You are the principal of a consulting firm, IDSCDR² Inc. Your consulting firm provides two basic services to clients. First, you provide advice to clients that wish to reduce their exposure. Second, you provide advice to clients that wish to implement sophisticated, non-traditional strategies to take advantage of their market beliefs.

IDSCDR²s most important client is the insurance company RestLife, Inc. RestLife has contacted IDSCDR² to assist RestLife in implementing a plan that aligns RestLifes exposure to RestLifes market beliefs.

RestLifes beliefs are twofold. First, they believe that the risk free rate of interest rates will increase dramatically over the next six months. Second, they believe that BBB corporate will be extensively downgraded by credit ratings agencies over the next six months while A, AA, and AAA corporate will retain their existing credit ratings.

Based on these beliefs, RestLife is looking for IDSCDR²s advice. Due to the proprietary nature of their portfolio, RestLife will not provide IDSCDR² detailed characteristics of the portfolio regarding which RestLife is requesting advice, beyond the following:

Portfolio size: $3 billion.

Exposure: 70% long BBB corporate, 20% long A corporate, 5% long AA corporate, 5% long AAA corporate.

Duration: 50% of the portfolio matures between 5-10 years. 50% of the portfolio matures between 10-20 years.

Securities: 60% corporate bonds, 40% syndicated loans.

RestLife is requesting IDSCDR² provide advice in relation to the following strategies. Specifically, they would like IDSCDR² to provide methodologies through which they can gain beneficial exposure to the forecasted downgrade of BBB corporate and increase in the risk free rate.

RestLife emphasizes that they do not require IDSCDR² to actually perform the calculations required to implement the proposed strategy indeed, they have not provided sufficient information to permit IDSCDR² to do so. Instead, they require IDSCDR² input regarding the types of strategies and calculations they should implement.

Deliverables:

Describe the characteristics of RestLifes portfolio, including the portfolios exposures.

How can RestLife transform their existing portfolio to allow them to gain exposure that is aligned with RestLifes beliefs? Provide a menu of alternatives. Make sure to provide details regarding the positions that should be held and provide an illustration of the resulting cash flows for a hypothetical portfolio. Examples of instruments that you may consider when developing your strategy include interest rate swaps, floors, collars, asset swaps, single name CDS, CDS indexes, CDOs, synthetic CDOs, full index trades, index tranche trades and/or combinations of the above.

Describe in details the pros/cons associated with alternative ways through which RestLife can gain the desired exposure and describe the full nature of the exposure following the implementation of each strategy (credit risk, IR risk, counterparty risk, liquidity risk).Which strategy do you recommend? Justify your recommendation, and be prepared to explain why it is optimal.

For the sake of illustration, consider a situation where RestLife holds a $120 MM face value position with an IR DV01 of 73,828.09 and SPRD DV01 of 95,908.09. What position in an IRS and a CDS should be held if the IR DV01 and SPRD DV01 of $10 MM notional principal positions are as follows?

	IR DV01	SPRD DV01
IRS	4,356.65	0
CDS	443.29	3,928.22

While RestLifes main focus is on implementation, in the past they have expressed appreciation when IDSCDR², Inc. has provided commentary about the wisdom of RestLifes beliefs. Under which macroeconomic conditions is their strategy sensible?