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Mary Bing is a senior portfolio manager at NMS Advisors (NMSA), an investment and wealth management firm with offices in Boston and Chicago. NMSA provides investment advisory and asset allocation services to private and institutional clients. Bing is an expert in the use of derivatives to manage portfolios. Bing is assisted by two analysts, Rakesh Sharma and Hernando Torres. Bing is performing a review of client portfolios. She has collected the stock and bond index futures information that is presented in Exhibit 1. Futures prices are shown after accounting for the multiplier. Bing also notes that risk-free bonds with one year to maturity yield 1.5%. Bing manages a portfolio invested in U.S. small-cap stocks for the Wellington Academy Endowment. The portfolio has a current market value of $321 million. Bing and her team believe that small-cap stocks will perform well over the next three months. After consulting with the trustees of the endowment, Bing decides to raise the beta of the portfolio from 0.8 to 1.2 for the next three months. Bing has also been informed that the endowment has received a $15 million cash donation that is to be invested in small caps. Bing and her team decide to use futures to equitize the new cash inflow for a period of three months.Another one of Bing's clients is KP McLane Incorporated (KPM Inc.), a U.S.-based manufacturer of men's apparel. The current market value of KPM Inc.'s pension portfolio is $950 million with a 65% allocation to U.S. midcap stocks and a 35% allocation to U.S. bonds. The stock allocation has a beta of 1.45, and the bond allocation has a modified duration of 5.3. Bing's research indicates that midcap stocks are likely to underperform over the near term. Accordingly, she decides to reduce the allocation to midcap stocks to 60% and increase the bond allocation to 40%.KPM Inc. exports a significant portion of its products to eurozone countries. KPM Inc. expects the dollar to rise against the euro and is concerned that this could lead to a decline in sales in the eurozone. KPM Inc. asks Bing for advice on how to manage this risk exposure.TCMS is a medical college that is a client of NMSA. TCMS currently has a two-year loan outstanding with a 5.5% fixed annual interest rate. Bing expects a decline in interest rates and advises TCMS to enter into a two-year interest rate swap where TCMS would pay LIBOR + 0.5% and receive a 5.5% fixed rate. From TCMS's perspective, the duration of a two-year fixed rate loan is –1.5 years and the duration of a floating rate loan is –0.125. Bing asks Torres, "Can you comment on the overall impact of the interest rate swap on TCMS?"Torres responds, "The net effect of entering the swap is to reduce the interest rate sensitivity of the overall loan plus swap position relative to the loan by itself; however, if the swap is added, it will be harder for TCMS to predict cash flows, and from this perspective, the swap does not serve as a good hedge."Bing asks Sharma, "We adjusted the asset allocation of the KPM Inc. pension fund using futures. Could we have used swaps to carry out the change?"Sharma responds, "Yes, we could have used a combination of a fixed-income swap on the Barclays US Aggregate Bond Index and an equity swap on the S&P 400 MidCap Index, where the notional value is $47.5 million." |
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