THROUGH 42 RELATE TO FIXED INCOME CHAT AND DINE (C&D)...

Questions 37 through 42 relate to Fixed Income Chat and Dine (C&D) Case Scenario Brenda Cross is part of the portfolio management team that manages the investment portfolio of Chat and Dine (C&D), a food chain with fourteen branches within New York, USA. C&D started off as a bakery around five years ago but has now diversified its business by incorporating coffee houses and restaurants as a part of their chain. Owing to an enhanced variety of products, C&D has incorporated the latest technologies to augment the effectiveness of their supply chain and reduce the transit time of perishable items. It has, thus, taken on a series of debt obligations to cover its technological investments. Cross has been advised to manage the firm’s investment portfolio in accordance with the firm’s debt portfolio which consists of cash outflows at regular intervals for a period of 15 years. While talking to Brown Smith, C&D’s CEO, about the appropriate investment strategy, Cross suggests two approaches: Fund A: “A portfolio that has a duration that equals the duration of the debt portfolio. The matching would be achieved by using Treasury zeros, each maturing at the dates of respective cash outflows. At the current interest rate of 7.5%, the present value of the investment portfolio will slightly exceed that of the debt portfolio. “ Fund B: “A portfolio consisting of interest rate futures and bonds that mature at dates that precisely match the dates of the future liability payouts. Cash inflows precisely equal cash outflows.” The firm’s CEO seems more comfortable with Fund B’s investment mandate and instructs Cross to structure the investment portfolio accordingly. In doing so, Cross shortlists three bonds to include in the fund. The characteristics of the bonds are given in Exhibit 1. Exhibit 1: Bond Characteristics Bond A Bond B Bond C Issue Size $35 million $40 million $50 million Time to Maturity 7 years 8 years 11 years Credit Rating AA AAA BBB Time since issuance New issue 3 months 6 months Issuer’s issuing frequency Moderate Moderate Frequent Short-term capital gains tax(< 2 years) 33% 25% 30% Long-term capital gains tax (>2 years) 21% 17% 19% Total Issuance Outstanding $1.20 billion $1.75 billion $0.89 billion The bond selected would be used to cover liabilities that would be due in five quarters from now. Smith states that liquidity is of a prime concern. C&D owns commercial real estate that it does not use in the normal course of its business. While talking to Cross about it, Smith expresses the desire to invest the locked up real estate value in a fixed-income fund. Since the focus is to enhance returns, Cross recommends using leverage to invest part of the value in fixed-income securities. She suggests investing $15 million for five years in a bond portfolio worth $22 million. Cross believes that this investment would earn them a return premium of 9.5%. A loan, taken for five years, costs 11.5% before taxes, and the risk-free rate equals 5.5%. Smith is not sure if this investment would add to the returns especially because of the additional risk added by the loan. He is also unsure whether taking a loan would be the most suitable approach. This is because he anticipates interest rates to decrease by 2-4% in the coming years and by 90 bps in the coming month. Cross states that, to take advantage of the rate decrease, the firm could invest $2 million in a corporate bond using a repurchase agreement. C&D would have to buy back the position in 1 day at a price of $2.0836 million and keep collateral worth $2.0257 million with the lender. Smith is still contemplating whether the profit on the short sale warrants the costs incurred. 37. With regards to the immunization of the single liability, which of the following is most accurate about the risks involved in the two strategies? A. Fund A has no reinvestment risk but price risk is present. B. Fund B has no price but reinvestment risk is present. C. Neither fund has either price risk or reinvestment risk. 38. Which of the following about the effectiveness of the immunization strategy of the funds is most accurate? A. Unlike Fund B, Fund A would only work in case of parallel yield curve shifts. B. Unlike Fund A, Fund B would only work in case of parallel yield curve C. Both funds would work regardless of the type of yield curve change. 39. Using only the information given in Exhibit 1, which of the following bonds should Cross add to the fund? A. Bond A. B. Bond B. C. Bond C. 40. How much value is Cross’s suggestion to use leverage to invest in the bond portfolio likely to add in percentage terms? A. 1.63%. B. -0.93%. C. 1.03%. 41. Based on Smith’s expectations of interest rate movements, the least appropriate way of adding leverage to the fixed-income portfolio would be to: A. be the fixed-rate receiver in a swap agreement. B. Go long an inverse floater. C. Go long interest rate futures. 42. The size of the credit protection in the repurchase agreement is closest to: A. 1.284%. B. 2.209%. C. 4.178%.