2. Finance
3. the company has issued superannuation pension guarantees under these guarantees...

# Question: the company has issued superannuation pension guarantees under these guarantees...

###### Question details

The company has issued superannuation pension guarantees. Under these guarantees, they will be required to pay $1 million in 3 years’ time. They would like to put some money away now at a certain interest rate to ensure they will have enough to meet their liability. The market yield to maturity is10% for all maturities, with annual compounding. The company would like to make an investment now to enable the fund to meet this obligation in 3 years’ time. Company is considering investment in one of the following two bonds:  Bond Face Value ($) Maturity (years) Coupon rate A 1000 3 0 B 1000 3 5% (paid annually)

Further, they are also concerned about changes in the rate at which they can invest. In order to effectively immunize their position, please answer the following questions:

a. Which of the two bonds provides better ‘immunisation' against interest rate risk? Calculate durations for bond A and bond B and explain. (keep the answer to the nearest 2 decimal places)(3 marks)

b. How many in bonds A or bonds B (based on your choice in a)that you need to buy to provide effective “immunisation”?(keep the answer to the nearest 2 decimal places) (2 marks)

c. Suppose that the yield decreased from 10% to 8% suddenly. How does the ‘immunisation’ work in this case? Do you expect the company will still be able to meet the obligation? (keep the answer to the nearest 2 decimal places) (3 marks)

d. Provide two examples of derivative contracts the company can also use to hedge the interest rate risk for obligation? Briefly explain the mechanism.  (2 marks)