The following is extracted from a Wall Street Journal article Texas Faces Some Risks With Fund, December
Question:
The following is extracted from a Wall Street Journal article
"Texas Faces Some Risks With Fund," December 9, 1994, p. C1], and describes a Texas State fund (TexPool) which was structured similarly to the Orange County investment pool that had earlier filed for bankruptcy protection. The Texas State Treasurer's office, which manages a short-term investment pool for more than 1,300 different municipalities, is running some of the same types of risks as Orange County, Calif. But nobody seems worried.
"We hold to maturity," says Texas State Treasurer Martha Whitehead of the $3.7 billion fund. Ms. Whitehead spent much of last summer promoting the money-market-type fund, called TexPool, to small municipalities all over the state. Because the fund never sells its securities, she argues, there isn't a problem because any paper losses on the fund's portfolio don't have to be realized. Last spring, former Orange County Treasurer Robert L. Citron used the same rationale to defend his own risky investment strategy. Texpool, like Orange County, leveraged its portfolio by borrowing from Wall Street brokers under repurchase agreements. While TexPool's leverage is much less racy than Orange Country's, which nearly tripled the size of that fund, it still poses the same interest-rate risks: It makes the fund's holdings more sensitive not only to rising rates, but also to the gap between its floating-rate [short-term]borrowings and the yield on its investments.
Currently, TexPool sits on $70 million of unrealized losses, Texas officials say. But they stress that the losses aren't due to leverage or derivatives, mainly to the drop in the value of its Treasury notes maturing in one year or more, which constitute $2 billion, or 40%, of its holdings. They add that they regularly mark down the value of the fund's portfolio to market prices. Meanwhile, TexPool has guaranteed all investors that they will receive all of their money any time they choose to cash out.
As with Orange County's fund, some TexPool investors have become spooked by the fund's $70 million unrealized loss. As a result, a number of them have moved to withdraw their funds during the past year and deposited them elsewhere. According to the state treasury office, assets in the fund have shriveled by more than 63% from more than$10 billion at the end of February.
Mr. Bell vehemently denied that the fund's losses were because of the use of leverage. "The repurchase agreements do not exacerbate interest-rate risk," said Mr. Bell. "We aren't doing business like Orange Country."
(a) TexPool has essentially borrowed by issuing short-term liabilities to finance the purchase of longer-term assets. The profitability of such an investment strategy is derived from the spread between short-term and long-term interest rates (that is, the "yield-curve spread'). First, how can a fund such as TexPool profit from playing the interest-rate spread? Second, consider the following hypothetical investment for TexPool: Issue a one-month liability and purchase a$1,000, 15-year, 5% coupon Treasury bond. Assume that the one-month interest rate is currently 2% and that the 15-year interest rate is currently 5%. How much in liabilities would the fund have to issue to finance the purchase of the Treasury bond? At the end of one year the fund has received the coupon-interest payment on the bond and paid interest on its short-term liabilities. What is the net earning for the fund for that year? What is the value of the bond investment at the end of the year (there are 14 years-to-maturity remaining on the bond)assuming that the long-term rate is still 5%? What is the net-asset value (NAV, value of assets minus liabilities) of the fund?
(b) At the beginning of the second year, assume that the short-term interest rate increases to 5%while the long-term rate increases to 7%. What happens to the earnings of the fund during the second year assuming that the short-term and long-term interest rates remain at 5% and 7%,respectively? What is the value of the bond investment at the end of the second year? What is the net-asset value of the fund for this hypothetical investment? Is the fund solvent?
Matching Supply with Demand An Introduction to Operations Management
ISBN: 978-0073525204
3rd edition
Authors: Gerard Cachon, Christian Terwiesch