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Maximizing the Bond Portfolio: Case Study

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1.To maximize the bond portfolio, one has to accept that there is such a thing as a worst case scenario. That would be dependent on the upper ceiling of interest rates, of which there is none. In addition, bonds can be held to maturity for face value, so there is no need at all for the worst case scenario to come to pass. Once these situations have been accepted, we can use the Solver function in Excel to answer the three questions. Expected Worst Case Weighted Weighted Weighted Bond Return Return Duration Weight Return Duration Worst Case 1 12.50% 8% 8 40% 0.050 3.200 0.032 2 11.50% 7.50% 7 25% 0.029 1.750 0.019 3 10.50% 6.80% 6 0% 0.000 0.000 0.000 4 9.50% 7% 5 0% 0.000 0.000 0.000 5 8.50% 7.40% 3 35% 0.030 1.050 0.026 1.000 0.109 6.000 0.077 Face 1,000,000 Expected return 10.85% Avg worst case return 7.67% Avg duration 6 The maximum return on the $1 million investment, given the constraints, is 10.85%. This is achieved with the following mix: 40% in Bond 1, 35% in Bond 5 and 25% in Bond 2. Qualitatively, the pattern is pretty straightforward. To maximize return, the bond with the highest return is given the most weight up to the constraint point. Then the next highest bond would be given the same. However, the constraint on maximum duration means that the one bond significantly lower than the average duration constraint threshold must be added to counterbalance Bond 1. Thus, the split between Bond 2 and Bond 5 is determined by the duration threshold, where as much

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