Questions 49 through 54 relate to Portfolio Management of Global Bonds.
Durham Case Scenario
Durham is a U.S.-based pension fund. The investment committee is concerned that
deteriorating economic conditions could adversely impact its fixed income portfolio. The
committee is also considering diversifying into international bonds. Peter Groton, the
pension fund’s fixed income manager, and Hugo Albariño, who manages an international
bond fund, have been asked to address these issues.
The investment committee has asked Groton to make a presentation that addresses the
exposure of the fixed income portfolio to interest rate risk and credit risk. Albariño has
been asked to address the potential impact of adding his fund to the fixed income
portfolio.
The portfolio is currently invested in U.S. Treasuries and corporate bonds. Durham
currently has liabilities with a duration of 6.83 years and asset/liability management is an
important consideration. Groton has been asked to make recommendations on how to
best manage these risk exposures. Exhibit 1 contains information about the pension
fund’s fixed income portfolio.
Exhibit 1
Summary Data – Current Fixed Income Portfolio
Sector Market Value
(Millions) Duration Average Yield
U.S. Treasuries $300 8.00 4.52%
U.S. Corporate Bonds $150 6.00 6.59%
Total $450 7.33 5.21%
Groton tells the investment committee that his research indicates the overall level of
interest rates is expected to rise; but he is unsure of the magnitude of the increase.
Groton notes the fixed income portfolio may underperform Durham’s liabilities in this
environment and suggests that the portfolio be hedged against interest rate risk using U.S.
Treasury futures. Groton also states that the effectiveness of a hedge depends on the
accuracy of the calculations of duration, projected basis values and the conversion factor
for the cheapest-to-deliver (CTD) bond.
Groton has identified a U.S. Treasury futures contract with a duration of 6.5 priced at
$110,425. The conversion factor for the CTD bond is 0.9177 and the yield beta is 1.12.
Groton tells the committee that the yield beta captures the relation between the CTD bond
and the futures contract.
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Groton makes the following statements about two positions in the fixed income portfolio:
Statement 1: “I am very concerned that one of our holdings, Primus Homebuilders
Inc. (PHI), is in imminent danger of a downgrade to a BB rating. We
hold 14,000 PHI bonds with a total market value of $15 million and a
face value of $14 million. We can use binary put options to hedge this
risk.
Statement 2: I expect credit spreads on our bond holding of Ventura Corporation
(VC) to widen by 165 basis points. The current spread over Treasuries
for these bonds is 209 basis points. These bonds have a market value of
$20 million and a face value of $18 million. Credit spread forward
contracts can be used to hedge this risk.”
Groton has contacted a credit derivatives dealer and obtained information on the
following derivative products:
• Binary credit put options on PHI bonds are quoted on a per bond basis (with a
strike of $1000), expire in three months, and carry a premium of $34.07.
• Credit spread forward contracts on VC bonds are available with a contracted
spread of 209 basis points, a notional value of $20,000,000, a risk factor of 3, and
expire in three months.
Albariño’s international bond fund invests primarily in the sovereign debt of European
countries. The fund has a duration of 5.2 years, an average yield of 5.7 percent and a
country beta of .57. Groton recommends to the investment committee that 10 percent of
the fixed income portfolio be allocated to Albariño’s fund.
49. Groton’s statement about the effectiveness of a hedge is most likely incorrect with
respect to the:
A. duration.
B. projected basis values.
C. conversion factor for the CTD bond.
50. Is Groton’s explanation of the yield beta most likely correct?
A. Yes.
B. No, because the yield beta captures the relation between the portfolio and the
CTD bond.
C. No, because the yield beta captures the relation between the portfolio and the
futures contract.
51. The approximate number of contracts that Groton needs to appropriately change
the duration of the portfolio is closest to:
A. 288.
B. 314.
C. 351.
52. If Groton’s concern in Statement 1 is realized and the price of PHI bonds is $925
at the end of three months, the payoff to the options is closest to:
A. $476,980.
B. $573,020.
C. $1,050,000.
53. The maximum loss for the appropriate forward strategy used to address the
situation in Statement 2 is closest to:
A. $990,000.
B. $1,128,600.
C. $1,254,000.
54. If Groton’s recommendation to invest in Albariño’s fund is approved, the
contribution to Durham’s portfolio duration is closest to:
A. 0.168.
B. 0.296.
C. 0.520.
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