22. A member of a firm's investment committee is very interested in learning about the management of fixed-income portfolios. He would like to know how fixed-income managers position portfolios to capitalize on their expectations concerning three factors which influence interest rates:
a. Changes in the level of interest rates.
b. Changes in yield spreads across/between sectors.
c. Changes in yield spreads as to a particular instrument.
Assuming that no investment policy limitations apply, formulate and describe a fixed-income portfolio management strategy for each of these factors that could be used to exploit a portfolio manager's expectations about that factor. (Note: Three strategies are required, one for each of the listed factors.)
23. Long-term Treasury bonds currently are selling at yields to maturity of nearly 8%. You expect interest rates to fall. The rest of the market thinks that they will remain unchanged over the coming year. In each question, choose the bond that will provide the higher capital gain if you are correct. Briefly explain your answer.
a. (1) A Baa-rated bond with coupon rate 8% and time to maturity 20 years. (2) An Aaa-rated bond with coupon rate 8% and time to maturity 20 years.
b. (1) An A-rated bond with coupon rate 4% and maturity 20 years, callable at 105. (2) An A-rated bond with coupon rate 8% and maturity 20 years, callable at 105.
c. (1) A 6% coupon noncallable T-bond with maturity 20 years and YTM = 8%. (2) A 9% coupon noncallable T-bond with maturity 20 years and YTM = 8%.
24. Currently, the term structure is as follows: one-year bonds yield 7%, two-year bonds yield 8%, three-year bonds and greater maturity bonds all yield 9%. You are choosing between one-, two-, and three-year maturity bonds all paying annual coupons of 8%, once a year. Which bond should you buy if you strongly believe that at year-end the yield curve will be flat at 9%?
25. A fixed-income portfolio manager is unwilling to realize a rate of return of less than 3% annually over a five-year investment period on a portfolio currently valued at $1 million. Three years later, the interest rate is 8%. What is the trigger point of the portfolio at this time, that is, how low can the value of the portfolio fall before the manager will be forced to immunize to be assured of achieving the minimum acceptable return?
26. What type of interest rate swap would be appropriate for a corporation holding long-term assets that it funded with floating-rate bonds?
Bodie-Kane-Marcus: Essentials of Investments, Fifth Edition
III. Debt Securities
10. Managing Bond Portfolios
© The McGraw-H Companies, 2003
10 Managing Bond Portfolios
27. What type of interest rate swap would be appropriate for a speculator who believes interest rates soon will fall?
28. Several Investment Committee members have asked about interest rate swap agreements and how they are used in the management of domestic fixed-income portfolios.
a. Define an interest rate swap and briefly describe the obligation of each party involved.
b. Cite and explain two examples of how interest rate swaps could be used by a fixed-income portfolio manager to control risk or improve return.
29. A corporation has issued a $10 million issue of floating-rate bonds on which it pays an interest rate 1% over the LIBOR rate. The bonds are selling at par value. The firm is worried that rates are about to rise, and it would like to lock in a fixed interest rate on its borrowings. The firm sees that dealers in the swap market are offering swaps of LIBOR for 7%. What swap arrangement will convert the firm's borrowings to a synthetic fixed-rate loan? What interest rate will it pay on that synthetic fixed-rate loan?
30. A 30-year maturity bond has a 7% coupon rate, paid annually. It sells today for $867.42. A 20-year maturity bond has a 6.5% coupon rate, also paid annually. It sells today for $879.50. A bond market analyst forecasts that in five years, 25-year maturity bonds will sell at yields to maturity of 8% and that 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 offers the higher expected rate of return over the five-year period?
31. a. Use a spreadsheet to calculate the durations of the two bonds in Spreadsheet 10.1 if the interest rate increases to 12%. Why does the duration of the coupon bond fall while that of the zero remains unchanged? [Hint: Examine what happens to the weights computed in column E.] b. Use the same spreadsheet to calculate the duration of the coupon bond if the coupon were 12% instead of 8%. Explain why the duration is lower. (Again, start by looking at column E.)
32. a. Footnote 2 presents the formula for the convexity of a bond. Build a spreadsheet to calculate the convexity of the 8% coupon bond in Spreadsheet 10.1 at the initial yield to maturity of 10%. b. What is the convexity of the zero-coupon bond?
Part THREE Debt Securities
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