You have been contacted by an old friend, who upon learning that you have undertaken FINM2003 Investments,
Question:
You have been contacted by an old friend, who upon learning that you have undertaken FINM2003 Investments, would like advice on funding a series of liabilities. The first amounts to $85,000 which is due in 2 years. The second payment is due in 4 years and amounts to $119,500. The third payment is due in 5 years, and is worth $149,000, and the final payment amounts to $75,750, and is due in 6 years.
After raising only $200,000 from the sale of some assets, your (now very stressed) friend is concerned that he may not be able to meet these obligations when due. You assure your friend that he may fully fund the above liabilities by formulating an immunisation strategy. The yield to maturity is 5% p.a.
Required:
i. What would be the maturity of a single zero-coupon bond, which would immunise the overall obligation? What is the face value of this bond?
ii. You have identified two bonds which you would like to use as part of an immunisation strategy. The first is a 7% coupon bond with a face value of $1000 which pays coupons semi-annually, and 1.5 years to maturity. The second is a zero-coupon bond with 7.5 years until maturity (also with a face value of $1000). Calculate the weighting and the number of each of the bonds required (rounded to the nearest whole bond), to immunise the overall obligation.
iv. Given the scenario above, explain why an immunisation approach is preferred over putting cash aside to fund payment of future obligations?