THROUGH 50 RELATE TO FIXED-INCOME. JIMMY PICKENS CASE SC...

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.