Sorry, you lost. SPX won and implemented its proposed strategy. Now the recession of 2018 has knocked down U.S. stock prices by 20%. The value of the Madison portfolio, after paying benefits for 2018, has fallen from $90 million to $78 million. At the same time interest rates have dropped from 5% to 4% as the Federal Reserve relaxes monetary policy to combat the recession.
Mr. van Wie calls again, chastened by the SPX experience, and he invites a new proposal to invest the pension assets in a way that minimizes exposure to the stock market and changing interest rates. Update your memo with a new example of how to accomplish Mr. van Wie's objectives. You can use the same portfolios and portfolio durations as in Question .
You will have to recalculate the PV and duration of the pension benefits from 2019 onward. Assume a flat term structure with all interest rates at 4%.
(Hint: Madison's pension obligations are now underfunded. Nevertheless you can hedge interest rate risk if you increase the duration of the pension assets.)