Consider a financial institution which has a possible liability payment of $ 2.5 million at the end of 3 years. The institution is currently considering an investment in a bond portfolio with a view to ensure that it would able to meet the liability after 3 years.
The bonds under consideration are:
Bond A : 7% coupon, 3 years maturity
Bond B : 8% coupon, 4 years maturity
With a view to immunize the portfolio, please advise in what proportions of the portfolio should the institution invest in each of the bonds.
6 months later, the interest rates have increased from 7% to 8%. The revised duration of the liability, Bond A and Bond B are as under:
Liability : 2.5 years
Bond A : years
Bond B : years
Please advise the company on what rebalancing it needs to do to ensure the portfolio remains immunized.