70.2K

Verified Solution

Link Copied!

1. Kate is investing in FED Fund, a mutual fund with a standard charge of "1 plus 8%". FED invests its money equally among 10 hedge funds, each of which charges 2 plus 18%. The hedge funds' incentive fees are only charged on the positive return after management fees. FED's managers calculate their incentive fee on the net (after management fees and incentive fees) average return of the hedge funds in which it invests and after FED's own management fee has been subtracted (no incentive fee if the after-management-fee return is negative). If the 10 hedge funds earn -4%, 2%, 5%, -10%, 15%, -8%, 12%, 30%, 25%, and 20%, what is the overall return on these investments? How is it divided between FED fund management, the hedge funds, and the FED investor like Kate?
2. Estimate the interest rate paid by P&G on the 5/30 swap in Business Snapshot 5.4 on p.120 if the CP rate is 7% and the Treasury yield curve is flat at 6.5% with semi-annual compounding. Briefly discuss the lesson that can be learnt from this story.

BUSINESS SNAPSHOT 5.4 Procter and Gamble's Bizarre Deal A particularly bizarre swap is the so-called 5/30 swap entered into by Bankers Trust (BT) and Procter and Gamble (P&G) on November 2, 1993. This was a five-year swap with semiannual payments. The notional principal was $200 million. BT paid P&G 5.30% per annum. P&G paid BT the average 30-day CP (commercial paper) rate minus 75 basis points plus a spread. The average CP rate was calculated from observations on the 30-day commercial paper rate each day during the preceding accrual period. The spread was zero for the first payment date (May 2, 1994). For the remain- ing nine payment dates, it was 98.5 max 0, - 5-yr CMT% 5.78% - (30-yr TSY Price) 100 In this, five-year CMT is the constant maturity Treasury yield (that is, the yield on a five-year Treasury note, as reported by the U.S. Federal Reserve). The 30- year TSY price is the midpoint of the bid and offer cash bond prices for the 6.25% Treasury bond maturing in August 2023. Note that the spread calculated from the formula is a decimal interest rate. It is not measured in basis points. If the formula gives 0.1 and the average CP rate is 6%, the rate paid by P&G is 6% 0.75% + 10% or 15.25%. P&G was hoping that the spread would be zero and the deal would enable it to exchange fixed-rate funding at 5.30% for funding at 75 basis points less than the commercial paper rate. In fact, interest rates rose sharply in early 1994, bond prices fell, and the swap proved very, very expensive. (See Problem 5.38.) BUSINESS SNAPSHOT 5.4 Procter and Gamble's Bizarre Deal A particularly bizarre swap is the so-called 5/30 swap entered into by Bankers Trust (BT) and Procter and Gamble (P&G) on November 2, 1993. This was a five-year swap with semiannual payments. The notional principal was $200 million. BT paid P&G 5.30% per annum. P&G paid BT the average 30-day CP (commercial paper) rate minus 75 basis points plus a spread. The average CP rate was calculated from observations on the 30-day commercial paper rate each day during the preceding accrual period. The spread was zero for the first payment date (May 2, 1994). For the remain- ing nine payment dates, it was 98.5 max 0, - 5-yr CMT% 5.78% - (30-yr TSY Price) 100 In this, five-year CMT is the constant maturity Treasury yield (that is, the yield on a five-year Treasury note, as reported by the U.S. Federal Reserve). The 30- year TSY price is the midpoint of the bid and offer cash bond prices for the 6.25% Treasury bond maturing in August 2023. Note that the spread calculated from the formula is a decimal interest rate. It is not measured in basis points. If the formula gives 0.1 and the average CP rate is 6%, the rate paid by P&G is 6% 0.75% + 10% or 15.25%. P&G was hoping that the spread would be zero and the deal would enable it to exchange fixed-rate funding at 5.30% for funding at 75 basis points less than the commercial paper rate. In fact, interest rates rose sharply in early 1994, bond prices fell, and the swap proved very, very expensive. (See Problem 5.38.)

Answer & Explanation Solved by verified expert

See Answer