Derivative

Vanguard High Yield Corporate Fund Materials Website information (23/05/2016) https://personal.vanguard.com/us/funds/snapshot?FundId=0029&FundIntExt=INT Summary Prospectus (27/05/2015) Prospectus (27/05/2015) Anakins Job In May 2016, Anakin leaves his job in Hollywood and returned to the finance industry. It is his first love after all and the industry appears to be picking up again after the credit crunch of 2007-2008. He applies to be the risk analyst to the fund manager of the Vanguard High Yield Corporate Fund as his quantitative training positions him well for a job that requires ever more numerical and computational skills over the years. His solid background in applied analytics in business management and humble demeanour help him clinch the post without much difficulty. The Vanguard Group is an American investment company that has approximately USD 3 trillion in asset-under-management. It is founded in 1975 by John Bogle who created the first index fund (tied to the S&P 500 index) in the process. After an initial lull, the index grew rapidly along with the bull market of the 1980s. The Group has since added various financial services and products to its core business, particularly the ETFs. Anakin is tasked by the fund manager to become thoroughly familiar with the structure of the fund as is documented by files provided under Materials. After that, he is to assess the exposure of the High Yield Corporate Fund to risks in the market. He seeks the opinion of Darth who is a veteran market analyst with the Vanguard Guard group for over 20 years. Outlook Darth has this to say about the economy and fixed income market: " The US economy is improving steadily. It will not be long before the Fed decides to raise interest rates. Once the Fed restarts the regime of rising rates, it will about 2 years for the yield curve to rise by 100 basis points. Consequently, in the more stringent economic environment, companies of lower credit qualities, namely those of Caa and below, are expected to have their credit standing further eroded. There is a 25% chance that a Caa-rated issuer may go into default and another 25% chance that it may be downgraded to C. The Greek debt problem, though much stabilized than before, is still a matter of grave concern for the Eurozone. Expect the euro to depreciate against the dollar over the course of the next 6 months. A fall of 500 pips will not be a surprise. " Assume Anakins role and answer the following questions. Questions 1 and 2 concern the Financial Environment. The Environment at large provides the context and sets the constraints within which financial decisions are weighed and taken. Questions 3 and 4 pertain to the task that Anakin needs to complete. Question 1 Describe the types of mutual funds that can be found in the market in a concise and systematic manner, suitable for presenting to a group of investors who are high net worth and impatient. (25 marks) Question 2 Collect data (e.g. from the internet and/or Eikon) to plot the term structures of bond yields. Each term structure describes the state of the fixed income market for bonds of the credit quality corresponding to that curve. The different term structures span the space of bonds across credit qualities and maturities. Analyse the states of these markets relative to the shape of the curves. Compare and contrast your analysis with current market views. Explain your steps, present your answers and quote your sources clearly. (25 marks) Question 3 To better understand the structure of the fund, answer the following questions: (a) Describe the composition of the fund. (b) What are the risks faced by the fund according to the prospectus? Analyse the nature of the portfolio risk accordingly and comment on whether commodity price risk and equity price risk matter to the fund management. (c) Discuss the performance of the fund based on the financial numbers provided. (d) Assess the quality of the management of the fund. (25 marks) Question 4 The fund is affected by changes in the financial markets. When interest rates rise, the value of the portfolio falls. Occurrences that are flagged by the rating agency to be credit events can result in the downgrading of credit rating of bond issuers. Bonds that denominated in foreign currency are affected by fluctuations in the foreign exchange market. (a) Analyse generally the need for hedging the various market risks for the fund. Take into account Darths outlook. Address some of these risk concerns by answering the following question: (b) Suppose that in the coming 2 years, the prevailing interest rates are expected to go up by 100 basis points and you are concerned. Show how you could hedge away the interest rate risk by using an interest rate swap, assuming that the fund by may represented by a single 5-year par bond on the $18.4 billion net assets with semi-annual 5% coupon payments starting from the current date. In your explanation, you may assume a scenario in which a flat yield curve increases uniformly across all terms by 25 basis points per half-a-year. (c) Credit default swaps may be used to ameliorate credit risk. Appraise the use of such option-like derivative instruments in managing the risk of the portfolio by explaining how such instruments function.