THE DECISION TO ADD VARIABLES TO THE OIL-RELATED INDUSTRY ANALYSIS...

30. The decision to add variables to the oil-related industry analysis will most likely lead to:

A. an appraisal bias.

B. a data-mining bias.

C. a regime-switching bias.

Berg Case Scenario

Alpha Consultants is working with the German-based Berg Pension Fund to select a fixed income firm to

manage a EUR100 million global bond portfolio. Delta Managers is the third and final presenter to Berg’s

investment committee. After going through its investment philosophy and process, Delta addresses

several questions.

Alpha expresses concern about the use of leverage in the portfolio. Delta indicates that by employing

100% leverage, it can generate incremental returns. Delta provides the committee with the portfolio’s

characteristics in Exhibit 1.

Exhibit 1

Portfolio Characteristics

Assets Liabilities

Portfolio (EUR millions) 200 100

Duration 6.00 1.00

Expected Return (%) 5.50

Interest Rate on Borrowed Funds (%) 4.75

Berg’s committee is concerned that the duration of the portfolio is inappropriate given its view that

rates might rise and asks how Delta can use the futures market to manage the interest rate risk of the

portfolio. The committee in fact states that it would like a target duration of 4.

Exhibit 2

Futures Market Data

Futures Contract Price EUR100,000

Conversion Factor 1.15

Duration of Cheapest to Deliver Bond 5.2

Market Price of Cheapest to Deliver Bond EUR98,000

Delta then makes the following statement to the committee:

International interest rates are not perfectly correlated. In fact, since this is a global bond portfolio, 60

percent of the portfolio is from German issuers and has average duration of 7 and the remainder is from

U.K. issuers with average duration of 4.5, both before any hedging activities to meet the committee’s

duration target. Historically, the country beta of the U.K. (i.e., for German rates relative to U.K. rates) is

estimated to be 0.55.

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Berg’s committee then asks Delta to make a recommendation as to whether the portfolio should be

hedged back to the euro, its domestic currency. Delta responds that currently short interest rates are