Chapter 26 Managing Risk 705
bre44380_ch26_673-706.indd 705 09/30/15 12:09 PM
Later you discover that RA has competition for Madison’s investment management business.
SPX Associates is proposing a strategy of investing 70% of the portfolio ($63 million) in index
funds tracking the U.S. stock market and 30% of the portfolio ($27 million) in U.S. Treasury secu-
rities. SPX argues that their strategy is “safe in the long run,” because the U.S. stock market has
delivered an average risk premium of about 7% per year. In addition, SPX argues that the growth
in its stock market portfolio will far outstrip Madison’s pension obligations. SPX also claims
that the $27 million invested in Treasuries will provide ample protection against short-term stock
market volatility. Finally, SPX proposes to charge an investment management fee of only 20 basis
points (.20%). RA had planned to charge 30 basis points (.30%).
QUESTIONS
- Prepare a memo for Mr. van Wie explaining how RA would invest to minimize both risk and
exposure to changing interest rates. Give an example of a portfolio that would accomplish this
objective. Explain how the portfolio would be managed as time passes and interest rates change.
Also explain why SPX’s proposal is not advisable for a conservative company like Madison.
RA manages several fixed-income portfolios. For simplicity, you decide to propose a mix
of the following three portfolios:
∙ A portfolio of long-term Treasury bonds with an average duration of 14 years.
❱ TABLE 26.6^
Madison Mills Pension
Fund, projected benefits
for retired employees.Year Date (t) Payment PV at 5% PV × t2018 1 10,020,000 9,542,857 9,542,857
2019 2 9,009,500 8,171,882 16,343,764
2020 3 8,522,000 7,361,624 22,084,872
2021 4 8,434,500 6,939,084 27,756,336
2022 5 7,858,500 6,157,340 30,786,702
2023 6 7,794,000 5,816,003 34,896,017
2024 7 7,729,500 5,493,211 38,452,479
2025 8 7,639,500 5,170,714 41,365,714
2026 9 6,440,500 4,151,604 37,364,434
2027 10 6,330,000 3,886,071 38,860,709
2028 11 6,242,500 3,649,860 40,148,465
2029 12 6,205,000 3,455,176 41,462,114
2030 13 5,775,500 3,062,871 39,817,322
2031 14 5,600,700 2,828,734 39,602,277
2032 15 5,432,000 2,612,885 39,193,273
2033 16 5,140,000 2,354,693 37,675,092
2034 17 4,234,900 1,847,673 31,410,438
2035 18 4,123,000 1,713,192 30,837,450
2036 19 3,890,000 1,539,405 29,248,697
2037 20 3,500,600 1,319,339 26,386,786
2038 21 3,400,500 1,220,584 25,632,254
2039 22 3,340,600 1,141,984 25,123,641SUM = 703,991,694
PV = 89,436,787
DURATION = 7.87