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The following information relates to Questions 21-24 Melissa Clarke, a recent graduate of Harvard Business School, is a mortgage-backed securities (MBS) portfolio manager at Star

The following information relates to Questions 21-24

Melissa Clarke, a recent graduate of Harvard Business School, is a mortgage-backed securities (MBS) portfolio manager at Star Flag Fund. The fund primarily invests in Agency MBS, that is, those issued by US Agencies such as Fannie Mae and Freddie Mac. The fund also uses various interest rate products such as US Treasuries, interest rate futures and, interest rate swaps (IRS) to manage the funds duration, cash flow and market risk.

A recent economic crisis has sharply reduced US interest rates, including fixed rates offered on conventional mortgages. The sudden drop in interest rates has sparked a re-financing boom, as US homeowners scrabble to refinance existing mortgages at lower interest rates. Clarke is worried about this development and notices that due accelerated mortgage prepayments, the portfolios average duration has contracted from 5.7 years to 4.1 years. Having a lower duration in an environment of falling interest rates will clearly hurt Star Flag Funds performance. Clarke wants to adjust the portfolios duration back to its target duration to offset the impact of increased MBS prepayments.

Fund information and market data are contained in the table below. USD IRS convention is to quote the fixed rate vs 6-month Libor. Also, assume all US IRS transactions are centrally cleared.

Fund size

$600 million

Fund target duration

5.5 years

Average duration of Agency MBS

3.7 years

Duration of 5y US Treasury

4.6 years

6m USD Libor

1.875%

5y IRS bid-offer quote

2.015% to 2.025%

7y IRS bid -offer quote

2.125% to 2.140%

21. To return the funds duration back to its target of 5.5 years, Clarke should

  1. Pay fixed rate and receive floating rate in the 5y IRS swap market

  2. Pay floating rate and receive fixed rate in the 7y IRS swap market

  3. Sell 5y US Treasuries and may buy agency MBS

22.Assuming the modified duration of the 5y and 7y swap are 4.25 a 5.75 respectively, find the swap notional needed for each tenor to return the portfolio back to its target duration.

  1. $198m and $146m respectively

  2. $227m and $146m respectively

  3. $198m and $183m respectively

23. If Clarke decides to execute a 7y IRS in the market, she is most likely to deal at an interest rate of

  1. 2.125%

  2. 2.140%

  3. Mid way between the bid and the offer or 2.1325%

24. If after having executed the appropriate swap to achieve the Funds target duration, 5y swaps rates rise. Marking to market the swap is likely to show

  1. A change in valuation resulting in a gain

  2. A change in valuation resulting in a loss

  3. An unchanged valuation

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