You are the principal of a consulting firm, IDSCDR2 Inc. Your consulting firm provides two basic services to clients. First, you provide advice to clients that wish to reduce their exposure. Second, you provide advice to clients that wish to implement sophisticated, non-traditional strategies to take advantage of their market beliefs.
IDSCDR2‘s most important client is the insurance company RestLife, Inc. RestLife has contacted IDSCDR2to assist RestLife in implementing a plan that aligns RestLife’s exposure to RestLife’s market beliefs.
RestLife’s beliefs are twofold. First, they believe that the risk free rate of interest rates will increase dramatically over the next six months. Second, they believe that BBB corporate will be extensively downgraded by credit ratings agencies over the next six months while A, AA, and AAA corporate will retain their existing credit ratings.
Based on these beliefs, RestLife is looking for IDSCDR2‘s advice. Due to the proprietary nature of their portfolio, RestLife will not provide IDSCDR2 detailed characteristics of the portfolio regarding which RestLife is requesting advice, beyond the following:
· Portfolio size: $3 billion.
· Exposure: 70% long BBB corporate, 20% long A corporate, 5% long AA corporate, 5% long AAA corporate.
· Duration: 50% of the portfolio matures between 5-10 years. 50% of the portfolio matures between 10-20 years.
· Securities: 60% corporate bonds, 40% syndicated loans.
RestLife is requesting IDSCDR2 provide advice in relation to the following strategies. Specifically, they would like IDSCDR2 to provide methodologies through which they can gain beneficial exposure to the forecasted downgrade of BBB corporate and increase in the risk free rate.
RestLife emphasizes that they do not require IDSCDR2 to actually perform the calculations required to implement the proposed strategy – indeed, they have not provided sufficient information to permit IDSCDR2 to do so. Instead, they require IDSCDR2 input regarding the types of strategies and calculations they should implement.
Question to be answered:
1. While RestLife’s main focus is on implementation, in the past they have expressed appreciation when IDSCDR
2, Inc. has provided commentary about the wisdom of RestLife’s beliefs. Under which macroeconomic conditions is their strategy sensible? Explain in detail.