25721 Fixed Income Analysis Simulation 02 Introduction The simulation 02 workbook has been placed on UTS Online for you to download. . Simulation 02 Rules In this simulation you are the manager of a fixed income fund that devotes at least 30%, and at most 70%, of the value of the fund to investment in a foreign country’s bonds. You are domiciled in, and report your performance in terms of fund income and fund rate of return in, country AA. However, you are required, under the terms of your prospectus, to invest a portion of the total value of your fund in the bonds of country BB (You must invest at least 30% of funds in BB and no more than 70% of your funds in BB). You must manage the bond fund to maximise returns over a six-year period. Your performance will be judged against an industry benchmark index. This index consists of the annual returns on an index, equally weighted between AA and BB bonds, each with an average maturity of 5 years. To simulate the industry index, all you need to do is to place 25% of your total worth in the 3-year bond and 25% in the 7-year bond of each country. The rate of exchange between country AA and BB is quoted as AAD/BBDx.xxxx. That is, AA is the commodity currency and BB is the terms currency. The return on funds invested is computed each year in AADs. At the end of each year, the value of BB bonds is converted to AADs by dividing the BBD value of the foreign bonds by the AAD/BBD rate of exchange. Fund returns, computed in AAD, are thus enhanced by any fall in the value of the AAD/BBD rate. Conversely, fund returns are hurt by any increase in the value of the AAD/BBD rate. You are able to hedge your currency risk. Rules for hedging are as follows: 1. You may hedge any portion of your exposure in BB from 0% to 100%, 2. You are not permitted to hedge until year two of the exercise. There are two ways in which you can hedge against any unfavourable (upward) movement in the value of the AAD\BBD rate of exchange. 1. By taking forward cover. You can commit to purchasing, at the end of the year, the AAD equivalent of between 0% to 100% of the beginning of the year value of funds invested in BB. The forward purchase of AAD for BBD is specified as the 1-year forward rate of exchange prevailing at the beginning of the year. 2. By taking FX option cover. You can buy a call option over the AAD equivalent of between 0% to 100% of the beginning of the year value of funds invested in BB. The call option strike rate is set at the 1-year forward rate of exchange prevailing at the beginning of the year. 3. By taking a mix of FX forward and FX option cover. Forward cover has a cost advantage relative to option cover. In fact, forward cover at the forward rate does not cost anything. In contrast, a call option always has a positive cost and thus is more expensive than an equivalent forward contract. The advantage of an option is that that it allows the holder to participate in any favourable movement (ie downward) in the rate of exchange AAD/BBD, while locking in a rate of exchange at the forward rate should exchange rates move upwards. The AAD/BBD rate of exchange affects the fund’s performance through its influence on the AAD value of BB bonds at the end of the period. As a fund manager, you can alter the exposure of the fund to fluctuations in the AAD\BBD rate by varying the amount of total fund value devoted to investment in BB bonds. However, you are required to hold a minimum of 30% of the fund’s value in BB bonds. Thus, the proportion of funds devoted to investment on AA and BB bonds must lie within these bounds: 30% of total to 70% of total. The decision on what proportion of funds to invest in country AA and BB is an asset class allocation problem. Having decided on the amount of funds to be devoted to a particular country, you, as manager, must then decide where on the yield curve to place those funds. Each country initially has 5 bonds in which you can invest. These are: Bond Coupon Bond01 (cash) 0.00% Bond03 5.00% Bond07 5.00% Bond10 5.00% Bond15 5.00% Each bond ages one year each round. However, note that each bond is renewed each year and so maintains its term from round to round. (this means that the start of year yield will differ slightly than the end of the previous year yield) The AA cash Bond01 is the only investment whose return is guaranteed1. All other bond investments are subject to capital gains/losses that result from shifts in the yield curves and/or shifts in the exchange rate. Your task is to place your investments so as to maximise fund growth relative to the benchmark index. Your performance will be judged against the performance of the benchmark portfolio consisting of an unhedged 50%AA/50%BB portfolio of 5-year bonds. The scoring table for your performance relative to the benchmark is as follows: Relative to the Benchmark Score card Score More than -20.00% and less than -11.00% -10.0 More than -10.00% and less than -8.50% -7.5 More than -7.50% and less than -6.00% -5.0 More than -5.00% and less than -4.00% -3.0 More than -3.00% and less than -2.50% -2.0 More than -1.50% and less than -1.50% -1.0 More than -0.50% and less than -0.50% 0.0 More than 0.50% and less than 0.50% 1.0 More than 1.50% and less than 2.00% 3.0 More than 3.00% and less than 4.00% 6.0 More than 5.00% and less than 6.50% 10.0 More than 7.50% and less than 9.00% 15.0 More than 20.00% 100.0 1 While the return on the BB cash bond is guaranteed in BBDs, fluctuations in the rate of exchange mean that the BB bond return expressed in AADs is uncertain. Prevailing Economic Conditions AA Initial Conditions AA Initial Conditions Bond Yield Year -1 0 1 01 3.20% Unemployment 4.7% 4.7% 4.6% 03 3.13% Inflation 3.0% 4.0% 2.1% 07 3.63% Growth 3.5% 3.1% 2.7% 10 3.94% Share Mkt 4.4% 8.4% 12.4% 15 4.24% BB Initial Conditions BB Initial Conditions1 Bond Yield Year -1 0 1 01 5.35% Unemployment 5.3% 4.7% 4.6% 03 4.56% Inflation 1.6% 1.9% 2.7% 10 4.40% Growth 1.3% 3.2% 2.4% 10 4.43% Share Mkt 10.5% 18.7% 7.7% 15 4.48% Exchange Rate History Year -1 0 1 Ex Rate AA/BB 1.1304 1.0188 1.0074 The four logical steps in your decision making process are: 1. decide on the split between AA and BB bonds 2. decide whether or not to hedge, and if hedging whether to use forward or option cover (note this can only be done after round 2 of the simulation) 3. decide where on the yield curve to place your AA investment and finally 4. decide where on the yield curve to place your BB investment. You must complete the Simulation 02 Submission Form and return it to me by email prior to 12:00 noon, Tuesday, May 23, 2017. Good luck.