1, 3, 9, 13, 15, 17, 22, 26, 27

The investment objectives of a portfolio manager of a life insurance company will likely be
different from that of a mutual fund manager due to the nature of each institution’s liabilities.
Life insurance companies typically invest more in fixed-income assets like bonds than mutual
funds do in order to safely meet life insurance policy obligations AND to turn a profit. Mutual
funds are typically more aggressive, investing in equities, to maximize investor return due to
the fact that most mutual funds do not have specific liabilities to be met.
a. The duration problem associated with a market-cap-weighted bond market
index is this: issuers of bonds make a decision as to the duration of the bonds
that they issue. The decision is based on minimizing funding costs for the
issuer. When investors make duration decisions, they are based on maximizing
total return given their investment objectives.
b. There is no reason to believe that there will be any consistency between the cost
minimization objective of the issuers and the return maximization objective of
the investors in the determination of the duration in the market. Siegel refers to
the duration that is obtained from an index as a “historical accident”.
c. Highly leveraged corporate bond issuers and troubled sovereign issuers that
issue greater amounts of debt have increasing weight in a market-cap index,
and portfolios formed on market-cap weights see increasing concentration in
bonds from these increasingly risky bond issuers. This is known as the bum’s
problem.
Some duration-matching strategies are indexing (or passive) strategies; however, some might
be active strategies. A duration-matching strategy ensures that the manager pursues a
duration equal to that of the benchmark; however, the manager is permitted to actively
manage other primary risk factors and to depart from the index.
First and foremost, it’s wise to note that both duration and convexity measures are
approximations. Secondly, the only managers who play with duration and convexity are those
who feel confident about where interest rates are headed in the future. If interest rates are
expected to decrease, a manager would strive to increase duration. In case of the opposite, a
manager would strive to decrease it. The risk with this is that returns are mainly speculative
and are as effective as the predictions of the managers. As with all speculative things, there is
great risk that a manager could be mistaken about the movement of interest rates.
Further, not all bonds in the portfolio will perform equally in event of changing interest rates.
Even two portfolios with the same duration today will perform differently especially when
large changes in interest rates occur. This has to do with the nature of duration and convexity
and that large changes in interest rates complicate the usage of duration to predict yield
changes.
a. Although it is better in general to have more convexity than less, it is not always
better to have a portfolio with greater convexity than another with less simply
because the market charges a premium for greater convexity. Bonds with
greater convexity might have lower yields.
b. This would depend on how exactly the yield curve is steepening and how the
bullet and barbell portfolios are constructed. But, no, a bullet portfolio will not
always outperform a barbell portfolio with the same dollar duration if the yield
curve steepens, although this is likely to happen in the event that the maturity
of the bullet falls in between the maturities of the investments contained within
the barbell.
a. 6% * $70 = $4.20 dollar duration of bond ABC
b. $70/$100 * $5 million = $3.5 million
c. 6% * $3.5 million = $210,000 dollar duration of the position of bond ABC
d. 3.5% * X = $210,000
e. X = $6,000,000 worth of market value in bond XYZ
f. X * 85% = $6,000,000
g. X = $7,058,824 in XYZ par value
a. Securities Counselors appears to be planning for increasing interest rates by
investing in really liquid securities that they can divest once interest rates rise to
reinvest the proceeds in higher-yielding, longer-term securities.
b. As the portfolio of an overall duration of 5.3 years divests 85% of its overall
holdings (the 10-year Treasuries) and replaces it with short-maturity (less than
5.3 years), cash-equivalent electric utility bonds the overall duration is
diminished. Because the overall duration is just an average, doing so brings the
average down.
c. Hostile corporate takeovers involve restructuring the finances and operations
of the target corporation. Debt held by Securities Counselors of Iowa in one
such target corporation could be called immediately in the event of a takeover,
forcing the portfolio to look for other alternatives with greater durations. As a
consequence, Securities Counselors might not be able to find as good of an
interest rate with the needed duration.
The duration of the levered portfolio is 350.
Step 1: 7
Step 2: 7 * 0.05 * $1 billion = $350 million
Step 3: $350 million / $200 million = 1.75
 Step 4: 1.75 * (100/50) *100 = 350 duration for the levered portfolio
Dollar interest: ($50 million / (1 + 2%)) * 4.2% * 20/360 = %114,379.08