6.) The decision to add variables to the oil-related industry analysis will most likely lead to
a(n):
A. regime-switching bias.
B. data-mining bias.
C. appraisal bias.
Rioja
Andres Rioja is the treasurer of Empresas Crianza. His duties have recently been expanded to
include oversight of the firm’s pension fund. Given his limited experience in overseeing
investments, he is relying on an outside consultant. Rioja prepares a number of questions for his
first meeting with the consultant, Manolo Priorat of Consulta Jerez.
Priorat starts the meeting by summarizing for Rioja the status of the defined benefit pension
plan and makes the following statement:
The pension liability has a duration of 14 years and a present value of $4 billion. The
liabilities are discounted using the spot rate on high-quality long-term corporate bonds.
Presently, the asset portfolio covers 87.5% of these liabilities and is invested entirely in
fixed-income assets. The plan assets have fallen short of the pension liabilities over the
past five years because their durations are not properly matched. I am concerned that
Crianza has selected the wrong benchmark for the pension plan. The current benchmark
is a weighted average of the benchmarks for the various strategies used in the
investment of pension assets. I believe the appropriate benchmark should be the
liability itself.
Priorat and Rioja review the fixed-income funds in which the pension assets are currently
invested. Portfolio managers have been given the mandate to meet or exceed their respective
benchmarks based on their investment styles. Details of the various portfolios are provided in
Exhibit 1.
Exhibit 1: Portfolio Information
Asset Value
Portfolio Duration
Benchmark Investment Style
(years)
($ thousands)
Money market 0.25 175,000 3-Month US T-
Bill Active management
Mortgage-backed
securities fund 3 700,000 Barclays
Mortgage Enhanced indexing
Emerging market bond
fund 4.6 675,000 JP Morgan
EMBI Active management
Long corporate bond
fund 14 1,575,000 Barclays Long
Corporate Active management
Treasury bond STRIPs 24 375,000 Barclays
20+Year STRIP Pure bond indexing
Rioja updates Priorat on Crianza’s current plans for the pension plan. Rioja states: “Crianza will
make a $500 million contribution to fully fund the plan and invest the funds in Treasury STRIPs.
In addition, we would like to completely reallocate pension investments away from the fund
that presents the greatest contingent claim risk and into the long corporate bond fund.”
Rioja then asks Priorat, “I would like to understand the risk profile of each index benchmark we
have assigned to the portfolio managers. What measures are available to do this?” Priorat
responds,
There are several key measures that come to mind. Effective duration measures the
sensitivity of the index’s price to a relatively small parallel shift in interest rates. For
large non-parallel changes in interest rates, a convexity adjustment is used to improve
the accuracy of the index’s estimated price change. Key rate duration measures the
effect of shifts in key points along the yield curve. Key rate durations are particularly
useful for determining the relative attractiveness of various portfolio strategies, such as
bullet strategies versus barbell strategies. Spread duration describes how a non-
Treasury security’s price will change as a result of the widening or narrowing of the
spread contribution.
Rioja then asks about the rationale for active managers to do secondary market trades. Priorat
Secondary market trades should be evaluated in a total return framework. The
exception is the yield or spread pickup trade, which should be evaluated in the context
of additional yield. Credit-upside trades provide an opportunity for managers to
capitalize on unexpected upgrades. Curve-adjustment trades are yet another example of
investors expressing their interest rate views in the credit markets in anticipation of
interest rate changes.
Finally, Priorat offers further explanation of how active managers can add value. He notes,
Structural analysis of corporate bonds is an important part of active management.
Credit bullets in conjunction with long-end Treasury structures are used in a barbell
strategy. Callable bonds provide a spread premium that can be valuable to an investor
during periods of high interest rate volatility. Put structures will provide investors with
some protection in the event that interest rates rise sharply but not if the issuer has an
unexpected credit event.”
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