TO 36 RELATE TO FIXED INCOME PORTFOLIO MANAGEMENT FRANCON...

Questions 31 to 36 relate to Fixed Income Portfolio Management

Franconia Notch Case Scenario

Mark Whitney, CFA, is the chief investment officer of Granite State Partners, a fixed income investment

boutique serving institutional pension funds. Paula Norris, a partner at consulting firm Franconia Notch

Associates, is conducting due diligence of Granite’s capabilities. At a meeting, they go over a

presentation Whitney has prepared.

The first page of the presentation addresses Granite’s investment style for managing portfolios. It states:

“Granite adjusts the portfolio’s duration slightly from the benchmark, and attempts to increase relative

return by tilting the portfolios in terms of sector weights, varying the quality of issues, and anticipating

changes in term structure. The mismatches are expected to provide additional returns to cover

administrative and management costs.”

Norris asks Whitney about Granite’s ability to successfully reflect, in its portfolios, its views on the

market and the direction of interest rates. Whitney makes the following statements:

Statement 1: “Granite uses effective duration to measure the sensitivity of the portfolio’s price to a

relatively small parallel shift in interest rates. For large parallel changes in interest rates,

we make a convexity adjustment to improve the accuracy of the estimated price

change. We believe that parallel shifts in the yield curve are relatively rare; therefore,

duration by itself is inadequate to capture the full effect of changes in interest rates.”

Statement 2: “We address yield curve risk by using key rate durations. When using this method, we

stress the spot rates for all points along the yield curve simultaneously. By changing the

spot rates across maturities, we are able to measure a portfolio’s sensitivity to those

changes.”

Statement 3: “We also measure spread duration contribution. This analysis is not related to interest

rate risk. This measure describes how securities such as corporate bonds or mortgages

will change in price as a result of the widening or narrowing of the spread to

Treasuries.”

Norris provides information on three clients he might refer to Whitney for portfolio management

services and asks him to design a dedication strategy for each. Whitney makes the following

recommendations:

Client 1: “This bank has sold a five-year guaranteed investment contract that guarantees an

interest rate of 5.00% per year. I would purchase a bond with a target yield of 5.00%

maturing in five years. Regardless of the direction of rates, the guaranteed value is

achieved.”

Client 2: The defined benefit pension plan for this client has an economic surplus of zero. In order

to meet the liabilities for this plan, I will construct the portfolio duration to be equal that

of the liabilities. In addition, I will have the portfolio payments be less dispersed in time

than the liabilities.

Client 3: This client’s long-term medical benefits plan has known outflows over 10 years. Because

perfect matching is not possible, I propose a minimum immunization risk approach,

which is superior to the sophisticated linear program model used in the current cash

flow matching strategy.

Norris asks Whitney what steps he takes to takes to reestablish the dollar duration of a portfolio to the

desired level in an asset–liability matching (ALM) application. Whitney responds: “First, I calculate a new

dollar duration for the portfolio after moving forward in time and shifting the yield curve. Second, I

calculate the rebalancing ratio by dividing the original dollar duration by the new dollar duration and

subtracting 1 to get a percentage change. Third, I multiply the new market value of the portfolio by the

desired percentage change from step two”.

Norris then asks Whitney, “What sectors are you currently recommending for client portfolios”?

Whitney responds: “I recommend investing 25% of the portfolio in mortgage-backed securities because

they are trading at attractive valuations. I will not, however, buy floating-rate securities because these

do not hedge liabilities appropriately.”

Norris asks how changing market conditions lead to secondary market trading in Granite’s client

portfolios. Whitney responds: “Our research teams run models to assess relative value across fixed

income sectors which, combined with our economic outlook, leads to trade ideas. For example,

currently our macroeconomic team is concerned about the situations in several sovereign nations and

the spillover effect to capital markets. These issues range from geopolitical risks that will likely increase

the price of oil to outright sovereign defaults or restructuring.”

31. The style of investing described in Whitney’s presentation is most likely:

A. a full replication approach.

B. enhanced indexing by small risk factor mismatches.

C. active management by larger risk factor mismatches.

32. Which of Whitney’s Statements with regard to implementing its market and interest rate views

is least likely correct?

A. Statement 1

B. Statement 2

C. Statement 3

33. Which of the following statements regarding Whitney’s recommendations for Norris’ three

clients is most likely correct?

A. Client 1 will achieve the guaranteed value only if the term structure of interest rates is

downward sloping.

B. Client 2 will meet the necessary conditions for a multiple-liability immunization in the case

of a non-parallel rate shift.

C. Client 3 will require less money to fund liabilities because a less conservative rate of return

can be assumed for short-term balances.

34. Is Whitney’s approach to rebalancing a portfolio using dollar duration most likely correct?

A. Yes.

B. No, there is no need to move forward in time

C. No, the steps do not provide the amount of cash needed for rebalancing

35. The two risks that Whitney’s is most likely exposed to given his recommendations on sectors

are:

A. interest rate risk and cap risk.

B. contingent claim risk and cap risk.

C. interest rate risk and contingent claim risk.

36. Whitney’s secondary trading rationale is best described as:

A. structure trades.

B. credit-defense trades.

C. sector-rotation trades.