Reading 27: Fixed-Income Portfol....anagementPart I－LOS i including

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CFA Institute Area 8-11, 13: Asset Valuation
Session 8: Management of Passive and Active Fixed Income Portfolios
Reading 27: Fixed-Income Portfolio ManagementPart I
LOS i: Discuss the extensions that have been made to classical immunization theory, including the introduction of contingent immunization.

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Which of the following is NOT a key consideration in implementing a contingent immunization strategy?

A) Identifying a suitable and immunizable safety net.

B) Establishing well defined immunized initial and ongoing available target returns.

C) Decide in advance about the frequency the portfolio will be rebalanced.

D) Implementing an effective monitoring procedure to ensure that the safety net return is not violated.

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Answer and Explanation

The frequency of rebalancing is determined (among other things) by the level of the safety net. So the rebalancing frequency is not exogenous to interest rate movements.

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In a contingent immunization strategy, which of the following is a reason why the minimum target return might NOT be realized? The minimum target return might not be realized because:

A) the yield volatility changes.

B) the convexity of the assets changes.

C) there is a rapid market yield movement.

D) interest rates move in a nonparallel manner.

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Answer and Explanation

A rapid market yield movement might not give the manager enough time to shift from an active strategy to immunization mode to achieve the minimum target.

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A portfolio manager has decided to pursue a contingent immunization strategy over a three-year time horizon. She just purchased at par $84 million worth of 9.2 percent semi-annual coupon, 10-year bonds. Current rates of return for immunized strategies are 9.2 percent and the portfolio manager is willing to accept a return of 8.5 percent. Given that the required terminal value is $107,829,022, and if interest rates rise to 11 percent immediately, which of the following is TRUE? The dollar safety margin is:

A) negative (-$3,237,038) and the manager can continue with contingent immunization.

B) positive ($1,486,948) and the manager must switch to immunization.

C) positive ($1,486,948) and the manager can continue with contingent immunization.

D) negative (-$3,237,038) and the manager must switch to immunization.

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Answer and Explanation

We are given the required terminal value of $107,829,022. Next, we calculate the current value of the bond portfolio: PMT=($84,000,000)(.046)=$3,864,000, N=20, I/Y=11/2=5.5%, and FV=$84,000,000, compute PV=$74,965,511.

Next, compute the present value of the required terminal value at the new interest rate: FV=$107,829,022, PMT=0, N=6, I/Y=11/2=5.5%, compute PV=$78,202,549.

The dollar safety margin is negative ($74,965,511-$78,202,549 = -3,237,038) and the manager can no longer employ contingent immunization.

Therefore, a switch to immunization is necessary.

Next, compute the present value of the required terminal value at the new interest rate: FV=$107,829,022, PMT=0, N=6, I/Y=11/2=5.5%, compute PV=$78,202,549.

The dollar safety margin is negative ($74,965,511-$78,202,549 = -3,237,038) and the manager can no longer employ contingent immunization.

Therefore, a switch to immunization is necessary.

We are given the required terminal value of $107,829,022. Next, we calculate the current value of the bond portfolio: PMT=($84,000,000)(.046)=$3,864,000, N=20, I/Y=11/2=5.5%, and FV=$84,000,000, compute PV=$74,965,511.

Next, compute the present value of the required terminal value at the new interest rate: FV=$107,829,022, PMT=0, N=6, I/Y=11/2=5.5%, compute PV=$78,202,549.

The dollar safety margin is negative ($74,965,511-$78,202,549 = -3,237,038) and the manager can no longer employ contingent immunization.

Therefore, a switch to immunization is necessary.

Next, compute the present value of the required terminal value at the new interest rate: FV=$107,829,022, PMT=0, N=6, I/Y=11/2=5.5%, compute PV=$78,202,549.

The dollar safety margin is negative ($74,965,511-$78,202,549 = -3,237,038) and the manager can no longer employ contingent immunization.

Therefore, a switch to immunization is necessary.

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If interest rates rise sufficiently such that the dollar safety margin is negative in a contingent immunization strategy, which of the following statements is FALSE?

A) A switch to immunization is necessary.

B) The portfolio manager can no longer use contingent immunization.

C) Contingent immunization is still a viable alternative.

D) The present value of the liabilities exceeds the present value of the assets.

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Answer and Explanation

If the dollar safety margin is negative, the present value of liabilities exceeds the present value of assets and the portfolio manager can no longer use contingent immunization. Equivalently, the portfolio manager must switch to immunization.

If the dollar safety margin is negative, the present value of liabilities exceeds the present value of assets and the portfolio manager can no longer use contingent immunization. Equivalently, the portfolio manager must switch to immunization.

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A portfolio manager has decided to pursue a contingent immunization strategy over a four-year time horizon. He just purchased at par $26 million worth of 6.0 percent semiannual coupon, 8-year bonds. Current rates of return for immunized strategies are 6.0 percent and the portfolio manager is willing to accept a return of 5.0 percent. Given that the required terminal value is $31,678,475, and if interest rates rise to 7 percent immediately, which of the following is TRUE? The dollar safety margin is:

A) positive ($370,765) and the portfolio manager must switch to immunization.

B) positive ($370,765) and the portfolio manager can continue with contingent immunization.

C) negative (-$1,423,980) and the portfolio manager must switch to immunization.

D) negative (-$1,423,980) and the portfolio manager can continue with contingent immunization.

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Answer and Explanation

We are given the required terminal value of $31,678,475.

Next, we calculate the current value of the bond portfolio: PMT=($26,000,000)(.03)=$780,000, N=16, I/Y=7/2=3.5%, and FV=$26,000,000, compute PV=$24,427,765.

Next, compute the present value of the required terminal value at the new interest rate: FV=$31,678,475, PMT=0, N=8, I/Y=7/2=3.5%, compute PV=$24,057,000.

The dollar safety margin is positive ($24,427,765-$24,057,000 = $370,765) and the manager can continue to employ contingent immunization.

Next, we calculate the current value of the bond portfolio: PMT=($26,000,000)(.03)=$780,000, N=16, I/Y=7/2=3.5%, and FV=$26,000,000, compute PV=$24,427,765.

Next, compute the present value of the required terminal value at the new interest rate: FV=$31,678,475, PMT=0, N=8, I/Y=7/2=3.5%, compute PV=$24,057,000.

The dollar safety margin is positive ($24,427,765-$24,057,000 = $370,765) and the manager can continue to employ contingent immunization.

We are given the required terminal value of $31,678,475.

Next, we calculate the current value of the bond portfolio: PMT=($26,000,000)(.03)=$780,000, N=16, I/Y=7/2=3.5%, and FV=$26,000,000, compute PV=$24,427,765.

Next, compute the present value of the required terminal value at the new interest rate: FV=$31,678,475, PMT=0, N=8, I/Y=7/2=3.5%, compute PV=$24,057,000.

The dollar safety margin is positive ($24,427,765-$24,057,000 = $370,765) and the manager can continue to employ contingent immunization.

Next, we calculate the current value of the bond portfolio: PMT=($26,000,000)(.03)=$780,000, N=16, I/Y=7/2=3.5%, and FV=$26,000,000, compute PV=$24,427,765.

Next, compute the present value of the required terminal value at the new interest rate: FV=$31,678,475, PMT=0, N=8, I/Y=7/2=3.5%, compute PV=$24,057,000.

The dollar safety margin is positive ($24,427,765-$24,057,000 = $370,765) and the manager can continue to employ contingent immunization.

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A portfolio manager has decided to pursue a contingent immunization strategy over a three-year time horizon. He just purchased at par $93 million worth of 10.0 percent semiannual coupon, 12-year bonds. Current rates of return for immunized strategies are 10.0 percent and the portfolio manager is willing to accept a return of 8.5 percent. If interest rates rise to 11 percent immediately, which of the following statements is TRUE? The dollar safety margin is:

A) positive ($303,066) and the portfolio manager must switch to immunization.

B) positive ($303,066) and the portfolio manager can continue with contingent immunization.

C) negative (-$2,489,748) and the portfolio manager must switch to immunization.

D) negative (-$2,489,748) and the portfolio manager can continue with contingent immunization.

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Answer and Explanation

We must first compute the required terminal value: PV=$93,000,000, N=6, I/Y=8.5/2=4.25%, PMT=0, compute FV=$119,382,132.

Next, we calculate the current value of the bond portfolio: PMT=($93,000,000)(.05)=$$4,650,000, N=24, I/Y=11/2=5.5%, and FV=$93,000,000, compute PV=$86,884,460.

Next, compute the present value of the required terminal value at the new interest rate: FV=$119,382,132, PMT=0, N=6, I/Y=11/2=5.5%, compute PV=$86,581,394.

The dollar safety margin is positive ($86,884,460-$86,581,394 = $303,066) and the manager can continue to employ contingent immunization.

Next, we calculate the current value of the bond portfolio: PMT=($93,000,000)(.05)=$$4,650,000, N=24, I/Y=11/2=5.5%, and FV=$93,000,000, compute PV=$86,884,460.

Next, compute the present value of the required terminal value at the new interest rate: FV=$119,382,132, PMT=0, N=6, I/Y=11/2=5.5%, compute PV=$86,581,394.

The dollar safety margin is positive ($86,884,460-$86,581,394 = $303,066) and the manager can continue to employ contingent immunization.

We must first compute the required terminal value: PV=$93,000,000, N=6, I/Y=8.5/2=4.25%, PMT=0, compute FV=$119,382,132.

Next, we calculate the current value of the bond portfolio: PMT=($93,000,000)(.05)=$$4,650,000, N=24, I/Y=11/2=5.5%, and FV=$93,000,000, compute PV=$86,884,460.

Next, compute the present value of the required terminal value at the new interest rate: FV=$119,382,132, PMT=0, N=6, I/Y=11/2=5.5%, compute PV=$86,581,394.

The dollar safety margin is positive ($86,884,460-$86,581,394 = $303,066) and the manager can continue to employ contingent immunization.

Next, we calculate the current value of the bond portfolio: PMT=($93,000,000)(.05)=$$4,650,000, N=24, I/Y=11/2=5.5%, and FV=$93,000,000, compute PV=$86,884,460.

Next, compute the present value of the required terminal value at the new interest rate: FV=$119,382,132, PMT=0, N=6, I/Y=11/2=5.5%, compute PV=$86,581,394.

The dollar safety margin is positive ($86,884,460-$86,581,394 = $303,066) and the manager can continue to employ contingent immunization.