Motivating Example
•
Image that you are obligated to pay $50,000 five years from now. To cover this
liability, you decide to buy zerocoupon bonds now. Assume you have the
following three bonds for choices:
(1) 3year zerocoupon $1,000 bond priced at an annual yield rate of 5%.
(2) 5year zerocoupon $1,000 bond priced at an annual yield rate of 3%.
(3) 7year zerocoupon $1,000 bond priced at an annual yield rate of 5%.
•
Observations:
X
5year bond is not as attractively priced as the other two.
X
If you purchase the 3year bond, you will be exposed to
reinvestment risk
.
The interest rate in the 4th and 5th years might be very low.
X
If you purchase the 7year bond, you have to sell the bond at time 5. If the
interest rate has risen, you may have a problem meeting your obligation.
•
Question: can we split our investment b/t the 3year bonds and 7year bonds so
as to gain the high return rate while avoid the risk from the fluctuation of the
interest rate?
=
⇒
Employ immobilization strategies.
C. Weng ([email protected])
– p. 2/1
7
This preview has intentionally blurred sections. Sign up to view the full version.
View Full DocumentImmunization Example
•
Example 9.1:
To finance an obligation of $50,000 in five years, we purchase a
3year zerocoupon bond with $22,675.74 redemption amount and a 7year
zerocoupon bond with $27,562.51 redemption amount. Suppose at the end of
three years, no matter what the yield rate
i
may be, we sell the remaining bond
at a purchase price to yield
i
, combine the proceeds with the $22,675.74 from
the redeemed bond, and use the total to buy a twoyear zerocoupon bond.
Illustrate that this immunizes against interest rate risk by showing that it
This is the end of the preview.
Sign up
to
access the rest of the document.
 Fall '09
 Chisholm
 Bond duration, Zerocoupon bond, C. Weng, [email protected])

Click to edit the document details