) THE DECISION TO ADD VARIABLES TO THE OIL-RELATED INDUSTRY ANALYSI...

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.”