25728 Fixed Income Analysis Group Work: Simulation 1 Exercise You have been selected by your bank to run a speculative high return fixed interest fund. Your fund will have an initial capital of $1m. At the beginning of each year the portfolio will be constructed by choosing percentage weightings for the following bonds which have the following characteristics at the fund's start. Bond Coupon Term Yields Mod Duration Price Cash 0.00% 1 5.90% 0.94 94.43 Bond05 4.00% 5 5.90% 4.35 91.97 Bond10 10.00% 10 5.70% 6.81 132.10 Bond15 8.00% 15 5.70% 9.29 122.78 While the last three bonds mature over time, the Cash bond is replaced each period (its value at the end of each year is always $100 and as such is the only riskless investment). Your aim as a speculative bond portfolio manager is to maximise the value of the bond portfolio over six annual periods by the judicial choice of bonds held. In each period the return on each bond comes from two sources: 1. Interest income - equal to the face value of your holding multiplied by the coupon rate. and 2. Capital gain/loss incurred. Remember the percentage change in the value of a bond consequent upon a 1%pa change in yields is approximately equal to the bond's modified duration. Note however that it will be the capital gain/loss consequent upon yield curve shifts that will dominate your period by period return performance. Your success in in this simulation depends upon your ability to correctly forecast changes in the yield curve and to make correct portfolio decisions based on the forecast changes in the yield curve. In the case of parallel changes in the yield curve, your strategy is fairly obvious:  If you think yields are to rise across all terms then you should move your portfolio towards the short-end of the term structure to minimise capital loss.  On the other hand, if you think yields are to fall in a parallel fashion, then you should move your portfolio towards the long-end of the term structure to maximise capital gain. There is no straightforward strategy if you believe that a future yield curve shift will be non-parallel. To assist you in your portfolio choice your analysts will provide you with current data on: 1. inflation 2. unemployment 3. GDP growth It may be worth noting that economists believe the following table reflects the influence of economic changes on the yield curve - then again you know what they say about economists - "if all of the economists in the world were laid end on end they still wouldn't reach a conclusion".Term Structure Factors Influences Short end Long end Growth Greatest Least Unemployment Greatest Least Monetary Policy Greatest Least Expectations Least Greatest Inflation Least Greatest Here is some historic time-series data on (1) the growth of GDP, (2) the inflation rate (3) the unemployment rate and (4) the share price index leading up to the commencement of the simulation period.Only the unemployment rate shows a discernible trend. Unemployment has steadily decreased over the previous 5 years. The Share market has experienced a sustained bull run of the previous 5 years as shown below. The dynamics of interest rates (as represented by the yields on 3-month and 10-year Government securities) are plotted below. 4.0% 4.5% 5.0% 5.5% 6.0% 6.5% 7.0% 7.5% -4 -3 -2 Year -1 0 1 Unemployment Rate 400 500 600 700 800 900 1,000 1,100 1,200 -4 -3 -2 Year -1 0 1 Share Market IndexIt is clear that interest rates have fairly steady at the long end of the term structure, but the short rate has risen significantly over the previous 5 years. At the beginning period the term structure is relatively flat with virtually no difference between the short and long rates. A snap shot of the initial term structure and economic data prevailing in year 1 are as follows Your task is to study the background data to assist you to undertake the following tasks so that you may complete and return to me Simulation 01 Form posted on UTS Online : 1. Articulate (forecast) what you believe is going to happen to the yield curve by the end of the Year 1. 2. Form a portfolio strategy that is best suited to your forecast of the change in the yield curve. 3. Specify a set of Year 1 portfolio weights. 4.0% 4.5% 5.0% 5.5% 6.0% 6.5% -4 -3 -2 -1 0 1 Year Interest Rates 3-Month Rate 10-Year Rate Game StartForecast End of Year One Yield Curve You need to study the material in Lecture 01 (and any other references you may choose to consult) in order to forecast where yields are likely to be at the end of Year One. You may wish to superimpose your view of end of year 1 yields on the following chart that depicts the beginning of year 1 rates. Portfolio Strategy Your general portfolio strategy will depend on your forecast of end of year rates. If you believe that any movement in the term structure will be parallel, then your strategy is obvious:  If yields are expected to fall then it is rational to move a bond portfolio weights to the long end of the term structure to maximise capital gains..  If yields are expected to rise it makes sense to move a bond portfolio weights to the short end of the term structure to minimise capital losses. Specify a Set of Portfolio Weights You need to specify a set of weights that is consistent with your strategy. For example, if you think that the anticipated change in the yield curve requires you to specify higher weightings for the longer bonds, then you need specify higher weights in for the longer bonds in range G5:G8. The 2.00% 2.50% 3.00% 3.50% 4.00% 4.50% 5.00% 5.50% 6.00% 6.50% 7.00% 1 3 5 7 9 11 13 15 Year One Yield Curveexample below shows a possible combination of the weights where more emphasis is on the long bonds, Whether your strategy is ultimately successful or not depends on what actually are the end of year rates which, upon announcement after you have set your weights, you will specify in cells J5:J8 in order that the worksheet calculates your year 1 annual return. Prior to the year 1 actual rates, you are free to play with possible end of year rates in cells J5:J8. If you are confident in your forecast of end of year rates you can optimise the weights to provide maximum return (or minimum loss) by placing your forecast rates in cells J5:J8 and experimenting with the weights to gauge the effect on annual return in cell G1. You need to read the yields for terms 1, 4, 9 and 14 years (all bonds except cash have moved one year closer to maturity) off your forecast yield curve and enter them in the appropriate cells in the range J5:J8. You can then tweak your weights in G5:G8 to maximise return. In the example below, I have forecast a steeping of the yield curve. Given this scenario, I have played around with the weights to come up with the following weights that give me a good return. Please contact me if you are having any problem with the software. Good luck. Don't forget to email me your completed Simulation 01 response form before May 1 (Use the Simulation 01 SubmissionForm.docx posted on UTS OnLIne.25721 Bond Portfolio Management Simulation One: Submission Form These two pages only to be emailed to me prior to Tuesday, 3:00pm September 8, 2015. Group: Student Number First Name Last NameYear One: Yield Curve Change Forecast (List your thoughts on the most likely yield curve to prevail at the end of the year here) Year One: Portfolio Strategy (Say what general portfolio strategy you have adopted consistent with your predictions about changes in the yield curve) List here your specific portfolio weights to enact your portfolio strategy. Choice of Weights Year 1 Bond Weight (%) Cash Bond05 Bond10 Bond15 Total 100%