Consider an insurance company that needs to pay 10 million in years 1, 2 and 3...

 

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Consider an insurance company that needs to pay £10 million in years 1, 2 and 3 from now. The term structure is flat at r=3% per year and only shifts in a parallel way (that is, the whole term structure shifts by some Ar). There are zero-coupon bonds maturing in years 1 and 2, respectively, and a three-year bond with a 10% coupon rate. All bonds have face value £100. The company wants to buy these bonds to perfectly immunize its liabilities so that the cash flows generated by the portfolio of bonds perfectly match the cash flows of its liabilities. How many units of each bond does the company need to buy? The company has £29 million in cash. Is this money enough to achieve perfect immunization? Consider an insurance company that needs to pay £10 million in years 1, 2 and 3 from now. The term structure is flat at r=3% per year and only shifts in a parallel way (that is, the whole term structure shifts by some Ar). There are zero-coupon bonds maturing in years 1 and 2, respectively, and a three-year bond with a 10% coupon rate. All bonds have face value £100. The company wants to buy these bonds to perfectly immunize its liabilities so that the cash flows generated by the portfolio of bonds perfectly match the cash flows of its liabilities. How many units of each bond does the company need to buy? The company has £29 million in cash. Is this money enough to achieve perfect immunization?

Answer rating: 100% (QA)

Lets break down the problem and find the optimal bond portfolio for perfect immunization 1 Liabilities The insurance company needs to pay 10 million i... View the full answer