Contract Information

Notional principal

$100,000

Coupon

6%

Range of maturities of deliverable bonds

8 years to 12 years

Basis point value (BVP) for one futures contract

$76.22

Mullins is very keen to find out as much as he can about fixed-income investing, and asks Tsurayaki

many questions about the different strategies he employs. During the course of the conversation,

Tsurayaki makes the following two statements:

Statement 1: “Immunizing a single liability is easy—once you have done it you can sit back and relax.

Even if interest rates do change, you can be sure that you will meet your liability when it comes due.”

Statement 2: “Duration matching only immunizes against a parallel shift in the yield curve. Any

change in the shape of the yield curve would lead to the immunization failing and would cause assets to

underperform the liability they are designed to meet.”

Tsurayaki explains to Mullins that he expects interest rates to fall in the near future and wants to make a

bond trade to profit from this view. Tsurayaki is looking to purchase a 15-year Treasury bond currently

priced at 112.01. He expects that in 1 year’s time the yield of the bond will have fallen to 2% and he

will exit the position. He assumes that reinvestment income will be zero and that the expected price

of the bond in 1 year’s time if yield curves remain the same will be 111.50. Tsurayaki asks Mullins to

decompose the total return expected on the trade.