Questions 43 through 50 relate to Fixed-Income.
Jimmy Pickens Case Scenario
Jimmy Pickens works at SkyLine Capital Specialists (SLCS), an investment firm in the
U.S. established by a group of experienced financial analysts and investment
professionals. Pickens is a senior portfolio manager at the firm who heads a team of more
than ten fixed income analysts. During his lunch break, Pickens was called by David
Pressman, a fixed income manager at SLCS. Pressman wanted help in analyzing the
immunization of a single liability that was due in fifteen years. He had short-listed three
bond portfolios composed of coupon-bearing government bonds for this purpose, with the
objective of minimizing structural risk over the investment horizon. Exhibit 1 displays the
risk and return characteristics of the three portfolios.
Exhibit 1: Immunization Portfolios Risk and Return (based on aggregation of bond cash
flows)
Cash flow yield
Annualized
stated on a semi-
Macaulay duration
convexity Annualized
annual bond basis
Portfolio A 9.11 145.06 15.01
Portfolio B 8.97 122.10 15.02
Portfolio C 8.99 133.90 14.9
*All portfolios have the same market value
After Pickens assisted Pressman with his calculations, he talked about how single and
multiple liabilities could be immunized to lock in a guaranteed rate of return over a
particular time horizon. When talking about multiple liability immunization, Pickens
made the following comment:
Statement 1: “To assure multiple liability immunization in the case of parallel rate
shifts, managers selecting securities to be included in the portfolio must
not only keep track of the matching of money duration between assets and
liabilities but also maintain a specified distribution for assets in the
Statement 2: “Perfect cash flow matching is less risky than horizon matching which in
turn is less risky than multiple liability immunization. However, cash flow
matching is the most costly to implement, whereas multiple liability
immunization is the least.”
In addition to the liability due in fifteen years, Pressman was also held in charge of
devising an effective strategy that would pay off the debt liabilities of Stone-Wash
Corporation (SWC), one of SLCS’s institutional clients. The market value of the portfolio
of multiple liabilities equaled 23.56 billion with a modified duration of 7.54, convexity of
69.13 and BPV of $12.36 million respectively. During a meeting with SWC’s board of
directors, Pressman suggested three different portfolios to pay off the debt. The portfolios
consisted of investment grade corporate bonds with maturities ranging from 5 to 12
years. The market value of all three portfolios was deemed sufficient to cover the
liabilities. Exhibit 2 displays key characteristics of the three portfolios.
Exhibit 2: Duration Matching Strategy
Portfolio A Portfolio B Portfolio C
Modified Duration 7.55 7.56 7.54
Convexity 65.10 74.20 69.14
BPV (in US
$millions) 12.40 12.43 15.77
Pickens is currently managing a $75.18 million government bond portfolio to immunize
corporate debt liabilities that have a market value of $76.45 million. The durations of the
asset and liability portfolios equal 11.30 and 11.37, and their BPVs’ equal $55,320 and
$59,890 respectively. To close the duration gap, Pickens has decided to use a futures
contract with a BPV per 100,000 of notional principal of 10.04837 and a conversion
factor of 0.7699.
Pickens is also managing a fixed income portfolio for Ryan Wicker, a chemical engineer
working for Triple-E Chemicals (TEC) in USA. The portfolio is worth $3 million, and
Wicker has instructed Pickens to use a long-term bond index as a benchmark for his
portfolio. The index includes long-term corporate bonds, long-term government bonds,
and long-term callable issues. To match the portfolio’s risk factors with those of the
benchmark, Pickens is using a multifactor model technique to identify the set of factors
that drive the index’s returns. Two of the risk factors that Pickens has identified are the
spread duration and the sector duration. To ensure that the indexed portfolio closely
tracks the benchmark with regards to these risk factors, Pickens matched the percentage
weight in the various sectors and qualities of the benchmark index. Also, since Pickens
knows that duration only captures the effect of small interest rate changes, he not only
matched the duration, but also the convexity of the index, especially to replicate the
index’s exposure to call risk.
Pressman is keen to understand the application of contingent immunization as an
alternative to the more traditional duration matching approaches to managing a set of
liabilities. He understands that duration matching is actually just hedging interest rate risk
over the desired investment horizon. However, he is somewhat perplexed about the
course of action a manager should take if interest rates are expected to fall and he/she is
hedging using interest rate futures.
43. Which of the following portfolios should Pickens most likely recommend to
Pressman for immunizing the liability due in 15 years?
A. Portfolio A.
B. Portfolio B.
C. Portfolio C.
44. Pickens is most accurate with respect to:
A. Statement 1 only.
B. Statement 2 only.
C. both statements 1 and 2.
45. The most appropriate portfolio to carry out an effective duration matching
strategy for paying off SWC’s liabilities would be:
46. With regards to his attempts to match the risk factors of Ryan Wicker’s bond
portfolio to those of the benchmark, Pickens is most accurate with respect to
the matching of the:
47. Which of the following is closest to the number of contracts that Pickens
needs to transact in to close the duration gap of the government bond portfolio
and the corporate debt liabilities?
A. Sell 275 contracts.
B. Buy 350 contracts.
C. Buy 455 contracts.
48. Given Pressman’s expectations about the future course of market interest
rates, the best hedging strategy given contingent immunization would involve:
A. Over-hedging the position.
B. Under-hedging the position.
C. Precisely hedging the position.
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