Exercises on Bond Portfolio Strategies

Msc. Silvia Faroni

Exercise 1
Answer the following questions assuming that at the initiation of an investment
account, the market value of your portfolio is 200 Euro Million and you immunize
the portfolio at 12% for six years. During the rst year, interest rates are
constant at 12%.

1. What is the market value of the portfolio at the end of Year 1?

2. Immediately after the end of the year, interest rates decline to 10%. Esti-
mate the new value of the portfolio, assuming you did the required rebal-
ancing (use only modied duration).

Exercise 2
Maria presents the CIO with a description, given the following table, of the
bond portfolio held by the Hospital Pension Plan. All securities in the bond
portfolio are noncallable U.S. Treasury securities.
Then,

ˆ Calculate the eective duration of each of the following

1. The 4.75% Treasury Security due 2036

2. The total bond portfolio

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Exercise 3
A university endownment fund has sought your advice on its xed-income port-
folio strategy. The charactristics of the portfolio's current holdings are listed
below:
Bond Rating Maturity Coupon D∗ C Mkt Position

A U.S. Govt 3 0 2.727 9.9 30,000

B A1 10 10 6.404 56.1 30,000
C aa2 5 5 3.704 18.7 30,000
D Agency 7 7 4.864 32.1 30,000
E Aa3 12 12 10.909 128.9 30,000
Tot. 150,000¿

ˆ Calculate the modied duration for this portfolio

ˆ Suppose you learn that the implied sensitivity (i.e. modied duration)
of the endowenment's liabilities is about 6.50 years. Identify whether the
bond portfolio is (1) immunized against interest rate risk, (2) exposed to
net price risk, or (3) exposed to net reinvestment risk. Briey explain
what will happen to the net position of the endowement fund if in the
future there is a signicant parallel upward shift in the yield curve

ˆ Briey describe how you could increase the conexity of the portfolio while
keeping the modied duration at the same level

ˆ Your current active view for the xed-income market over the coming
months is that Treasury yields will decline and corporate credit spreads
will also decrease. Briey discuss how you could restructure the existing
portfolio to take advantage of this view

Exercise 4
An insurance company must make payments to a customer of 10 $ million in 1
year and $ 4 million in 5 years. The yield curve is at at 10%.

ˆ if it wants to fully fund and immunize its obligation to this customer with a
single issue of a zero-coupon bond, what maturity bond must it purchase?

ˆ What must be the face value and market value of that zero-coupon bond?

Exercise 5
Currently the term structure is as follows: 1-year zero-coupon bonds yield 7%,
2-year bonds yield 8%, 3-year bonds and longer maturity bonds all yield 9%.
You are choosing between 1-,2-, and 3-year maturity bonds all paying annual
coupons of 8%. Which bond should you buy for a 1-year investment if you
strongly believe that at year-end the yield curve will be at at 9%?

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Exercise 6
You will be paying 10,000 ¿ a year in tuition expenses at the end of the next 2
years. Bonds currently yield 8%.

ˆ What is the present value and duration of your obligation?

ˆ What maturity zero-coupon bond would immunize your obligation?

ˆ Suppose you buy a zero-coupon bond with value and duration equal to
your obligation. Now suppose that rates immediately increase to 9%.
What happens to your net position, that is, to the dierence between the
value of the bond and that of your tuition obligation? What if rates fall
immediately to 7%?

Exercise 7
Pension funds pay lifetime annuities to recipients. If a rm will remain in busi-
ness indenitely, the pension obligation will resemble a perpetuity. Suppose,
therefore, that you are managing a pension fund with obligations (i.e. engage-
ments) to make perpetual payments of 2 $ million per year to beneciaries. The
yield to maturity on all bonds is 16%.

1. If the duration of 5-year maturity bonds with coupon rates of 12% (paid
annually) is 4 years and the duration of 20-year maturity bonds with
coupon rates of 6% (paid annually) is 11 years, how much of each of these
coupon bonds (in market value) will you want to hold to both fully fund
and immunize your obligation?

2. What will be the par value of your holdings in the 20-year coupon bond?

Exercise 8
You are managing a portfolio of 1 $ milion. Your target duration is 10 years,
and you can choose from two bonds: a zero-coupon bond with maturity of 5
years, and a perpetuity, each currently yielding 5%.

1. How much of each bond will you hold in your portfolio?

2. How will these fractions change next year if target duration is now 9 years?

Exercise 9
My pension plan will pay me 10,000 $ once a year for a 10-year period. The rst
payment will come in exactly 5 years. The pension fund wants to immunize its
position.

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 1. What is the duration of its obligation to me? The current interest rate is
10% per year.

2. If the plan uses 5-year and 20-year zero-coupon bonds to construct the
immunized position, how much money ought to be placed in each bond?
What will be the face value of the holdings in each zero?

Exercise 10
A 30-year maturity bond has a 7% coupon rate, paid annually. It sells today for
867.42$. A 20-year maturity bond has 6.5% coupon rate, also paid annually. It
sells today for 879.50 $. A bond market analyst forecasts that in 5 years, 25-year
maturity bonds will sell at yields to maturity of 8% and 15-year maturity bonds
will sell at yields of 7.5%. Because the yield curve is upward sloping, the analyst
believes that coupons will be invested in short-term securities at a rate of 6%.
Which bond oers the higher expected rate of return over the 5-year period?

Exercise 11
Aetna has a 15$ M claim payable in 5 years. To manage the market risk, Aetna
invests assets of 12$ M today in U.S. 5-year Notes paying an annual coupon of
4%. The market interest rate is 4%.

ˆ Calculate the static asset-liability gap, G(0)

ˆ Calculate the sensitivity of the gap t=0

ˆ Assume that rates immediately move up by 100 bp. Recalculate the gap
at 5% rates. Did the interest rate movement create or destroy value on
Aetna's balance sheet?

Exercise 12
A pension fund has liabilities with the following characteristics:

ˆ Present Value: $ 10 574 M

ˆ Macaulay duration: 20.65 years

ˆ Convexity 432.54

The pension fund managers would like to create and investment portfolio using
just two of the following three products:

ˆ 5-year Treasury Strip

ˆ 20-year Treasury strip

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 ˆ 30-year Treasury strip

He would like to make his position Redington immunized against any chages in
yields.
The annual eective rate for each of the bond products is 6.5%.
Which two bonds should the manager choose, and how much does he need
to invest in each?
Hint: ensure that the bond portfolio has a greater convexity than the liabil-
ities.

Exercise 13
An insurance company wants to cash-ow match liabilities of 45,000 ¿ payable
in two-years and 65,000 ¿ payable in four-years with specic assets. Here are
the asset choices available:

ˆ Two-year bond with an annual coupon of 5.15% at par

ˆ Two-year zero yielding a 6% annual eective rate

ˆ Four-year bond with an annual coupon of 6.5% at par

ˆ Four-year zero yielding a 7% annual eective rate

Calculate the smallest amount the company needs to outlay today to exactly
match the liabilities.

Exercise 14
Swiss Life is required to pay a liability claim of 546,978 ¿ due in four years.
The director invests 112,500¿ in a bond with a modied duration of 2.75 and
337,500 in a bond with modied duration D, in order to Redington immunize
the liability against interest rate uctuations. The annual eective rate is 5%.
Calculate D

Exercise 15
A pension fund must pay liabilities of 98 at the end of year 1, 103 at the end of
year 2, and 102 at the end of year 3. Consider three bond investments available:
Bond Maturity YTM Nominal Yield

X 1 5% 6%
Y 2 7% 0%
Z 3 9% 5%
All three bonds have a par value of 100. Set up a dedicated portfolio that
will fund exactly these three future liabilities.

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 1. How many units of Bond X, Bond Y, and Bond Z are needed?

2. What is the total cash outlay (amount to invest) at t=0?

3. Show that the cashows in years 1,2, and 3 exactly meet the liabilities due

Exercise 16
Recall the portfolio Barbell and Bulle:
Bullet Barbell

Maturity 100% in 10-year Bonds 50.2% in 5 Year Bonds / 49.8% in 20-year Bonds
Coupon 9.25% 8.5% / 9.5%
YTM 9.25% 8.5% / 9.5% -> 9.19%
Duration 6.434 4.005 / 8.882 -> 6.434
Convexity 55.4506 19.8164 / 124.1702 -> 77.7846
You can verify the Duration and convexity calculations with XL.
The Yield curve is currently upward-sloping with 5-year rates at 8.5%, 10-
year rates at 9.25%, and 20-year rates at 9.50%. You are a bond trader seeking
to prot from yield curve shifts.

1. Suppose you forecast a attening of the yield curve by year-end. 5-year

rates will increase by 35bp, 10-year rates increase by 10 bp, and 20-year
rates fall by 15 bp. In which portfolio do you want to position your money?

2. Suppose you forecast a steepining of the yield curve by year-end. 5-year

rates will decrease by 50 bp, 10-year rates decrease by 15 bp, and 20-year
rates increase by 20 bp. In which portfolio do you want to position your
money?

Exercise 17
Assume the yield curve is at at a level of 3%.

1. Calculate the convexity of a bullet xed-income portfolio, that is, a

portfolio with a single cash ow. Suppose a single 1,000$ cash ow is paid
in year 5.

2. Now calculate the convexity of a barbell xed-income portfolio, that is,

a portfolio with equal cash ows over time. Suppose the security makes
100$ cash ows in each of years 1-9 (FV=0$), so that its duration is close
to the bullet in part 1.

3. Do barbells or bullets have greater convexity?

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Exercise 18
A major requirement in managing a xed-income portfolio using a contingent
immunization policy is monitoring the relationship between the current market
value of the portfolio and the required value of the oor portfolio. The dierence
is dened as the margin of error. In this regard, assume a 300$ milion portfolio
with a time horizon of 5 years. The available market rate at the initiation of the
portfolio is 12%, but the client is willing to accept 10% as a oor rate to allow
use of active management strategies. The current market values and current
market rates at the end of Years 1,2, and 3 are as follows:
End of Year Market Value Market Yield Required Floor Portfolio Margin of Error

1 340.9 10%
2 405.5 8%
3 395.2 12%
Assuming semi-annual compounding.

ˆ Calculate the required ending-wealth value for this portfolio

ˆ Calculate the value of the required oor portfolios at the end of Years 1,2,
and 3

ˆ Compute the margin of error at the end of Years 1,2, and 3.

ˆ Indicate the action that a portfolio manager utilizing a contingent immu-

nization policy would take if the margin of error at the end of any year
had been zero or negative.