Question

In: Finance

Consider a state pension fund that needs to generate a series of fixed payments for its...

Consider a state pension fund that needs to generate a series of fixed payments for its retires. Assume that the compensation of the fund’s portfolio managers is tied to the return earned on the investments each year. What a short essay that explains how the compensation plan might lead to investment strategies that do not serve the needs of the retirees

Solutions

Expert Solution

Retirees usually want a fixed cash flow to finance their post retirement expenses month on month. They do not want excess returns and don't want to take any kind of risk with their principal. A state pension fund with the objective of generating fixed cash flows should focus on those products which ensure safety of capital and offer an interest slightly higher than the risk free rate. The return on debt instruments will be slightly higher than the risk free rate. One cannot expect to earn the kind of returns that are generated in equity market in a low risk debt instrument. If the pension fund's manager's compensation is tied to the investment returns i.e. the higher the returns higher the compensation, this may lead to a biased investment strategy which may not be in sync with the investment objective.

The manager may try to invest in those assets which may be risky for a pension fund. If the manager sets the primary objective of managing the fund as his desired compensation he will not be able to serve the objective of the pension fund. Risky assets may erode the capital of the fund and this may lead to no cash flows for retirees.

To keep the retirees investment safe, only those products should be part of the portfolio which can generate a consistent return. A fund manager's compensation should not be tied to such a fund. This will help avoid any unnecessary losses.


Related Solutions

Corporate bonds offer a series of fixed payments consisting of interest payments and face value at...
Corporate bonds offer a series of fixed payments consisting of interest payments and face value at maturity. As so, managers of financial intermediaries like pension funds and insurance companies frequently utilize such instruments to achieve their financing objectives. Questions for discussion: What is assumed the interest payments can be reinvested at? What is interest rate risk and what would happen to the price of a bond given interest rates increase? Assume the manager of a $100 million portfolio of corporate...
Consider the following two cash flow series of payments: Series A is a geometric series increasing...
Consider the following two cash flow series of payments: Series A is a geometric series increasing at a rate of 4% per year. The initial cash payment at the end of year 1 is $1,000. The payments occur annually for 5 years. Series B is a uniform series with payments of value X occurring annually at the end of years 1 through 5. You must make the payments in either Series A or Series B. Click here to access the...
Bonnie and Clyde the Houston’s company's pension fund management division, with Bonnie having responsibility for fixed...
Bonnie and Clyde the Houston’s company's pension fund management division, with Bonnie having responsibility for fixed income securities (primarily bonds) and Clyde being responsible for equity investments. A major new client, Ms. Victoria, has requested that Houston Company present an analysis of Sugar Land Company (SLC) she is considering to purchase. Assume that Sugar Land (SLC) has a beta coefficient of 1.2, that the risk-free rate (the yield on 10-year Treasury-Note) is 7 percent, and that the market risk premium...
A business has agreed to fund a pension program for its employees. It will need to...
A business has agreed to fund a pension program for its employees. It will need to have a fund balance of $4.5 million in 10 years. The company has $1,000,000 to invest right away and does so at 2% compounded quarterly. It will make additional contributions monthly in arrears for the next 10 years. How much does each monthly contribution need to be if money is assumed to earn 1.2% over the next 10 years? ***Show Calculator computations***
Chelsea Finance Company receives fixed inflow payments from its provision of fixed rate loans. Its outflow...
Chelsea Finance Company receives fixed inflow payments from its provision of fixed rate loans. Its outflow payments are floating-rates. a) Describe the interest rate risk faced by Chelsea. How can Chelsea use swap to hedge against the interest rate risk? b) If Chelsea expects interest rate to fall, what feature can it add to the swap to protect itself from losing too much? c) What are the main risks associated with swaps?
Consider the following probability distribution for Stock Fund (S) and Bond Fund (B). State Probability Return...
Consider the following probability distribution for Stock Fund (S) and Bond Fund (B). State Probability Return on Bond Fund Return on Stock Fund 1 .2 -10% 20% 2 .4 10% 30% 3 .4 18% -10% The expected return and the standard deviation of the Stock Fund are 12% and 18.33%, respectively. What is the expected return of Bond Fund? 8.2% 8.5% 8.9% 9.2% 9.6% What is the standard deviation of Bond Fund? 8.57% 9.23% 9.45% 10.25% 12.78% What is the...
1. You manage a pension fund that promises to pay out $10 million to its contributors...
1. You manage a pension fund that promises to pay out $10 million to its contributors in five years. You buy $7472582 worth of par-value bonds that make annual coupon payments of 6% and mature in five years. Right after you make the purchase, the interest rate on same-risk bonds decreases to 4.1%. If the rate does not change again and you reinvest the coupon payments that you receive in same-risk bonds, how much will you fall short of the...
IBM (US) needs to raise $100 or an equivalent in foreign currency to fund its operations...
IBM (US) needs to raise $100 or an equivalent in foreign currency to fund its operations in New York. It can issue a 3-year maturity Japanese yen bond at par, coupon rate 1% per annum. The current exchange rate is ¥85/$. Alternatively, it can issue the 3-year Eurodollar bond at par, with 3% coupon per year. You forecast the future exchange rates as follows: Year 1 - ¥92 Year 2 - ¥98 Year 3 - ¥107 The Bank has quoted...
Consider an ideal gas at a given state expanded in two different ways to a fixed...
Consider an ideal gas at a given state expanded in two different ways to a fixed final volume. In the first case, the gas is expanded at constant pressure, and in the second case at constant temperature. Sketch each process on a P-v diagram. For which case is the work done greater?
Consider a $300,000, 4.50% fixed-rate mortgage, which requires the borrower to make annual payments. If the...
Consider a $300,000, 4.50% fixed-rate mortgage, which requires the borrower to make annual payments. If the security currently has 23 years remaining until maturity, and is selling to offer a yield-to-maturity of 6%, what is this mortgage’s modified duration
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT