Question

Derivative

Vanguard High Yield Corporate Fund
Materials
• Website information (23/05/2016)
https://personal.vanguard.com/us/funds/snapshot?FundId=0029&FundIntExt=INT
• Summary Prospectus (27/05/2015)
• Prospectus (27/05/2015)
Anakin’s Job
In May 2016, Anakin leaves his job in Hollywood and returned to the finance industry. It is his
first love after all and the industry appears to be picking up again after the credit crunch of
2007-2008. He applies to be the risk analyst to the fund manager of the Vanguard High Yield
Corporate Fund as his quantitative training positions him well for a job that requires ever more
numerical and computational skills over the years. His solid background in applied analytics
in business management and humble demeanour help him clinch the post without much
difficulty.
The Vanguard Group is an American investment company that has approximately USD 3
trillion in asset-under-management. It is founded in 1975 by John Bogle who created the first
index fund (tied to the S&P 500 index) in the process. After an initial lull, the index grew
rapidly along with the bull market of the 1980s. The Group has since added various financial
services and products to its core business, particularly the ETFs.
Anakin is tasked by the fund manager to become thoroughly familiar with the structure of the
fund as is documented by files provided under “Materials”. After that, he is to assess the
exposure of the High Yield Corporate Fund to risks in the market. He seeks the opinion of
Darth who is a veteran market analyst with the Vanguard Guard group for over 20 years.
Outlook
Darth has this to say about the economy and fixed income market:
" The US economy is improving steadily. It will not be long before the Fed decides to raise
interest rates. Once the Fed restarts the regime of rising rates, it will about 2 years for the yield
curve to rise by 100 basis points.
Consequently, in the more stringent economic environment, companies of lower credit
qualities, namely those of Caa and below, are expected to have their credit standing further
eroded. There is a 25% chance that a Caa-rated issuer may go into default and another 25%
chance that it may be downgraded to C.
The Greek debt problem, though much stabilized than before, is still a matter of grave concern
for the Eurozone. Expect the euro to depreciate against the dollar over the course of the next 6
months. A fall of 500 pips will not be a surprise. "
Assume Anakins’ role and answer the following questions. Questions 1 and 2 concern the
Financial Environment. The Environment at large provides the context and sets the constraints
within which financial decisions are weighed and taken. Questions 3 and 4 pertain to the task
that Anakin needs to complete.

Question 1
Describe the types of mutual funds that can be found in the market in a concise and systematic
manner, suitable for presenting to a group of investors who are high net worth and impatient.
(25 marks)
Question 2
Collect data (e.g. from the internet and/or Eikon) to plot the term structures of bond yields.
Each term structure describes the state of the fixed income market for bonds of the credit quality
corresponding to that curve. The different term structures span the space of bonds across credit
qualities and maturities.
Analyse the states of these markets relative to the shape of the curves. Compare and contrast
your analysis with current market views.
Explain your steps, present your answers and quote your sources clearly.
(25 marks)
Question 3
To better understand the structure of the fund, answer the following questions:
(a) Describe the composition of the fund.
(b) What are the risks faced by the fund according to the prospectus? Analyse the nature of
the portfolio risk accordingly and comment on whether commodity price risk and equity
price risk matter to the fund management.
(c) Discuss the performance of the fund based on the financial numbers provided.
(d) Assess the quality of the management of the fund.
(25 marks)
Question 4
The fund is affected by changes in the financial markets. When interest rates rise, the value of
the portfolio falls. Occurrences that are flagged by the rating agency to be credit events can
result in the downgrading of credit rating of bond issuers. Bonds that denominated in foreign
currency are affected by fluctuations in the foreign exchange market.
(a) Analyse generally the need for hedging the various market risks for the fund.

Take into account Darth’s outlook. Address some of these risk concerns by answering the
following question:
(b) Suppose that in the coming 2 years, the prevailing interest rates are expected to go up
by 100 basis points and you are concerned. Show how you could hedge away the
interest rate risk by using an interest rate swap, assuming that the fund by may
represented by a single 5-year par bond on the $18.4 billion net assets with semi-annual
5% coupon payments starting from the current date.
In your explanation, you may assume a scenario in which a flat yield curve increases
uniformly across all terms by 25 basis points per half-a-year.
(c) Credit default swaps may be used to ameliorate credit risk. Appraise the use of such
option-like derivative instruments in managing the risk of the portfolio by explaining
how such instruments function.