30 RELATE TO FIXED INCOME DERIVATIVES. TODD BERMUDEZ IS A...

Questions 25-30 relate to Fixed Income Derivatives.

Todd Bermudez is a senior client advisor at PWB, a U.S.-based investment management

firm. Bermudez has extensive experience with the use of derivative overlays as a cost-

efficient tool for the tailoring of risk exposures.

Bermudez has been asked by one of his colleagues to manage the pension plan of SII, one of

their largest clients. Based on PWB's outlook, Bermudez plans to use a derivatives overlay to

make a temporary reallocation of the plan's assets. Exhibit 1 shows the desired target and

current portfolio exposures. Exhibit 2 shows the necessary futures contract data to make the

changes.

Exhibit 1: SII Pension Plan Portfolio-Equity and Fixed-Income Exposures

Target Current (August 15)

Asset

Modified

Class

Duration Beta Allocation (USD

millions)

Equity n/a 1.14 450 n/a 0.95 390

Fixed

income 8.5 n/a 250 6.5 n/a 310

Exhibit 2: Futures Contracts as of August 15

Treasury Bond Futures S&P 500 Index Futures

Quoted price 154,250 Quoted price 2,423

Modified duration 8.2 Modified duration 250

Maturity (months) 4 Beta 1.03

Each contract is 100,000 par Maturity (months) 4

Immediately before making the trades, PWB's economics team dramatically revises its

outlook. Based on the new outlook, Bermudez:

Sells 62 S&P futures contracts at 2,423.

Buys 220 bond futures contracts at 154,250.

A few days later, there is a dramatic 70 basis point decline in interest rates and the bonds in

the portfolio have increased in value to USD323.90 million. The bond contract has also

increased in value as shown in Exhibit 3. Bermudez is familiar with calculating ex-post

(effective) beta for the equity portion of the portfolio and plans to do something similar to

determine his effective duration. To do so he will use the old standby: %Δ in value = -D Δy.

Exhibit 3: Treasury Bond Futures

Quoted price $162,398

Modified duration 8.03

Maturity (months) 2

Some time later on 14 October, SII makes a cash contribution of $280 million to the plan.

Bermudez is highly optimistic regarding the short-term prospects for U.S. equities, but is

unclear which stocks to buy. Instead, he decides to make a $280 million synthetic equity

investment using the contract data in Exhibit 4.

Exhibit 4: S&P Index Futures

Quoted price 2,392 Risk-free rate 1.02%

Multiplier 250 Index dividend yield 5.1%

Beta 1.06

Bermudez also has a U.S. client with a holding of U.K. stocks worth GBP2.57 million.

Bermudez assembles the data in Exhibit 5.

Exhibit 5: UK Stocks and Market Data

Beta of U.K. stocks 0.93

Spot USD/GBP exchange rate $1.27

Short-term interest rates United States: 3.58%

United Kingdom: 2.32%

9-month futures contract on the U.K. equity market Price: GBP74,600

Beta: 0.97

All interest rates are annualized.

The same U.S. client also own a USD-denominated callable corporate bond issued by

Etherweb Communications (EC). Bermudez is now expecting a significant fall in U.S.

interest rates and is interested in ways to offset the call risk embedded in the EC bond.

...

To achieve the target equity allocation and beta shown in Exhibit 1, Bermudez would:

A) purchase 48 contracts.

B) purchase 137 contracts.

C) purchase 228 contracts.

Question #26 of 60

Assume that Bermudez wants to achieve the target bond allocation and duration shown in

Exhibit 1 and he has correctly calculated that he needs 308 contracts for the desired bond

allocation and 395 contracts for the desired duration changes. The transaction he will require

is to:

A) purchase 87 contracts.

B) sell 308 contracts.

C) purchase 617 contracts.

Question #27 of 60

Using the data in Exhibit 1 and based on the 70 basis point decrease in interest rates, the ex-

post effective duration for the bond portion of the portfolio is closest to:

A) 8.50.

B) 7.25.

C) 6.50.

Question #28 of 60

The number of futures contracts to purchase for the two-month synthetic equity position is:

A) 468.

B) 469.

C) 472.

Question #29 of 60

If Bermudez hedges the foreign market and foreign currency risk of his U.S. client's U.K.

stock position, the expected USD value at the end of the nine-month hedging period

is closest to:

A) USD3.264 million.

B) USD3.294 million.

C) USD3.352 million.

Question #30 of 60

Bermudez can effectively remove the economic effects of the call feature in the EC bond by:

A) selling a receiver swaption.

B) buying calls on bond futures contracts.

C) entering a receive fixed swap.

Question #31 of 60