Given: Economist believes long term interest rates should fall over the next year, but the short term interest rates should gradually increase. The client wishes to maintain the duration of its bond portfolio at 8.7.
Q: Determine the most appropriate portfolio for the client.
Portfolio 1: 100% Bond B
Portfolio 2: 50% Bond A/ 50% Bond B
Portfolio 3: 60% Bond A/ 10% Bond B/ 30% Bond C
Bond A: Annualised Bond Yield = 6.2%, Bond maturity = 5.25 yrs, Semi coupon =$3.10
Bond B: Annualised Bond Yield = 6.6%, Bond maturity = 8.5 yrs, Semi coupon =$3.30
Bond C: Annualised Bond Yield = 7.1%, Bond maturity = 19.75 yrs, Semi coupon =$3.55
@vincentt It’s from the Schweser Practice Exam Volume 1
Just realsied…I misread the question!!! Portfolio 2 is 50% in Bond A and 50% in Bond C.
The relevant section in full:
As part of their increased emphasis on active bond management, Cardinal has retained the services of an economic consultant to provide expectations input on factors such as interest levels, interest rate volatility and credit spreads. During his presentation, the economist states that he believes long term interest rates should fall over the next year, but that short term rates should gradually increase.
Weaver and McNally are currently advising an institutional client that wishes to maintain the duration of its bond portfolio at 8.7. In light of the economic forecast, they are considering 3 bond portfolios.
The economist believes that long term interest rate will fall over the next year, but that short term rates will gradually increase. The appropriate portfolio in this scenario is Portfolio 2 (a barbell portfolio). The decrease in long term rates will result in an increase in price for Bond C. This will be greater than the decline in Bond A’s price from the increase in short term rates because Bond C has a longer duration.
if it’s 50% bond C then it would still make more sense since Portfolio 1 would be out of the question (short term interest rate will rise; price will fall), we will just be left with Portfolio 2 and 3.
Again in this scenario i don’t really know if we should comply with the desired duration of 8.7 or should we focus on maximizing income.
if it’s to maximize income, then obviously the one with the longest maturity will have the longest duration which will benefit from the long term interest rate fall.
So I’m not too sure between 2 and 3.
For Option 2
Bond C = 19.75/2
Bond A= 5.25/2
Weighted average is 12.5
So when rates start decreasing duration decreases and can move towards requirement of 8.7
For Option-1 it is already less than that – so invalid
For Option -3 it comes down to 9.25 so even this can move towards our 8.7 target.
if we see economist statement “During his presentation, the economist states that he believes long term interest rates should fall over the next year, but that short term rates should gradually increase.”
if both happen the probability of option-3 not matching our requirement is more.
@RaviVooda but the thing is if the client wants to maintain a certain duration doesn’t that mean you would have to obtain the required duration now and not in the future ?
For duration to reduce what other factors would contribute to that? Isn’t it down to just the time to maturity (since coupon rate is fixed from the start)? So that would means it would take 3.8 years (12.5-8.7) to achieve it wouldn’t it?
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