A company has a liability of DKK 500,000, which must be paid in three years. The company
Question:
A company has a liability of DKK 500,000, which must be paid in three years.
The company wants to invest in a portfolio of bonds that will immunize the interest rate risk on the obligation in the sense that the present value of the portfolio and the duration of Macaulay are like the obligation.
The current interest rate structure is flat at an interest rate of 4% (per year calculated by annual interest accrual)
a) What is the present value of the obligation and the duration of the Macaulay obligation?
b)The company can choose to only invest in a specific bond if it is traded onthe market. What bond is this?
As the bond in question is not traded, the company will try to put together a portfolioof a 6% standing bond with a residual maturity of exactly 2 years and a 5% standing bond,which has a residual maturity of exactly 4 years. Both bonds have an annual term.
c)Find the present value of each of them and the Macaulay duration on each of the bonds
d)How should the portfolio of the two bonds be composed so that it immunizes the interest rate risk on the obligation?
e)Can you use the same portfolio for the entire period until the obligation falls due?
f)Discuss the prerequisites for the success of the above immunization strategy.
Expert Answer:
A The Macaulay duration is the weighted average term to maturity of the cash flows from a bond The weight of each cash flow is determined by dividing the present value of the cash flow by the price Ma... View the full answer
