Question

Project scenario:

You are the principal of a consulting firm, IDSCDR² Inc. Your consulting firm provides two basic services to clients. First, you provide advice to clients that wish to reduce their exposure. Second, you provide advice to clients that wish to implement sophisticated, non-traditional strategies to take advantage of their market beliefs.

IDSCDR²‘s most important client is the insurance company RestLife, Inc. RestLife has contacted IDSCDR² to assist RestLife in implementing a plan that aligns RestLife’s exposure to RestLife’s market beliefs.

RestLife’s beliefs are twofold. First, they believe that the risk free rate of interest rates will increase dramatically over the next six months. Second, they believe that BBB corporate will be extensively downgraded by credit ratings agencies over the next six months while A, AA, and AAA corporate will retain their existing credit ratings.

Based on these beliefs, RestLife is looking for IDSCDR²‘s advice. Due to the proprietary nature of their portfolio, RestLife will not provide IDSCDR² detailed characteristics of the portfolio regarding which RestLife is requesting advice, beyond the following:

• Portfolio size: $3 billion.
• Exposure: 70% long BBB corporate, 20% long A corporate, 5% long AA corporate, 5% long AAA corporate.
• Duration: 50% of the portfolio matures between 5-10 years. 50% of the portfolio matures between 10-20 years.
• Securities: 60% corporate bonds, 40% syndicated loans.

RestLife is requesting IDSCDR² provide advice in relation to the following strategies. Specifically, they would like IDSCDR² to provide methodologies through which they can gain beneficial exposure to the forecasted downgrade of BBB corporate and increase in the risk free rate.

RestLife emphasizes that they do not require IDSCDR² to actually perform the calculations required to implement the proposed strategy – indeed, they have not provided sufficient information to permit IDSCDR² to do so. Instead, they require IDSCDR² input regarding the types of strategies and calculations they should implement.

Teams will make a 25 - 30 minute presentation followed by a question and answer session with the reviewers. In addition, each team will submit a briefing book documenting their work. The briefing book will be in the form of a CD ROM. The following list of deliverables must be addressed in the presentation and the sequencing of the deliverables should remain the same as requested by RestLife.

Deliverables:

1. Describe the characteristics of RestLife’s portfolio, including the portfolio’s exposures.

Answer 1

1. By looking at the details provided in the question, Rest Life Inc's portfolio looks like an aggressive one, as 70% of the value is invested in BBB corporates. (BBB corporates maybe referred here as midcaps, emerging firms with relatively stronger fundamentals and growing opportunities with innovation and technologies)

2. A portfolio with majority of amount invested in such instruments shows the aggressive nature of the firm and it's wealth creation opportunities in a relatively less longer run.

3. However, Rest Life is equally diligent in forecasting the market dynamics. They are of the view about declining growth of BBB corporates and increase in the risk free rate of return.

4. The following strategies will be most suitable for the firm to mitigate their exposures at best:

a) Enter into a Fixed to Floating Interest Rate Swaps - This instrument with allow the company to exchange their fixed returns from BBB corporate with floating returns (Risk free rate). Since, company is having good prospects for Risk Free Rates. In this, returns can be optimized till, the time exit from BBB corporate bonds are not allowed.

b) Matching and Smoothing: - It is a technique wherein, the amount is churned in fixed interest and variable earning interest assets. The company is long over floating rates and short of fixed rates. Hence, it can churn its portfolio a bit to invest more in floating rates and exit some from fixed rate to maintain equilibrium.

c) Forward Rate Agreements / Issue new securities - Since, company has done a specific forecast Entering in a forward rate agreement as per the forecast may help the position to hedge.

Alternatively, company can issue new securities, (borrow at fixed rates and invest at floating rates) to optimize arbitrage opportunity.

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