12. (4 points) You are give the following statistics on a real estate portfolio.
Property
Type
Portfolio
Weighting
Index
Weighting
Portfolio
Returns
Index
Returns
Warehouse 15% 15% 5.50% 6.00%
Apartment 15% 15% 3.00% 4.00%
Retail 50% 40% 7.88% 7.50%
Office 20% 30% 4.25% 4.00%
Total 100% 100% 6.06% 5.70%
The real estate portfolio manager has made the following assertion:
“When it comes to real estate investing, I know exactly which properties are great
performers!”
He also provided the following two recommendations:
•Sell some of the apartment holdings because the occupancy rates are high in all of the
apartment buildings in the portfolio leaving little room left for any major price
appreciation.
•Invest in a retail complex being deve loped on the outskirts of town because of the
potential for price appreciation.
(a) Evaluate the validity of the real estate portfolio manager’s assertion.
(b) Critique each of the recommendations.
COURSE 8: Fall 2004 -13- GO ON TO NEXT PAGE
Investment
Afternoon Session
13. (5 points) You are the Mortgage Backed Security analyst at ABC Life Insurance
Company. ABC’s chief economist, Jane Schmeau, is projecting that interest rates will
rise sharply over the next 12 months and then continue to rise steadily into the
foreseeable future. Ms. Schmeau makes the following statement:
“Because it is solely the current level of interest rates that determines the rate of
mortgage refinancing, the rate of mortgage prepayments will drop sharply in my
projected interest rate scenario”.
(a) (1 point) Assess Ms. Schmeau’s statement.
(b) (4 points) Describe the characteristics, advantages and disadvantages of each of
the following securities based upon Ms. Schmeau’s economic projection. Select
one of these bonds for purchase.
(i) A newly issued PAC with a 7 year average life, a collar of 100%-250%
PSA, and a 6 year lockout period
(ii) An intermediate pay sequential PAC with a 7 year average life and 6 years
of prepayment lockout
(iii) Z bond
(iv) Z-jump bond
COURSE 8: Fall 2004 -14- GO ON TO NEXT PAGE
Investment
Afternoon Session
14. (7 points) Your company is considering adding a Market Value Ad justment (MVA) to its
SPDA. The SPDA has the following characteristics:
•surrender charges decline over 5 years
•minimum guaranteed credited rate of 3.0%
•initial crediting rate is 4.0% fixed for 5 years and reset annually thereafter
using a new-money rate
The MVA Factor being considered uses the following formula:
1
1
T t j
i
éù
êú
for i > j
where:
i is the current market rate
j is the fixed crediting rate
T-t is the fixed rate period remaining
You asked a student to calculate the duration of the SPDA without the MVA. The
student’s immediate response is:
“This product is sold as a 5 year CD in the bank channel, it will behave like a
zero coupon bond with 5 year maturity and effective duration close to 5 years.”
(a) Assess the student’s response.
(b) Describe the benefit of the MVA feature from an ALM perspective.
(c) Compare the effective duration of SPDA with and without the MVA.
(d) Describe in what situation a return of premium feature applied before the
surrender charge will be in-the- money with 4 more years of initial guarantee
remaining.
(e) Assess the impact on effective duration of the return of premium feature.
(f) Assess the impact of minimum guaranteed rate on the effective duration of the
SPDA with MVA.
COURSE 8: Fall 2004 -15- GO ON TO NEXT PAGE
Investment
Afternoon Session