Question

Class o You are the financial manager of a small Financial Institution (FI) and anticipate that your company will have future liabilities as shown in the following table. You also know that the three government bonds A, B, and C are available with the cash flows shown in the following table: 10 $10,000,000 $11,700,000 $11,000,000 $10,000,000 Year Liabilities Cash Flow (A) Cash Flow (B) Cash Flow (C) S3,700,000 S1000 $70 $100 S1070 $100 SI100 a) You are concerned that the future fluctuations in the interest rates may affect your ability to fulfil your debt obligations. Thus you want to insulate your company from the shifts in the term structure. You are convinced that the best insulation for the first three years is to exactly match the cash inflows and outflows. You want to form a portfolio of the three bonds A, B, and C so that their cash inflows exactly matches your debt obligations in years 1, 2, and 3. How would you form this portfolio? How many of each bond should you invest in? Clearly show your work Knowing that bonds A, B, and C are not able to hedge your 5-year and 10-year positions, you want to invest enough money in one or combination of the following government bonds (D, E, and F) to insulate your company against interest rate fluctuations. 1. Bond D, with 10% annual coupon and five years to maturity. 2. Bond E, with 15% annual coupon, 6.28 years duration, and 10 years to maturity. 3. Bond F, with no coupon and 10 years to maturity. All bonds have $1,000 face value. Assuming that the current interest rate is 10% and that duration is a perfect measure of interest rate risk, what combination of these bonds would provide you with a complete protection against interest rate risk for the 5-year and 10-year debt obligations? Show your work carefully. Now suppose your chief economist has convinced you that the interest rate will decline significantly in the near future and will remain low for the next five years. How will this information affect your 5-year bond investment strategy?

just part A please

Answer 1

A). Start with Year 3 cash flows:

Liability is 11,000,000. The only other cash flow is from Bond C so Bond C is used to offset the liability.

Number of Bond C's required = liability/maturity value = 11,000,000/1,100 = 10,000

Year 2 cash flows:

Liability = 11,700,000

Bond C cash flow = coupon*number of bonds = 100*10,000 = 1,000,000

Remaining liability to be offset = 11,700,000 - 1,000,000 = 10,700,000

The only other cash flow is from Bond B so it is used to offset the remaining liability.

Number of Bond B's required = 10,700,000/1,070 = 10,000

Year 1 cash flows:

Liability = 3,700,000

Bond C cash flow = 1,000,000

Bond B cash flow = 70*10,000 = 700,000

Remaining liability = 3,700,000 - 1,000,000 - 700,000 = 2,000,000

The only other cash flow is from Bond A so the remaining liability is offset using that.

Number of Bond A's required = 2,000,000/1,000 = 2,000

Number of bonds required:

Bond A = 2,000

Bond B = 10,000

Bond C = 10,000