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1. Immunization (35 points) A manager has to pay $ 1,000,000 in two years. There are currently two annual coupon bonds available for investment. Coupon rate Maturity YTM Current price Duration Bond A 7% 1 year 10% $ 972.73 Bond B 8% 3 years 10% $ 950.25 2.78 a. (5 points) if the market discount rate (yield) is currently 10%, how much will the manager have to set aside (and invest) today in order to meet her future obligation? b. The manager has several investment strategies available to her. Assume she decides to invest all the funds (from part a), with the expectation to roll over her investment at the end of the first year. 1. (5 points) What is the risk of this strategy? il (5 point) What happens to her strategy if the interest rate (yield) drops to 9% at the end of the first year? What will the value of her position be after two years? C. Consider the alternative strategy of putting all her funds in Bond B (reinvesting the coupon). 1. (5 points) What is the risk of this strategy? il (5 point) Consider a 1% increase in interest rates moments before the manager liquidates her position. What will be the total value (including the reinvested coupons) of her position? d. (5 points) The previous two strategies might not be optimal. Can you recommend a better one? One that provides immunization? e. (5 points) Following your proposed optimal strategy, what is the value of the manager's total position in two years if the yield drops to 9% after one year? (HINT: the proceeds from Bond A would have to be reinvested at 9%) 1. Immunization (35 points) A manager has to pay $ 1,000,000 in two years. There are currently two annual coupon bonds available for investment. Coupon rate Maturity YTM Current price Duration Bond A 7% 1 year 10% $ 972.73 Bond B 8% 3 years 10% $ 950.25 2.78 a. (5 points) if the market discount rate (yield) is currently 10%, how much will the manager have to set aside (and invest) today in order to meet her future obligation? b. The manager has several investment strategies available to her. Assume she decides to invest all the funds (from part a), with the expectation to roll over her investment at the end of the first year. 1. (5 points) What is the risk of this strategy? il (5 point) What happens to her strategy if the interest rate (yield) drops to 9% at the end of the first year? What will the value of her position be after two years? C. Consider the alternative strategy of putting all her funds in Bond B (reinvesting the coupon). 1. (5 points) What is the risk of this strategy? il (5 point) Consider a 1% increase in interest rates moments before the manager liquidates her position. What will be the total value (including the reinvested coupons) of her position? d. (5 points) The previous two strategies might not be optimal. Can you recommend a better one? One that provides immunization? e. (5 points) Following your proposed optimal strategy, what is the value of the manager's total position in two years if the yield drops to 9% after one year? (HINT: the proceeds from Bond A would have to be reinvested at 9%)
