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

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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 

1000 

1000 

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)  

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