CATT Endowment is a fund set up by billionaire George De Niro. He is a past student of IWN University. He wanted to give back to the institution and thus decided to set up the endowment to help finance the operations of the university which lost most of its government financing over the last couple of years. The objective of the endowment is to finance a portion of the annual operating budget of the entity. The annual budget of IWN University is $30 million. By law, an endowment is required to donate 75% of its annual return in order to maintain its endowment status. The only exception to this rule is that if the annual return is negative the endowment is not required to make a donation for that year. One of the benefits of an endowment is that the portfolio returns are not taxed. An investment committee was established to monitor the performance of the fund and hire and fire the investment managers that underperform. The Investment Policy statement (IPS) of the fund requires 100% of the fund be invested in bonds. Mr. De Niro, donated a portfolio of bonds equal to $100 million. The fund is expected to exist forever and thus the principal (the initial donation) cannot be spent. The investment committee is comfortable with an annual return of 8% as they believe that that is the minimum required return needed to allow the fund to meet its obligation to the University and maintain its legal status as an endowment. The duration (Macaulay) of the portfolio that was donated is equal to 10 years. The current yield in the market is 10%. Bonds pay interest on a semiannual basis. a.

a. Calculate what percentage of the universitys annual budget the investment committee is expecting to finance when it decided to set the return target of 8%. (3 points)

b. What is the modified duration of the portfolio that was donated? (2 points)

c. The investment committee expects interest rates to increase by 70 basis points in the next year. If the committee is correct by how much will the portfolio change by, ignoring the effect of convexity? (3 points)

d. How much will the endowment donate to the university next year if interest rates increase by 70 basis points, ignoring the effect of convexity? (2 points)

e. One of the committee members than pointed out that he does not like using the duration measure (the Macaulay and modified duration) as measures of portfolio risk. He also believes that there are alternative measures that can be used. List two reasons why the committee members may have an issue with the duration measures and outline one alternative measure that can be used. (3 points)

f. Another committee member then said that there is a bond in the portfolio that he doesnt like. The bond has a duration of 10 years and represents 5% of the portfolio. He then asked: If we sell this bond and replace it with a zero coupon bond that matures in three years what impact would that swap have on the overall duration of the portfolio? How would you answer? (3 points)

g. A discussion that began about active or passive investment style for the portfolio. One member then pointed out that he likes when there is not a lot of turnover on the portfolio ( buying and selling of the assets) and thus he believes that the best active management style is a buy and hold investment strategy. Do you agree or disagree with him and why? (2 points) 2

h. The head of the University has reached out Mr. De Niro for support in financing another project for the school which Mr. De Niro has decided to finance with another donation. It will be administered by the investment committee of the endowment. The head has some influence in government circles and has gotten a special wavier for this additional donation. The rules that govern endowments were waived but the fund still enjoys its tax free status. The cost of the project is expected to cost $32.578 million in 5 years. The size of the donation that Mr. De Niro made today towards the financing of the project is 20 million. If you wanted to build an immunized portfolio to finance this future liability what would be the duration of that portfolio? (2 points)

i. Using information from part h, and the fact that the university is comfortable with a return of 10% per annum. After the second year of management (three years left) the portfolio value is $23 million and market interest rates are 12%. What is the require floor value of the portfolio and would you recommend continued active management of the portfolio? (5 points) (Reminder: we assume bonds pay interest semiannually)