Kyle Morgan is the manager of a large pension fund for the Firefighters' Union. As the pension fund is currently underfunded by approximately $300 million, Kyle is arranging for the plan sponsor to issue a privately placed two-year bond that will be held by the plan to maturity. The bond will carry an interest rate of 80 basis points (0.8% per annum) above the U.S. Treasury bill yield.
However, Kyle notes that after the private placement the allocation of the pension fund will significantly skew toward the fixed-income asset class. Moreover, the duration of the pension fund will be shortened for the next two years due to the private placement. Kyle's colleagues advise him that he may adjust the portfolio weight and duration to any target level (including the target portfolio allocation of 50% in equity and 50% in fixed income instruments) using either futures and swap contracts during the two-year horizon prior to the bond's maturity.
a. What are the possible strategies for Kyle to restore the 50:50 portfolio allocation using
(1) Futures
(2) Swap contracts? Briefly describe the transactions involved.
b. Compare and contrast the advantages and disadvantages of using futures and swaps as described in Part a.