Section B

Question B1

You need to create an investment in government bonds to fund a liability of 15 million due for payment in nine years time. The following UK government bonds are available.

Term to Maturity	Annual Coupon Rate	Annual Yield to Maturity
7 years	1.30%	1.88%
9 years	2.10%	1.88%
11 years	3.40%	1.88%

Coupons are semi-annual and paid on the same day for all three bonds. Assume the next coupon payments occur in six months time and that bond par values are 100.

Required

1. Calculate the market prices of the three bonds.

(6 marks)

2. Calculate the modified duration of each bond

(9 marks)

3. Adopt a liability funding strategy comprising an investment in the bond whose term to maturity coincides with the term of the liability. Assess how well the funding approach works if the annual yield immediately falls by one half of percentage point (0.5%) and thereafter remains constant.

(12 marks)

4. Create a two-bond investment based on an immunisation approach to funding the liability and show effectively the strategy works if the yield immediately falls by one percentage point and subsequently remains constant.

(16 marks)

5. Briefly discuss the reason for the difference between the income generated by the immunisation strategy and the amount needed to fund the liability.

(7 marks)