10. (Otange County blues) Orange County managed an investment pool nto which sev

Question

10. (Otange County blues) Orange County managed an investment pool nto which seveial municipalitics made short-teim investments A total o $7 5 billion was invested in this pool, and ths oney was used to purchase securities Using these securities as collateral, the pool botrowed $12 5 billion from Wall Street brokeiages, and these funds were uscd to purchase additional securities The $20 billion total was invested primarily in long-tein fixed-income securities to obtain a highei yield than the short-tei m alternatives Futheintore, as iuterest rates slowly declincd, as they did in 1992-1994, an even greatei return was obtained I hings lell apart in 1994, when interest tates rose sharply Hypothetically, assune that initially the duration o the vested porttolio was 10 years, the short-teim rate was 6%, the average coupon interest on the portfolio was 85% of face value, the cost of Wall Street money was 7%, and shot-term interest rates were tailing at % pel yea (a) What was te ate of retuiu that pool investois oblained dui ing tlis early period? Does it compare favorably with the 6% that these investors would have obtained by investing normally i sioit-teiin securities? (b) When interest rates had fallen two percentage points and began increasing at 2% per year, what rate of return was obtained by the pool?

Explanation / Answer

Investment pool amount = $7.5 billion

Borrowing from Wall Street brokerage = $12.5 billion

Total investment = $20 billion

Duration = 10 years

Short-term rate = 6%

Coupon interest on portfolio= 8.5% of FV

cost of Wall Street money= 7%

reduction in short-term rates= 1/2% per year

(a) During 1992:

short-term rate= 6%

amount to be payed to the Wall Street=0.875 billion

Return made on the 20 billion= 1.7 billion

So, total return=1.7-00.875=0.825 billion

So, return = 0.825/7.5=11%

Hence, return through this is higher than that which would have been obtained through short term securitites.

(b) fallen interest rate =6-2=4%

The rate of return obtained by the pool remained the same at 11%.

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