Immunization of a Portfolio to satisfy a single liability: Bond Analysis.

Companies/Investors 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 a liability of $100 million due in five years and the company is going to buy 5 year bonds today in order to meet this future liability.

a). At the current YTM of 8 percent, what is the face (market) value of the bonds the company has to purchase today in order to meet its future obligations? Assume the desired bonds carry a coupon rate of 5.5% and how many bonds could be purchased given the standard par value of $1000?

b). If interest rates in the market remain unchanged for next 5 years, what will be the value of the portfolio?

c). Suppose that immediately after the ICI buys the bonds interest rates either fall or rise by 1%. What will be the value of the portfolio in 5 years under these circumstances?