Fixed Income Case_407

Fixed Income Case_407 - 15.407 Finance Theory Jiang Wang...

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15.407 Jiang Wang Finance Theory Due: 4 p.m., Friday, October 17, 2003 Bemus Investment Management (BIM) Bemus Investment Management (BIM) manages portfolios for institutional investors (primarily corporate pension plans) and wealthy individuals. BIM is located near Chautauqua Lake at Bemus Point, NY. Despite its bucolic location, BIM is linked real-time to all major markets and exchanges. In mid-2003, it had about $1.4 billion under management. Its management fees averaged 55 basis points (.55%); so BIM’s total revenue for 2003 will be about (.0055)(1.4)(10 9 )= $7.7 million. BIM has landed a new client, Quest of Toys, a conservative, established manufacturer of toys and electronic games. Quest has a defined-benefit 1 pension plan for its employees. Current plan funding is $101 million, with $84 million in fixed-income securities (mostly U.S. Treasury bonds, notes and strips) and $17 million in equities. Exhibit 1 shows the current composition of the fixed-income portfolio. You have been assigned to restructure and then manage this portfolio. The management fee will be 35 basis points (0.35%) per year. 2 1 Defined benefit means that the company is committed to pay retirement income according to a formula. For example, annual retirement income could equal 40% of the employee’s average salary in the five years prior to retirement. In a defined benefit plan, retirement income does not depend on the performance of the pension fund, provided, of course, that the assets in the fund are sufficient to cover pension benefits. If the assets are not sufficient, the company is required to contribute enough additional cash to cover the shortfall. In defined contribution plans, the corporation contributes to the pension fund on behalf of its employees. Each employee owns part of the fund, just as if the employee held shares in a mutual fund. Employees’ retirement incomes depend on their balances in the fund at retirement. In this case, retirement income is directly linked to fund performance. 2 Management fees are almost always lower for fixed-income portfolios than for equity portfolios.
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Exhibit 2 shows a projection of Quest’s obligations to its already-retired employees from 2004 to 2025. Each of these employees receives a fixed dollar amount each month. Total dollar payments from the fund decline as the employees die off. 3
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This note was uploaded on 01/19/2011 for the course 15 15.407 taught by Professor Wang during the Fall '03 term at MIT.

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Fixed Income Case_407 - 15.407 Finance Theory Jiang Wang...

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