Ah Lee, a financial manager at a US based mid-sized manufacturing firm, has been caught off-guard before. To earn the most on excess cash, Ah Lee once bought five-year coupon Treasury bonds (a maturity longer than the firms liabilities) only to see interest rates rise. The loss when the Treasury bonds were sold did not make Ah Lees supervisor, Carlo, Chief Financial Officer, very happy.

Ah Lee is now in a similar situation - Carlo has asked Ah Lee for a recommendation on the investment of another $10 million in excess cash.

Risk and Return using Duration & RCY Analysis

The risk of unexpected changes in interest rates is a given with coupon-paying bonds. Even if the bonds are held to maturity, there is reinvestment risk. A bonds exposure to interest rate risk depends on the size and the number of coupon payments made to the bondholder. The realized return from a bond depends on the rates at which the coupons are invested; the rates can only be estimated at the time the bond is purchased.

Given estimates of futures spot interest rates, however, the expected realized compound yield (RCY) can be calculated in order to cope with the reinvestment problem. For a bond that pays annual coupons over n years, the appropriate calculation for the annualized return is:

RCY = [(Total future dollar value/Initial Purchase price of bond)1/n - 1].

Where the Total future dollar value is the sum of (1) the coupon payments, (2) the reinvestment value on each coupon, and (3) the value of the bond at the end of the holding period.

In estimating the future dollars from a bond investment, Ah Lee needs a forecast of the direction and level of future interest rates in order to calculate the RCY.

At yesterdays investment meeting, Carlo stated his view that interest rates term structurewould remain unchanged for the next three years because of a stable (and most possiblyunchanging) in expected inflation rate and the economy environment will be stabilized.

Ah Cheung, another financial manager at the firm and someone that has earned Carlos respect for his reasoned judgment, suggests Ah Lee use the current term structure to gauge interest rate expectations. He reviews the past 20 years historic trends of Y1 to Y4 interest rate (see diagram below) for insight.

Ah Lee uses the following table obtained from Federal Reserve Statistical Release H.15 to get current spot rates on one-, two-, three- and four-year constant maturity Treasury securities. (See table below).

Treasury constant maturities	Spot Rate Today
1-month	0.01%
3-month	0.05%
6-month	0.19%
1-year	0.38%
2-year	0.75%
3-year	0.99%
4-year	1.10%
5-year	1.29%
7-year	1.47%
10-year	1.55%
20-year	2.00%
30-year	1.96%

Ah Lee is to recommend the best investment strategy among the four different US Treasury bonds. See table below. The $10 million investment will be liquidated in three years to help repay a bank loan charging a fixed rate interest at 8.50% per year. The bonds, each with a $1,000 par value and annual convention, are described as following:

Bond	Annual Coupon	Current Price	Maturity (yrs)
Bond 1	0%	$882.50	5
Bond 2	11.625%	$1403.39	5
Bond 3	5.5%	$1107.59	3
Bond 4	3.5%	$905.25	4

Note: This is an important recommendation for Ah Lee that can affect his career. Although no one knows the future course of interest rates (not even Carlo), Ah Lee knows it is essential to consider the impact of an unexpected change in interest rates on each of the bonds. To Ah Lee, it is probably least risky to assume Carlos forecast is the best because hell have no one to blame but himself if Ah Lee makes a recommendation based on the forecast.

Some background: "Carlo will accept a recommendation different than his own only if it is justified by analysis," advises Ah Cheung. "Well-reasoned analysis is an opportunity to gain back some of Carlo trust, which was lost after your last bond investment." Ah Cheung also adds, If you follow Carols view, he also wants to see the reasons behind your agreement.

CASE TASK: You (Ah Lee) are tasked to write an Investment Proposal for recommending an investment to Carlo (your boss) for $10 million with the prime objective to reduce the funding cost of the fixed rate loan as mentioned above over the next 3 years. The proposal should start with a summary of recommendation and followed by detailed parts containing analysis which has to have the following 3 major areas:

(i) Interest Rate View Forecast Part

Before choosing your investment, you must form your interest rate view over your investment period as it will direct your choice of bond investment. Economic and other market factors will influence the interest rate movement as you need to forecast interest rate change across the whole curve. Would you (being Ah Lee) go by Carlos forecast on interest rate term structure remain unchanged for the next 3 years? (Give reasons to support if you agree to the same view or not? This is important as your interest rate view would directly affect your investment recommendation and you need to determine the expected change in the yield curve.) Of course, you can disagree with Carlo and you need to forecast the change.

(Note: I am open to what you want to discuss about the interest rate term structure over the next 3 years. Whether you agree or disagree with the view that term structure will remain the same in the coming 3 years. You should frame your discussion on interest rate view with current economic and market factors (such as ate cut after rate hike, inflation/deflation expectation, monetary/fiscal policy, trade war etc). Your interest rate view and the exact levels would directly affect your investment decision in Q3 as the basis to evaluate in Part II.)

(25 Points)

(ii) Risk and Return analysis Part

Duration and risks are important to form an investment recommendation especially given that you do have an interest rate view about its future years as projected in Part 1.

From the case text,

Ah Lee once bought five-year coupon Treasury bonds (a maturity longer than the firms liabilities) only to see interest rates rise. The loss when the Treasury bonds were sold did not make Ah Lees supervisor, Carlo, Chief Financial Officer, very unhappy.

So, it should have analysis of the durations of the 4 bonds with respective to the forecast you made in Part 1. (10 Points)

(Hint: You need to calculate the YTM of the 4 bonds in order to calculate the Duration.

You should discuss in relevant investment context here for selecting bonds based on duration given the target return linked to offset to a loan lability. (10 Points)

(Hint: The discussion should be about why matching duration on companys asset and liability balance affects investment choice)

Given the sensitivity of duration and interest rate forecast, perform RCY analysis on the 4 bonds based on the current interest rate and compare with the RCY analysis based on your forecasted interest rate view. (you need to show details of your calculation). (30 Points)

(A) Calculation of Coupon Reinvestment (Hint: if you expect the rates will be unchanged, you can make use of current spot rates to calculate the corresponding forward rates for coupon reinvestment calculation, otherwise you can use your forecasted forward rates in the future. See an example of cashflow diagram.)

(B) Calculation of Bond Price in 3 years. (Hint: You also need forward rates for future Bond price. See example of cashflow diagram)

(iii) Based on Part 1s interest rate expectation and Part 2s calculations, explain yourrecommendation on the investment of $10 million? (25 Points)

(Hint: Your recommendation does not only base on interest rate view and the RCY/durationanalysis. You also need to consider the funding cost the company currently paying for itscurrent liability.) If your interest rate view is not the same as Carlo, RCY in Part 2 will not be the same and therefore you need to recalculate the RCY based on interest rate scenario analysis to see if you are better or worse off.

I have already finished part i & ii. How about part iii?