Question

Suppose that you need $35,000 in three years and that you can finance this with zero-coupon bonds yielding 5.5% in terms of two years and six years. Imagine that you spend $22,354.86 purchasing a 2 year bond$7451.62 for a six-year bond, and these are each priced yield 5.5%. Suppose also that at the end of two years, no matter what the yield rate i may then be, you sell the remaining bond at a purchase price to yield i, combine the proceeds with $24,881.52 from the redeemed bond, and use the total to buy a one-year zero-coupon bond. Illustrate that this immunizes against interest rate risk by showing that it produces the needed $35,000 three years after your initial bond purchases if i=18% (a high rate) or i= 1% (a low rate).

Answer 1

OPENING UP THE FORMULAS IN THE SHEET BELOW: