QUESTION $2[25$ MARKS$]$

An Insurance Company has to make a lump sum payment of USD$260,000,000$ in five

years. The pension team calculates the present value of the lump sum payment to be

USD $202,700,000.$ This is the amount they intend to invest today to immunize the lump

sum payment. The Insurance Company is not permitted to use leverage for this nature

of payment and the current effective duration is $4\mathrm{.}5.$

The pension fund is building a suitable portfolio and already holds the U$.$S$.$ government

bonds shown in Exhibit $1.$

Existing Portfolio Bonds

Bond Market Price $($USD$)$

Total Market Value

$($USD$)$

Total Dollar

Duration

Bond A $102\mathrm{.}3259,113,600854,278$

Bond B $94\mathrm{.}9109,630,0004,809,878$

The Insurance Company must choose a U$.$S$.$ government bond to complete the

immunized portfolio.

Page $4$ of $6$

REQUIRED:

$($a$)$ Why would a classical immunization strategy be suitable for the Insurance

Company?

$(5$ marks$)$

$($b$)$ What are the prerequisite assumptions for the successful implementation of a

classical immunization strategy?

$(5$ marks$)$

$($c$)$ What should be the additional fixed$-$income investment to be made by the pension

fund and the modified duration of the fixed$-$income investment in order to have a

fully immunized portfolio?

$(10$ marks$)$

$($d$)$ With the rising interest rate environment, critically explain the impact on value of

fixed income instruments and implication of an immunization strategy with respect

to the value of the portfolio?

$(5$ marks$)$