Business 3079 Portfolio Management

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					Business 4179

Portfolio Management



      Chapter 3

      Setting Portfolio Objectives – Problem
      Solutions

                     K. Hartviksen             1
Question 3 - 1
   The income objective generates a reasonably consistent level of
    income from the portfolio. Higher levels of income can be
    achieved by investing in higher risk securities. The growth of
    income objective initially accepts a lower level of income
    because of some investment in equity securities. As time
    passes, the equity securities normally appreciate, thereby
    increasing the principal value of the portfolio, and enabling
    additional funds to be invested in income-producing securities.




                              K. Hartviksen                      2
Question 3 - 2
   Secondary objectives help find the percentage of the fund that
    should be invested in equity securities.




                              K. Hartviksen                          2
Question 3 - 3
   Try to figure out what the income is needed for: retirement
    income, a supplement to retirement income, funds to augment an
    organization’s operating budget, etc.
   Also determine the length of time the income will need to be
    generated. An 80 year old person would be more likely suited to
    an income objective generating level income, whereas a recently
    retired 65 year old would probably want to seek increasing
    retirement income via a growth of income objective.




                              K. Hartviksen                     2
Question 3 - 4
   Common stock is inappropriate when stability of principal is
    either the primary or the secondary objective.




                               K. Hartviksen                       2
Question 3 - 5
   No. Investing in riskier securities (bonds, most likely) can always
    increase current yield, but the purchase of CC-rated bonds is not
    likely always to be the prudent thing to do.




                               K. Hartviksen                        2
Question 3 - 6
   One set of factors includes subjective matters that the client
    might suggest, such as a desire to invest locally or a desire to
    avoid certain industries. The size of the portfolio also may
    dictate the number of different issues that should be selected. In
    general, it is a good idea to avoid placing too great a percentage
    of the portfolio’s funds in any single security.




                               K. Hartviksen                       2
Question 3 - 7
   Technically, this statement is true.
   Some clients, however, will not understand duration, and if they
    choose to focus on maturity instead, you should be able to deal
    with the fact.




                               K. Hartviksen                       2
Question 3 - 8
   Many people agree with this.
   There is a difference in risk, however small, and whether it is
    material is a matter of opinion. Some portfolios may be
    prohibited from investing in a bond that is not AAA rated, too.




                               K. Hartviksen                          2
Question 3 - 9
   Income comes from current yield; it is more important in this
    situation.




                               K. Hartviksen                        2
Question 3 - 10
   Zero coupon bonds could be used with the capital appreciation
    objective and conceivably with the growth of income.




                              K. Hartviksen                         2
Question 3 - 11
   No




                  K. Hartviksen   2
Question 3 - 12
   There is no reason certificates of deposit are inconsistent with a
    stability of income objective.




                               K. Hartviksen                        2
Question 3 - 13
   There is reinvestment rate risk, but ideally the effects of interest
    rate risk will offset it.




                                K. Hartviksen                          2
Question 3 - 14
   Investment policy is a long-term concept; investment strategy
    comprises the short-term steps taken that are consistent with
    investment policy.




                              K. Hartviksen                         2
Question 3 - 15
   There is some truth to this. Duration matching does require the
    use of principal to provide income in some circumstances.




                              K. Hartviksen                       2
Question 3 - 16
   This involves some personal preference, but many people would
    recommend a combination of capital appreciation and growth of
    income. Others who are more conservative would prefer growth
    and income. Still others would choose income and stability of
    principal.




                             K. Hartviksen                     2
Question 3 - 17
   The issue of whether the SSA should be able to invest in equity
    securities is a debatable issue.

   This has been addressed in Canada with the CPP…and funds
    are invested in equity markets (this might be an unfortunate issue
    vis a vis the timing of entry to those markets)




                               K. Hartviksen                       2
Question 3 - 18
   The results are an anomaly with no obvious explanation.




                              K. Hartviksen                   2
Problem 3 - 1
   The portfolio must generate $50,000 every September 1. All four bonds
    in Table 4-6 pay interest on September 1, so any or all four of them can
    be used. One simple solution would be to buy 500 of the JKL bonds.
    They have a 10% coupon, meaning that they generate $50,000 per
    year in income.
   Because the bonds pay semi-annually, you can reinvest the first
    coupon proceeds until they are needed. If you assume that you can
    reinvest at the coupon rate of 10%, each bond actually generates
    $102.50 per year. This means that you only need 488 bonds. They
    would generate $24,400 in interest twice, plus you would earn $1,220
    on the reinvestment of the first interest cheque.




                                 K. Hartviksen                           2
Problem 3 - 2
   First, find the present value of the $50,000 twenty-year annuity.
   PVA = $50,000(PVIFAn=20,r=10%)
       At 10%, the answer is $425,678
   Next, find the duration of this annuity.
       This is easiest using the closed-form equation: the answer is 7.50.
   Then find a package of bonds that has this duration and this market
    value.
       162 of the ABC bonds and 261 of the GHI bonds.




                                     K. Hartviksen                            2
Problem 3 - 3
   $9,000 = $7,000 (1.04)N
   1.2857 = (1.04)N
   ln 1.2857 = N ln 1.04
   .2513 = N (0.0392)
   N = 6.41
Problem 3 - 4
   The present value depends on whether the first payment occurs
    immediately or in one year. You could also consider the annuity due as
    having twelve or thirteen payments given that her life span is 12 more
    years. Regardless, compare the three present values:
    a. PV of annuity @ 8%, 12 years, C=$55,000: $414,484 (ordinary
       annuity, 12 payments); $469,484 (annuity due with 13 payments);
       $447,643 (annuity due with 12 payments)
    b. PV of growing annuity @ 8%, C=$55,000 times .85, g = 5%:
       $446,993 (ordinary growing annuity); $516,093 (growing annuity
       due with 13 payments);
    c. PV of lump sum = $400,000
   Under any of the assumptions the growing annuity has the highest
    present value.
Problem 3 - 5
   A higher discount rate can change the preferred alternative. In this
    case, the new present values are:
    a. $298,134 (ordinary annuity)
       $353,134 (annuity due with 13 payments)
       $342,854 (annuity due, 12 payments)
    b. $310,580 (ordinary growing annuity
       $372,859 (growing annuity due with 13 payments)
       $357,167 (growing annuity due with 12 payments)
    c. $400,000


    Clearly the lump sun is now preferable.
Problem 3 - 6
   The BONDPORT file on the Strong Software disk is helpful in
    solving this problem. The problem here is to compare monthly
    income needs with the income we expect the portfolio to
    generate.
   You first need to make a schedule of income receipts based on
    the data given to you in Table 4 - 7….remember bonds pay
    coupon interest semi-annually. The semi-annual coupon
    payments can be found by multiplying the coupon rate times the
    bond par value and then dividing that product by 2.
            Income Forecast for 1991
                                  Income Forecast for 1991
                      December January February March  April   May     June    July Aug      Sept    Oct    Nov    Dec
                         90      91
Cash Receipts:                  $3,025 $1,200       $0 $1,223 $9,704 $2,764 $3,025 $1,200         $0 $1,223 $9,704 $2,764
Cash Payments:                    4778    4778    4778   4778    4778    4778    4778 4778 4778 4778 4778 4778
Transfers from Equity                            17417
Cash on Hand             $7,000 $5,247 $1,669 $14,308 $10,753 $15,678 $13,664 $11,911 $8,333 $3,555      $0 $4,926 $2,912

                                  Schedule of Income Receipts
                                                        Semi-annual Coupon Receipt Amounts
                                 Coupon Maturit                   March April    May     Jun
Principal              Bond      Rate   y Date    Jan Jul       1 Sept    Oct    Nov     Dec
             $25,000   FMC        8.75%      94         $0     $0      $0     $0 $1,094      $0
             $40,000   VEP        9.38%      98         $0     $0      $0     $0      $0 $1,876
             $30,000   FHLB       8.15%      92         $0     $0      $0 $1,223      $0     $0
             $25,000   FHLB       8.60%      92         $0     $0      $0     $0 $1,075      $0
             $15,000   FHLB       8.80%      92         $0     $0      $0     $0    $660     $0
             $30,000   FHLB       9.50%      93     $1,425     $0      $0     $0      $0     $0
             $40,000   FHLB      10.75%      93         $0     $0      $0     $0 $2,150      $0
             $40,000   US         8.00%      94     $1,600     $0      $0     $0      $0     $0
             $20,000   FHLB       8.88%      95         $0     $0      $0     $0      $0 $888
             $50,000   FNMA       9.35%      97         $0     $0      $0     $0 $2,338      $0
             $50,000   FNMA       9.55%      97         $0     $0      $0     $0 $2,388      $0
             $30,000   US         8.00%      99         $0 $1,200      $0     $0      $0     $0
            $395,000
                       Monthly Totals              $3,025   $1,200    $0   $1,223   $9,704 $2,764
Problem 3 - 6
   Yield to maturity and duration are not needed for this problem.
   The “schedule of income receipts” table shows the monthly totals
    received from the bonds.
   The “Income Forecast” table shows the end of the month cash balance
    after receipt of the bond income and the payment of the monthly check
    to the church. At the bottom of Table 4-7 we learn that we start this
    table with $7,000 cash on hand.
   By finding the maximum shortfall over the year, this amount can be
    transferred the first time any shortfall occurs, eliminating the need to
    transfer funds again during the year. Here, a transfer of $17,417 in
    March results in a zero cash balance in October.
Problem 3 - 6
   Ideally, it is not a good idea for the cash balance to fall all the way to
    zero, so the actual transfer perhaps should be higher. Also, there will
    be some interest earned on idle funds that has not been incorporated
    into the income forecast.
   Planning for 1992 can occur the same way, with the $60,196 target
    allocated over the twelve months and shortfalls noted. It will again be
    necessary to transfer funds from the stock portfolio to meet the income
    constraint. During 1992 there also will be bond maturing; they will need
    to be replaced, and at an uncertain rate.
   The actual solution to this problem provided by the author also showed
    $4,000 interest on the mortgage being transferred to principal so that
    some maturing principal could be transferred to income.

				
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