In: Finance
A financial institution has the following liabilities which it is trying to immunize against a change in interest rates (all are priced to yield 8%):
Available for the purpose of immunization each year are a 1-year zero coupon bond (a rolling issue, new ones each year) and consol (perpetual) bonds with a 11% coupon, both yielding 10% to maturity. Assuming that you re-balance the portfolio each year immediately after any payments are made, what is the dollar amount of each hedging instrument you will hold at t=0 and t=1 to completely neutralize the institution’s exposure to interest rate changes over the coming year?
Duration of the liabilities calculation:
Duration of the liabilities = 3.82 years
Duration of the zero-coupon bond = 1 year (as it is a one year bond)
Duration of the perpetuity = (1+yield)/yield = (1+10%)/10% = 11 years
Let the weight of the amount put in zero-coupon bond be w. Then, the weight of the amount put in the perpetuity is (1-w).
For immunization, duration of assets = duration of liabilities
(1*w) + (11*(1-w)) = 3.82
Solving for w, we get w = 71.80%
1-w = 100%-77.44% = 28.20%
So, for immunization at T = 0, put 77.44%*PV of total liability = 71.80%*125.88 = 90.38 million in zero-coupon bonds and
28.20%*125.88 = 35.50 million in perpetuity.
Duration of liabilities at T = 1 calculation:
Duration of the liabilities at T = 1 is 3.60 years
Again, using weight w for duration of zero-coupon bond and (1-w) for duration of perpetuity, we have
1*w + 11*(1-w) = 3.60
Solving for w, we get w = 74% and 1-w = 26%
So, for immunization at T = 1, put 74%*106.51 = 78.82 million in zero-coupon bond and 26%*106.51 = 27.69 million in perpetuity.