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Dakota Watson and Anthony Smith are bond portfolio managers for Northern Capital Investment Advisors,

which is based in the U.S. Northern Capital has $2,000 million under management, with S950 million of that in

the bond market. Northern Capital's clients are primarily institutional investors such as insurance companies,

foundations, and endowments. Because most clients insist on a margin over the relevant bond benchmark,

Watson and Smith actively manage their bond portfolios, while at the same time trying to minimize tracking

error.

One of the funds that Northern Capital offers invests in emerging market bonds. An excerpt from its prospectus

reveals the following fund objectives and strategies:

“The fund generates a return by constructing a portfolio using all major fixed-income sectors within the Asian

region (except Japan) with a bias towards non-government bonds. The fund makes opportunistic investments

in both investment grade and high yield bonds. Northern Capital analysts seek those bond issues that are

expected to outperform U.S. bonds with similar credit risk, interest rate risk, and liquidity risk-Value is added by

finding those bonds that have been overlooked by other developed world bond funds. The fund favors nondollar, local currency denominated securities to avoid the default risk associated with a lack of hard currency on

the part of issuer."

Although Northern Capital does examine the availability of excess returns in foreign markets by investing

outside the index in these markets, most of its strategies focus on U.S. bonds and spread analysis of them.

Discussing the analysis of spreads in the U.S. bond market, Watson comments on the usefulness of the option

adjusted spread and the swap spread and makes the following statements:

Statement 1: Due to changes in the structure of the primary bond market in the U.S., the option adjusted

spread is increasingly valuable for analyzing the attractiveness of bond investments.

Statement 2: The advantage of the swap spread framework is that investors can compare the relative

attractiveness of fixed-rate and floating-rate bond markets.

Watson's view of the U.S. economy is decidedly bearish. She is concerned that the recent withdrawal of liquidity

Garrison Investments is a money management firm focusing on endowment management for small colleges

and universities. Over the past 20 years, the firm has primarily invested in U.S. securities with small allocations

to high quality long-term foreign government bonds. Garrison's largest account, Point University, has a market

value of $800 million and an asset allocation as detailed in Figure 1.

Figure 1: Point University Asset Allocation

*Bond coupon payments are all semiannual. Managers at Garrison are concerned that expectations for a strengthening U.S. dollar relative to the British pound could negatively impact returns to Point University's U.K. bond allocation. Therefore, managers have collected information on swap and exchange rates. Currently, the swap rates in the United States and the United Kingdom are 4.9% and 5.3%, respectively. The spot exchange rate is 0.45 GBP/USD. The U.K. bonds are currently trading at face value. Garrison recently convinced the board of trustees at Point University that the endowment should allocate a portion of the portfolio into international equities, specifically European equities. The board has agreed to the plan but wants the allocation to international equities to be a short-term tactical move. Managers at Garrison have put together the following proposal for the reallocation: To minimize trading costs while gaining exposure to international equities, the portfolio can use futures contracts on the domestic 12-month mid-cap equity index and on the 12-month European equity index. This strategy will temporarily exchange $80 million of U.S. mid-cap exposure for European equity index exposure. Relevant data on the futures contracts are provided in Figure 2. Figure 2: Mid-cap index and European Index Futures Data

Carl Cramer is a recent hire at Derivatives Specialists Inc. (DSI), a small consulting firm that advises a variety

of institutions on the management of credit risk. Some of DSI's clients are very familiar with risk management

techniques whereas others are not. Cramer has been assigned the task of creating a handbook on credit risk,

its possible impact, and its management. His immediate supervisor, Christine McNally, will assist Cramer in the

creation of the handbook and will review it. Before she took a position at DSI, McNally advised banks and other

institutions on the use of value-at-risk (VAR) as well as credit-at-risk (CAR).

Cramer's first task is to address the basic dimensions of credit risk. He states that the first dimension of credit

risk is the probability of an event that will cause a loss. The second dimension of credit risk is the amount lost,

which is a function of the dollar amount recovered when a loss event occurs. Cramer recalls the considerable

difficulty he faced when transacting with Johnson Associates, a firm which defaulted on a contract with the

Grich Company. Grich forced Johnson Associates into bankruptcy and Johnson Associates was declared in

default of all its agreements. Unfortunately, DSI then had to wait until the bankruptcy court decided on all claims

before it could settle the agreement with Johnson Associates.

McNally mentions that Cramer should include a statement about the time dimension of credit risk. She states

that the two primary time dimensions of credit risk are current and future. Current credit risk relates to the

possibility of default on current obligations, while future credit risk relates to potential default on future

obligations. If a borrower defaults and claims bankruptcy, a creditor can file claims representing the face value

of current obligations and the present value of future obligations. Cramer adds that combining current and

potential credit risk analysis provides the firm's total credit risk exposure and that current credit risk is usually a

reliable predictor of a borrower's potential credit risk.

As DSI has clients with a variety of forward contracts, Cramer then addresses the credit risks associated with

forward agreements. Cramer states that long forward contracts gain in value when the market price of the

Milson Investment Advisors (MIA) specializes in managing fixed income portfolios for institutional clients. Many

of MIA's clients are able to take on substantial portfolio risk and therefore the firm's funds invest in all credit

qualities and in international markets. Among its investments, MIA currently holds positions in the debt of Worth

inc., Enertech Company, and SBK Company.

Worth Inc. is a heavy equipment manufacturer in Germany. The company finances a significant amount of its

fixed assets using bonds. Worth's current debt outstanding is in the form of non-callable bonds issued two

years ago at a coupon rate of 7.2% and a maturity of 15 years. Worth expects German interest rates to decline

by as much as 200 basis points (bps) over the next year and would like to take advantage of the decline. The

company has decided to enter into a 2-year interest rate swap with semiannual payments, a swap rate of 5.8%,