An insurance company issued a $90 million one-year note at 8 per cent add on annual interest (paying one coupon at the end of the year) and used the proceeds to fund a $100 million face value two-year commercial loan at 10 per cent annual interest. Immediately after these transactions were (simultaneously) undertaken, all interest rates went up 150 basis points!
(a) What happened to the market value of the insurance company’s loan investment? (Get a precise answer.)
(b) What is the duration of the commercial loan investment when it is first issued?
(c) Use the duration approximation to answer part (a).
(d) Use the convexity adjustment to correct your answer to part (c).
(e) What happened to the market value of the insurance company’s $90 million liability? (Get a precise answer.)
(f) What is the duration of the insurance company’s liability when it is first issued?
(g) Use the duration approximation to answer part (e).
(h) What is the net effect on the market value of the insurance company’s equity? (Get a precise answer.)