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Question #1, Fixed Income Portfolio Management

You are a portfolio manager running a fixed income portfolio all of one bond. The bond is XYZ bond with a YTM of 5%, coupon 8%, term 6 years semiannual, BBB credit rating. The reinvestment rate assumption is 3%.

You have a $500M pension liability with a duration of 8 years.

Two derivative instruments available are:

  • Tbond futures, priced at 97 with a duration of 3 and
  • Interest rate swaps with a duration of 3.
  • Calculate the bond duration.
  • Calculate the # of bonds needed to fund the liability.
  • Explain the conditions to immunize the portfolio using a classical duration-match immunization.
  • Provide the number of Tbond contracts.
  • If the reinvestment rate falls from 3% to 1%, provide the projected deficit.
  • Provide the NP (notional principal of Interest Rate Swaps to hedge)
  • Prove that the futures gain will > the loss attributed to the deficit.
  • Prove that the IRS (interest rate swap) gain will > the loss attributed to the deficit.
  • Indicate the type of swap needed.

2. Fixed Income Derivatives

The ZB US Treasury Bond Futures contract has a par of $100,000, an initial margin of $4,620, a maintenance margin of $4,200. The duration is 5 years and it is priced at 99. As an investor you open a futures trading account with $100,000.

  • How many contracts can you open (long)?
  • If the interest rates fall by 30 basis points, what is your ROI?
  • If the interest rates fall by 30 basis points, what is your dollar profit?
  • At what point will you get a margin call? Be specific.
  • If the Federal Reserve started to raise the interest rates, would you
    • Stay long?
    • Reverse and go short?
    • Desire to increase or decrease your portfolio duration?

Question #3. Credit

Exhibit 1, Balance Sheet

Company A Company B Sector Average

ASSETS

Current assets

Cash and cash equivalents 5 5 7

Marketable securities 5 0 2

Accounts receivable, net 5 15 12

Inventories 15 20 16

Prepaid expenses 5 15 11

Total current assets 35 55 48

Property, plant, and equipment, net

40 35 37

Goodwill 25 0 8

Other assets 0 10 7

Total assets 100 100 100

LIABILITIES AND SHAREHOLDERS’ EQUITY

Current liabilities

Accounts payable 10 10 10

Short-term debt 25 10 15

Accrued expenses 0 5 3

Total current liabilities 35 25 28

LIABILITIES AND SHAREHOLDERS’ EQUITY

Long-term debt 45 20 28

Other non-current

liabilities 0 10 7

Total liabilities 80 55 63

Total shareholders’ equity 20 45 37

Total liabilities and

shareholders’ equity 100 100 100

Question 4-A Based on Exhibit 1, which statement is most likely correct?

A Company A has below-average liquidity risk.

B Company B has above-average solvency risk.

C Company A has made one or more acquisitions.

Question 4-B The quick ratio for Company A is closest to:

A 0.43.

B 0.57.

C 1.00.

Question 4-C Based on Exhibit 1, the financial leverage ratio for Company B is closest to:

A 0.55.

B 1.22.

C 2.22.

Question 4-D Based on Exhibit 1, which ratio indicates lower liquidity risk for Company A

compared with Company B?

A Cash ratio

B Quick ratio

C Current ratio

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