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Matrix Corporation is a multidivisional company with operations in energy, telecommunications, and shipping.

Matrix sponsors a traditional defined benefit pension plan. Plan assets are valued at $5.5 billion, while recent

declines in interest rates have caused plan liabilities to balloon to $8.3 billion. Average employee age at Matrix

is 57.5, which is considerably higher than the industry average, and the ratio of active to retired lives is 1.1. Joe

Elliot, Matrix's CFO, has made the following statement about the current state of the pension plan.

"Recent declines in interest rates have caused our pension liabilities to grow faster than ever experienced in our

long history, but I am sure these low rates are temporary. I have looked at the charts and estimated the

probability of higher interest rates at more than 90%. Given the expected improvement in interest rate levels,

plan liabilities will again come back into line with our historical position. Our investment policy will therefore be

to invest plan assets in aggressive equity securities. This investment exposure will bring our plan to an overfunded status, which will allow us to use pension income to bolster our profitability."

Pace Insurance is a large, multi-line insurance company that also owns several proprietary mutual funds. The

funds are managed individually, but Pace has an investment committee that oversees all of the funds. This

committee is responsible for evaluating the performance of the funds relative to appropriate benchmarks and

relative to the stated investment objectives of each individual fund. During a recent investment committee

meeting, the poor performance of Pace's equity mutual funds was discussed. In particular, the inability of the

portfolio managers to outperform their benchmarks was highlighted. The net conclusion of the committee was

to review the performance of the manager responsible for each fund and dismiss those managers whose

performance had lagged substantially behind the appropriate benchmark.

The fund with the worst relative performance is the Pace Mid-Cap Fund, which invests in stocks with a

capitalization between S40 billion and $80 billion. A review of the operations of the fund found the following:

• The turnover of the fund was almost double that of other similar style mutual funds.

• The fund's portfolio manager solicited input from her entire staff prior to making any decision to sell an existing

holding.

• The beta of the Pace Mid-Cap Fund's portfolio was 60% higher than the beta of other similar style mutual

funds.

• No stock is considered for purchase in the Mid-Cap Fund unless the portfolio manager has 15 years of

financial information on that company, plus independent research reports from at least three different analysts.

• The portfolio manager refuses to increase her technology sector weighting because of past losses the fund

incurred in the sector.

• The portfolio manager sold all the fund's energy stocks as the price per barrel of oil rose above $80. She

expects oil prices to fall back to the $40 to S50 per barrel range.

A committee member made the following two comments:

Comment 1: "One reason for the poor recent performance of the Mid-Cap Mutual Fund is that the portfolio

lacks recognizable companies. I believe that good companies make good investments."

Comment 2: "The portfolio manager of the Mid-Cap Mutual Fund refuses to acknowledge her mistakes. She

Smiler Industries is a U.S. manufacturer of machine tools and other capital goods. Dat Ng, the CFO of Smiler,

feels strongly that Smiler has a competitive advantage in its risk management practices. With this in mind, Ng

hedges many of the risks associated with Smiler's financial transactions, which include those of a financial

subsidiary. Ng's knowledge of derivatives is extensive, and he often uses them for hedging and in managing

Srniler's considerable investment portfolio.

Smiler has recently completed a sale to Frexa in Italy, and the receivable is denominated in euros. The

receivable is €10 million to be received in 90 days. Srniler's bank provides the following information:

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

underlying increases above the contract price. McNally encourages Cramer to include an example of credit risk

and forward contracts in the handbook. She offers the following:

A forward contract sold by Palmer Securities has six months until the delivery date and a contract price of 50.

The underlying asset has no cash flows or storage costs and is currently priced at 50. In the contract, no funds

were exchanged upfront.

Cramer also describes how a client firm of DSI can control the credit risks in their derivatives transactions. He

writes that firms can make use of netting arrangements, create a special purpose vehicle, require collateral

from counterparties, and require a mark-to-market provision. McNally adds that Cramer should include a

discussion of some newer forms of credit protection in his handbook. McNally thinks credit derivatives

represent an opportunity for DSL She believes that one type of credit derivative that should figure prominently in

their handbook is total return swaps. She asserts that to purchase protection through a total return swap, the

holder of a credit asset will agree to pass the total return on the asset to the protection seller (e.g., a swap

dealer) in exchange for a single, fixed payment representing the discounted present value of expected cash

flows from the asset.

A DSI client, Weaver Trading, has a bond that they are concerned will increase in credit risk. Weaver would like

protection against this event in the form of a payment if the bond's yield spread increases beyond LIBOR plus

3%. Weaver Trading prefers a cash settlement.

Later that week, Cramer and McNally visit a client's headquarters and discuss the potential hedge of a bond

issued by Cuellar Motors. Cuellar manufactures and markets specialty luxury motorcycles. The client is

considering hedging the bond using a credit spread forward, because he is concerned that a downturn in the

economy could result in a default on the Cuellar bond. The client holds $2,000,000 in par of the Cuellar bond

and the bond's coupons are paid annually. The bond's current spread over the U.S. Treasury rate is 2.5%. The

characteristics of the forward contract are shown below.

Information on the Credit Spread Forward

Determine whether the forward contracts sold by Palmer Securities have current and/or potential credit risk.

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