Chapter 8 - Master It! Companies often buy bonds to meet a future liability or cash outlay. Such an investment is called a dedicated portfolio since the proceeds of the portfolio are dedicated to the future liability. In such a case, the portfolio is subject to reinvestment risk. Reinvestment risk occurs because the company will be reinvesting the coupon payments it receives. If the YTM on similar bonds falls, these coupon payments will be reinvested at a lower interest rate, which will result in a portfolio value that is lower than desired at maturity. Of course, if interest rates increase, the portfolio value at maturity will be higher than needed. Suppose Ice Cubes, Inc. has the following liability due in five years. The company is going to buy bonds today in order to meet the future obligation. The liability and current YTM are below. Amount of liability: $100,000,000 Current YTM: 8%

			Bond A	Bond B
	Settlement:		1/1/2000	1/1/2000
	Maturity:		1/1/2003	1/1/2008
	Coupon rate:		7.00%	8.00%
	YTM:		7.50%	9.00%
	Coupons per year:	2	2

a.	Value of liability today:
b, c.	Coupon payment:
				Original YTM	YTM decrease	YTM increase
			Reinvestment YTM:
			Coupon rate:
	Year	Six-month period	Coupon payment	Value of reinvested coupons at Year 5	Value of reinvested coupons at Year 5	Value of reinvested coupons at Year 5
	1	1
		2
	2	3
		4
	3	5
		6
	4	7
		8
	5	9
		10
		Future value of coupons:
		Par value received:
		Total portfolio value:
d.	Since the liability is a lump sum in five years, the duration is equal to the maturity, or five years.
e.	Macaulay duration:
	Bond A:
	Bond B:
	Bond weights:
	Bond A:
	Bond B: