ACTSC 231 ch09-slides_correcion_and_eg_soln

# ACTSC 231 ch09-slides_correcion_and_eg_soln - Motivating...

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Motivating Example Image that you are obligated to pay \$50,000 five years from now. To cover this liability, you decide to buy zero-coupon bonds now. Assume you have the following three bonds for choices: (1) 3-year zero-coupon \$1,000 bond priced at an annual yield rate of 5%. (2) 5-year zero-coupon \$1,000 bond priced at an annual yield rate of 3%. (3) 7-year zero-coupon \$1,000 bond priced at an annual yield rate of 5%. Observations: X 5-year bond is not as attractively priced as the other two. X If you purchase the 3-year 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 7-year 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 3-year bonds and 7-year 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

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Immunization Example Example 9.1: To finance an obligation of \$50,000 in five years, we purchase a 3-year zero-coupon bond with \$22,675.74 redemption amount and a 7-year zero-coupon 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 two-year zero-coupon bond. Illustrate that this immunizes against interest rate risk by showing that it
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ACTSC 231 ch09-slides_correcion_and_eg_soln - Motivating...

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