ASSUMING SILVA’S ADVICE IS FOLLOWED AND LIBOR RATES ARE 5% AND 6%...

48. Assuming Silva’s advice is followed and LIBOR rates are 5% and 6% on 15 October 2011, and 15

December 2011, respectively, the effective annual interest rate on Short Hills Corporation’s loan

is closest to:

A. 3.50%.

B. 4.64%.

C. 5.42%.

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Midwest Case Scenario

Erik Smith, CFA, is director of Investments for Midwest Industries’ pension fund. He is meeting with

James Brown, ASA, his actuary, and Paul Jones, CFA, an investment consultant, to discuss changes to the

fund’s management and asset allocation.

Brown makes the following statement regarding Midwest’s pension plan:

Discounting the projected benefit cash flows using a market-based discount rate of 6.2%, the

present value of Midwest’s pension fund is $1 billion. The fund’s duration is 12, and the plan

assets currently cover 100% of this liability. Because the objective is primarily to meet these

liabilities and we are using market rates as the discount rate, we should select a bond market

index as the benchmark.

Jones offers his opinion on the appropriate investment strategy for the pension fund: “I believe that an

immunization strategy that meets multiple liabilities is the best strategy. For multiple liability

immunization, the necessary and sufficient conditions are: 1) the duration of the portfolio must equal

the duration of the weighted average liabilities, and 2) the distribution of durations of individual

portfolio assets must have a wider range than the distribution of the liabilities. As such, this strategy will

not require us to rebalance the portfolio if interest rates change.”

Smith expresses some concerns regarding immunization as a strategy and states:

Even if immunization minimizes risk, it assumes that the yield curve shifts in a parallel fashion,

which is not what I have observed in the market. In addition, the ability to earn some

incremental return to offset additional benefit requirements is not possible.

Jones then comments on portfolio holdings:

The current portfolio contains 40% in mortgage-backed securities (MBS), which present certain

risks when immunizing a portfolio. These securities have a market value that is below their

purchase price, and I am reluctant to recommend a sale in which we have to recognize a loss.

The discussion progresses to implementation of an investment strategy. Brown presents several

alternative portfolios that may be used to implement this strategy and states:

Although we are currently fully funded, I am concerned that future service benefits are not

covered unless we make additional contributions. We should evaluate the alternative portfolios

below to determine which one best address this concern while covering the liability’s market-

related exposures.

Portfolio A: The fixed income assets will closely mimic the liabilities with regard to both expected

return as well as variability. This is a low-risk strategy to meet our objectives.

Portfolio B: Hedges uncompensated liability risks, such as interest rate risk with derivatives. This frees

up capital to invest in higher returning assets, such as equities as well as bonds.

Portfolio C: A traditional mix of securities with 60% in equities and the remainder in medium duration

bonds but not fully hedging interest rate risk.

Smith is not completely convinced about the portfolio choices and offers the following alternative:

I believe cash flow matching is a superior strategy. This strategy will allow funds to be available

when each liability is due and will require less cash to fund liabilities. A conservative interest

rate assumption for cash must be made throughout the life of the plan.