Line 1 of the following table shows cash payments that your company has just promised to make. Below that are the cash flows on a blue-chip corporate note. The interest rate is 10 percent. Your company can borrow at this rate if it wishes.

a. What is the present value of your liability?

b. Calculate the durations of the liability and the note.

c. Suppose you wish to hedge the liability by investing in a combination of the note and a short-term bank deposit with a duration of zero. How much must you invest in each?

d. Would this hedge continue to protect your company if

i. Interest rates dropped by 3 percent?

ii. Short-term interest rates fluctuate while longer-term rates remain basically constant?

iii. Interest rates remain the same but two years pass?

e. Can you set up a hedge portfolio that relieves the financial manager of all the worries mentioned in (d)? Describe that portfolio.

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Year 1 Year 2 Year 3 Year 4 -$20 Liability (millions) Note's cash payments as percent of face value -$20 12 12 12 112