The Citrix Fund

The Citrix Fund has invested in a portfolio of government bonds that has a current market value of $45.1
million. The duration of this portfolio of bonds is 13.3 years. The fund has borrowed to purchase these
bonds, and the current value of its liabilities (i.e., the current value of the bonds it has issued) is $38.4
million. The duration of these liabilities is 3.7 years. The equity in the Citrix Fund (or its net worth) is
obviously $6.7 million. The market-value balance sheet below summarizes this information:

Assume that the current yield curve is flat at 5.9%. You have been hired by the board of directors to
evaluate the risk of this fund.

a. Consider the effect of a surprise increase in interest rates, such that the yields rise by 50 basis points
(i.e., the yield curve is now flat at 6.4%). What would happen to the value of the assets in the Citrix
Fund? What would happen to the value of the liabilities? What can you conclude about the change in
the value of the equity under these conditions?

b. What is the initial duration of the Citrix Fund (i.e., the duration of the equity)?

c. As a result of your analysis, the board of directors fires the current manager of the fund. You are hired
and given the objective of minimizing the fund’s exposure to interest rate fluctuations. You are instructed
to do so by liquidating a portion of the fund’s assets and reinvesting the pro-ceeds in short-term Treasury
bills and notes with an average duration of two years. How many dollars do you need to liquidate and
reinvest to minimize the fund’s interest rate sensitivity?

d. Rather than immunizing the fund using the strategy in part (c), you consider using a swap contract. If
the duration of a 10-year, fixed-coupon bond is seven years, what is the nota-tional amount of the swap
you should enter into? Should you receive or pay the fixed-rate portion of the swap?

The Bond Investment Decisions of Dave and Marlene carter

Dave and Marlene Carter live in the Boston area, where Dave has a successful orthodontics practice.
Dave and Marlene have built up a sizable investment portfolio and have always had a major portion of
their investments in fixed-income securities. They adhere to a fairly aggressive invest-ment posture and
actively go after both attractive current income and substantial capital gains. Assume that it is now 2016
and Marlene is currently evaluating two investment decisions: one involves an addition to their portfolio,
the other a revision to it.

The Carters’ first investment decision involves a short-term trading opportunity. In particular, Marlene
has a chance to buy a 7.5%, 25-year bond that is currently priced at $852 to yield 9%; she feels that in
two years the promised yield of the issue should drop to 8%.

The second is a bond swap. The Carters hold some Beta Corporation 7%, 2029 bonds that are currently
priced at $785. They want to improve both current income and yield to maturity and are considering one
of three issues as a possible swap candidate: (a) Dental Floss, Inc., 7.5%, 2041, currently priced at $780;
(b) Root Canal Products of America, 6.5%, 2029, selling at $885; and (c) Kansas City Dental Insurance, 8%,
2030, priced at $950. All of the swap candidates are of comparable quality and have comparable issue
characteristics.
Questions

a. Regarding the short-term trading opportunity:

1. What basic trading principle is involved in this situation?

2. If Marlene’s expectations are correct, what will the price of this bond be in two years?
3. What is the expected return on this investment?
4. Should this investment be made? Why?

b. Regarding the bond swap opportunity:

1. Compute the current yield and the promised yield (use semiannual compounding) for the bond the
Carters currently hold and for each of the three swap candidates.

2. Do any of the swap candidates provide better current income and/or current yield than the Beta
Corporation bonds the Carters now hold? If so, which one(s)?

3. Do you see any reason why Marlene should switch from her present bond holding into one of the
other issues? If so, which swap candidate would be the best choice? Why?

Grace Decides to Immunize her Portfolio

Grace Hesketh is the owner of an extremely successful dress boutique in downtown Chicago. Although
high fashion is Grace’s first love, she’s also interested in investments, particularly bonds and other fixed-
income securities. She actively manages her own investments and overtime has built up a substantial
portfolio of securities. She’s well versed on the latest investment techniques and is not afraid to apply
those procedures to her own investments.

Grace has been playing with the idea of trying to immunize a big chunk of her bond portfolio. She’d like
to cash out this part of her portfolio in seven years and use the proceeds to buy a vacation home in her
home state of Oregon. To do this, she intends to use the $200,000 she now has invested in the following
four corporate bonds (she currently has $50,000 invested in each one).

1. A 12-year, 7.5% bond that’s currently priced at $895

2. A 10-year, zero-coupon bond priced at $405

3. A 10-year, 10% bond priced at $1,080

4. A 15-year, 9.25% bond priced at $980

(Note: These are all noncallable, investment-grade, nonconvertible/straight bonds.)

Questions

a. Given the information provided, find the current yield and the promised yield for each bond in the
portfolio. (Use annual compounding.)
b. Calculate the Macaulay and modified durations of each bond in the portfolio and indicate how the
price of each bond would change if interest rates were to rise by 75 basis points. How would the price
change if interest rates were to fall by 75 basis points?
c. Find the duration of the current four-bond portfolio. Given the seven-year target that Grace has set,
would you consider this an immunized portfolio? Explain.
d. How could you lengthen or shorten the duration of this portfolio? What’s the shortest port-folio
duration you can achieve? What’s the longest?
e. Using one or more of the four bonds described above, is it possible to come up with a $200,000 bond
portfolio that will exhibit the duration characteristics Grace is looking for? Explain.
f. Using one or more of the four bonds, put together a $200,000 immunized portfolio for Grace. Because
this portfolio will now be immunized, will Grace be able to treat it as a buy-and-hold portfolio-one she
can put away and forget about? Explain.

Ejercicio Arbitraje 1

Ejercicio Arbitraje 2