IC314: Bond and Money Markets Individual Project Report Assessment Brief Semester 1

IC314 Assessment Brief:

1. What is the purpose of this assessment? 

The following table shows which of the module learning outcomes are being assessed in this assignment. Use this table to help you see the connection between this assessment and your learning on the module.

Module Learning Outcomes being assessed 

By the end of the module, it is expected the students will: 

• Define the main aspects of the economic theories of the determination of interest rates, money market rates, bond yields and their interlinkages with central bank monetary policy operations.
• Evaluate economic situations to determine the likely implications for bonds and money market instruments, with real-world examples taken from a variety of bond and money markets across the world.
• Explain and apply common trading strategies and portfolio management strategies of bond and money markets, and the key features of funding liquidity management.

2. What is the task for this assessment?

Task (attach an assignment brief if required)

As part of this project, you will need to answer questions 1 and 2 (mandatory), plus 2 questions of your choice among questions 3, 4, 5 and 6 shown below, for a total of 4 questions. 

Mark Weights for each question and sub-question:

Question 1: 35% in total. Question 1 A: 15%; Question 1 B: 20%.

Question 2: 15%: Question 1 A: 12%, Question 1 B: 3%.

Questions 3, 4, 5, and 6: 25% each, so 50% in total.

Question 3, A: 10%, Question 3, B: 10%, Question 3, C:5%

Question 4, A: 10%, Question 4, B: 10%, Question 4, C:5%

Question 5, A: 10%, Question 5, B: 10%, Question 5, C:5%

Question 6, A: 10%, Question 6, B: 10%, Question 6, C:5%

Question 1 - Fixed Income Portfolio Construction and Allocation (compulsory)

Assume you are writing a report advising an asset management firm for its proprietary book. The asset management firm is re-evaluating its fixed-income portfolio allocation and trading strategies of fixed-income securities in one of its portfolios. The assets under management of this portfolio are US $500 million and should be all allocated to only fixed income and money market securities.

Please carry your computations in US dollars for questions 1 and 2. Use exchange rates as of 28 October 2024 for securities denominated in different currencies.

A. Your first task is to suggest a list of securities for the portfolios using 10 securities and indicate optimised allocation across the selected securities. You should assume that your analysis is conducted on 28th October 2024 as the settlement date (end of day). All the data you need to collect will have to be consistent with the settlement date. Please clearly state the source of data and describe the data used. State the assumptions, if any, you need to make to carry out your calculations and explain why, in your opinion, they are sensible. 

Please provide a description of each security and corresponding ISIN/CUSIP (identifier of the securities). Please provide a rationale for the selection of issuers/countries in your portfolio. Report bond prices or yields, and compute price or yields (based on the information you source), duration, modified duration, convexity, and price sensitivity for each security. For calculation purposes of bonds, use the day count convention Actual/Actual if required and the appropriate day count convention for zero-coupon bonds.

The risk management and diversification targets specify the following allocation requirements. To construct the portfolio (part A and B), you need to apply the constraints reported below:

• You should use only sovereign bonds that pay a fixed coupon (annual or semi-annual coupon payment frequency) or sovereign zero-coupon bonds or treasury bills. Inflation-linked bonds are not allowed.
• You need to include at least the following: one zero-coupon bond, 2 German Bunds with remaining years to maturity in the range 8.5-10.5, one US Treasury bond with 10-year residual maturity (or in the range 8.5-10.5), and one US treasury bond with 2-year residual maturity (or in the range 1.5-2.5 years)
• Every security must have a positive allocated amount equal to or greater than 2% of the overall asset under management in the portfolio.
• No more than 30% to individual securities. No more than 10% to individual zero-coupon bonds.
• Include at least one sovereign bond or zero-coupon bond from the following list of countries: Canada, France, Italy, Japan, the UK, and Spain.
• Include only sovereign bonds or zero-coupon bonds from the following list of countries: the U.S., Germany, Canada, France, Italy, Japan, the UK, and Spain.
• You can decide whether you want to include all the countries or only some of the countries listed in the previous two bullet points. This means that you should have at least three different countries in your portfolio, US, Germany plus another one from the above list. Please do not choose countries not included in the list. 

B. Then, use the Excel Solver to determine the optimised asset allocation under these targets:

• Target 1: the asset management firm has given a target to earn at least 4% as portfolio, while minimising the duration.
• Target 2: maximise convexity with at least 4% portfolio yield (hint: use the approximation formula for convexity).

For each target, report the portfolio yield, duration, convexity, and allocation, and explain how these proposed allocations would benefit the asset management firm.

[Hint: see the method explained in the lectures on fixed income portfolio management and the related seminar.]

Note: If the solver does not find an optimised solution and you are certain to have correctly applied the constraints, please relax some of the assumptions and explain why (results these will be checked in the supporting Excel file). Please show the application of the solver in the supporting Excel file and explain this in your main report. It is not good practice to simply report the results.

Question 2 - Yield Curve and View on Interest Rates (compulsory) You are asked to advise the asset management firm about future interest rates and provide your view.

You need to form your view on future interest rates for the US Treasury yield curve for the 3 month, 6-month, 1-year and 2-year horizons from the settlement date and compare it to what the market and central banks expect. 

A. Explain your view, whether you agree or disagree with the expectations of central bankers and the market. Describe what macroeconomic factors and  central banking decisions influence your view on interest rates and the observed expected shape of the US Treasury yield curve. 

[Hint: To form your view, please estimate and use a non-linear yield curve model of your choice (e.g., regression models, cubic interpolation, or NelsonSiegel model as covered in Topic 3). To gauge expectations of future interest rates, you could make use of the FOMC forecasts, policy reports, and common forward interest rate instruments traded in the market.]

B. Explain in words how you could use a plain vanilla interest rate swap to hedge or speculate based on your views on interest rates.

PLEASE ANSWER ONLY 2 OUT F 4 OF THE FOLLOWING QUESTIONS (NUMBER 3, 4, 5 AND 6)

Please do not answer more than 2 as I will mark the first two questions presented in the project report only.

Question 3 - Curve Trade with US Treasuries

Based on your view on expected interest rates over the next year and your macroeconomic analysis (question 2), you decide to investigate a strategy that profit from possible changes in the slope of the US Treasury yield curve, using the 10-year and the 2-year US Treasuries in your portfolios (buying or shorting the 10year bond while shorting or buying the 2-year bond), and propose this strategy to the  asset management firm and their fixed-income traders.

1. Calculate the forward prices and yields of the two bonds for settlement on 28 October 2025. [Hint: Please source the relative refinancing rate using the Actual/360]. Could you explain if there is a profitable opportunity based on your view on interest rate? Could you explain your positions in the above bonds?
2. Calculate the PV01 of both bonds. Please use the approximation formula when computing the modified duration and show your full working calculations. How would you structure the trading position per USD 10m of exposure in the 10-year bond? What type of risk are you hedging in this case?
3. Assume that forward short-term interest rates are above the forward guidance rates provided by the Federal Reserve. Based on this observation, briefly discuss the risks to your chosen trading strategy. Explain how the dynamics of inflation could affect your trading strategy. 

Question 4- Cash and Carry Strategy using German Bunds and Futures You are now proposing to the asset management firm a cash and carry strategy.  

Consider a German government bond 10-year futures contract on a notional bond with a 6% coupon and 10-years to maturity (Annual, Actual/Actual) (e.g, Euro Bund Futures) with 6th December 2024 delivery cycle [Please source the corresponding clear price of the Euro Bund Futures contract]. Assume you could deliver both German bunds of the portfolios you constructed in Question 1. [Hint: If you experience issues with the bunds originally selected, please choose two alternative bunds for this question so that these would be deliverable in the corresponding Euro-bund future contract for the corresponding delivery cycle, or change delivery cycle based on what it is traded in the market and explain your assumptions].

1. Compute the conversion factors and gross basis of the two bonds.
2. What is the implied repo rate of the two bunds? Please show all working computations and explain. Which bond you would choose for delivery between the two? Why?
3. What is the ‘net basis’ for the two bunds if the actual repo rate is 4.50 % per annum? Is this strategy profitable? Would you suggest this strategy to the asset management firm? Why or why not? 

Question 5 - Repos and Government Bonds Trading Strategies

You are suggesting the asset management firm traders using repo and reverse repos to devise trading strategies on US Treasuries in the portfolio of question 1. 

1. Please construct, show the calculations and explain the following strategies, assuming you are trading 10 million notional amount of US Treasuries for each strategy, with settlement date 28 October 2024:
   • funding a long bond position for 7 days from the settlement date, and
   • covering a short bond position for 7 days from the settlement date.
2. By observing the prices of the US Treasuries traded after 7 days from the settlement date, explain whether these strategies made a profit or loss. Explain whether your results are plausible with reference to your yield curve expectations of question 2 and the observed market prices.  Would you suggest these strategies to the asset management firm? Why or why not?
3. Explain the main risks factors that may affect your repo rates and trading strategies, and how their impact might vary in normal times, during a financial crisis or because of exogenous shocks to the economy and the financial markets.

Question 6 – Plain Vanilla Corporate Bonds and Corporate Green Bonds

One of the clients of the asset management firm is considering the issuance of a possible plain vanilla corporate bond with the following features, and you are asked to conduct an analysis of the intended corporate bond. Assume an ideal 5year corporate bond paying a coupon of 6% (annual, 30/360) and repaying at par. Assume the swap zero-rate term structure is flat at 4.5%. 

1. Calculate the expected cash flows, the ‘fair value’ price and yield of the bond if the default intensity is constant at 2.0% and the recovery rate in the event of default is 50%. Then, calculate the present value of the bond’s promised cash flows using risk-free discount rates. If the corporate bond is trading at its ‘fair value’ price, what is the expected loss given default?
2. Assume that the client is considering the issuance of a corporate green bond. The price of the green bond is 112.00, but Settlement, Maturity, Coupon Rate, Face Value, Frequency and Default Intensity are the same as for the 5year corporate bond described above. Calculate the yield to maturity of the green bond and compare it to the yield of the corporate bond computed in question 6, A. What factors might account for the spread between the yield to maturity of the plain vanilla corporate bond and the corporate green bond?
3. Choose a 5-year US corporate bond observed in the market with settlement date of 28 October 2024. Compute the spread basis of the corporate bond

when comparing its yield with the yield of 5-year Treasury bond and the 5year US Dollar Swaps. What factors could explain this spread? Then, compare your example with the computations carried in part A and B. What could explain the difference in the yields computed in A and B with respect to the yield of the corporate bond observed in the market?

Other information, suggestions, and requirements

Add the word count to the overall project (maximum 3,000 - this is a hard limit, with no buffer permitted). There is not a word count for each sub-question, but only for the overall project. You should clearly signpost responses by question and apply the style of a professional and clean report. In your answer to each subquestion, you could include snapshots from Excel to highlight your key computations. Please explain all working calculations. You can make use of figures or tables that best illustrates one or more of the key points you are discussing. Figures and tables can be taken from existing published material, in which case the source needs to be acknowledged in the figure/table legend or built by yourself with data you may obtain from Bloomberg, Eikon, Datastream, or other professional and reputable services. Tables’ and figures’ legends should not be included in the word count. You need to compute trading strategies in the Excel file and report them also in the World document report. The report should be selfcontained, so you need to explain how you source data, your assumptions, your calculations and the rationale of the strategies.

If you have queries concerning the project, you can contact us via email or during office hours. Please bear in mind that data collection is your responsibility and forms part of the assessment for your project.

3. What is required of me in this assessment?

Admin

As part of the assessment for this project you will need to submit:

1. An Excel spreadsheet with all your calculations. The spreadsheet should be tidy and easy to read. The Excel file should also include all the raw data indicated in the data section below. The data provider and data identifiers (i.e., Bloomberg, DataStream or Eikon securities codes) should be reported so that I can verify what you have done. In the spreadsheet, you should clearly explain what you are doing. You should label data/results and comment on your calculations. If you make assumptions about some data, please state them and explain your choices.
2. A report using a Word document with a separate answer to all the questions. The Word document should be self-contained so that the reader will not need to refer back to the Excel file. In other words, all the main results discussed in the Word document should be reported and summarised in it. Each answer should be clearly labelled with the number of the question or sub-question it refers to. The Word document should be professionally written in the form of a report.

By 28th January 2025 at 12:00 pm you should submit, via Blackboard, the two documents above. You can do so by going to the “Assessment” folder of the module. Then select “individual project” and upload the files (you can find instructions on how to do this by clicking the "student support" tab and checking the material under "Submitting work online via the Blackboard Assignment tool"). The name of the student should be clearly indicated on all the documents. 

If you wish to change your submission, you can do so up until the deadline.

Self regulation: Make sure that you…

Manage your time properly and download the data as soon as possible considering the choice of the questions. You can revise and update your responses as the deadline is approaching if any relevant market updates should be included.

Three key pieces of advice based on the feedback given to the previous cohort who completed this assignment

1. Don’t wait until last minute before the deadline.
2. Work regularly on the project to make progress.
3. Keep the submitted document tidy and clean.

Formatting Guidelines

1. The spread sheet should be tidy and easy to read. The Excel file should also include all the raw data indicated in the data section below. The data provider and data identifiers (i.e.,ISIN/securities codes) should be reported so that I can verify what you have done. In the spreadsheet you should clearly explain what you are doing. You should label data/results and comment on your calculations.
2. The Word document report should be self-contained so that the reader will not need to refer to the Excel file. In other words, all the main results discussed in the Word document should be reported and summarised in it. Each answer should be clearly labelled with the number of the question or sub-question it refers to.

Word limit/guidance and penalty applied
We will only consider the last submission received before the deadline. Late submissions will be penalised as per the following University rules:

- 10% of the total marks available for that piece of work will be deducted from the mark for each working day (or part thereof) following the deadline up to a total of five working days; where the piece of work is submitted more than five working days after the original deadline: a mark of zero will be recorded.