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2018 Immunization Case - Question

1. The document presents a case study on bond portfolio management for an insurance company with two guaranteed investment contracts (GICs) maturing in 2 and 3 years. It asks the student to determine the amounts needed to invest in a floating rate bond and coupon bond to immunize the liabilities, and calculate the portfolio value if rates change. 2. It then repeats the exercise, asking the student to rebalance the existing portfolio after 1 year to minimize costs while satisfying duration and convexity, using additional bond assets. 3. The student is asked to submit concise answers in a PDF file along with any detailed calculations in a separate file.

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Sofia Lima
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50 views2 pages

2018 Immunization Case - Question

1. The document presents a case study on bond portfolio management for an insurance company with two guaranteed investment contracts (GICs) maturing in 2 and 3 years. It asks the student to determine the amounts needed to invest in a floating rate bond and coupon bond to immunize the liabilities, and calculate the portfolio value if rates change. 2. It then repeats the exercise, asking the student to rebalance the existing portfolio after 1 year to minimize costs while satisfying duration and convexity, using additional bond assets. 3. The student is asked to submit concise answers in a PDF file along with any detailed calculations in a separate file.

Uploaded by

Sofia Lima
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Case on “Bond portfolio management”

João Pedro Pereira


Nova School of Business and Economics
Universidade Nova de Lisboa
[email protected]

February 14, 2018

1 Questions

Exercise 1
Suppose an insurance company sold two “Guaranteed Investment Contracts”
(GICs) today that will require the company to pay back to investors the follow-
ing amounts:
• GIC1: the insurance company will have to pay $100,000 in 2 years.
• GIC2: the insurance company will have to pay $110,000 in 3 years.

The term structure of interest rates is flat at r∞ (0, T ) = 2.00%, ∀T (contin-


uous compounding).
The company wants to immunize these liabilities by investing in the following
assets:
• Floating-Rate Bond (FRB): 4-year maturity, paying c(Ti ) = r1 (Ti−1 ) an-
nually. Assume that the index r1 (Ti−1 ) is equivalent to the continuous rate
at time Ti−1 . For example, the first coupon will be c(1) = r1 (0) = e0.02 −1.
(Alternatively, we can think of this FRB as a sequence of 1-year term
deposits, or revolving investments in 1-year ZCBs.)
• Coupon-Bearing Bond (CBB): 5-year maturity, paying c = 5% annually.

Questions:
1. Determine the amount that the insurance company has to invest in each
asset today to immunize the liabilities.
Note: Ignore the convexity condition.
2. Assume that interest rates change to r∞ (0, T ) = 2.40%, ∀T , immedi-
ately after the portfolio allocation determined in the previous question.
Assume that interest rates remain the same over the whole investment
period and therefore that all future cash flows can be reinvested at that
same rate. Determine the final wealth of the insurance company, i.e., the
terminal value at time T = 3 after paying the last liability.

1
Remark: You can assume that the weights in each asset determined in
question 1 remain constant over all future time periods. In fact, given
how we are assuming that interest rates vary in this example, the final
result does not change with whatever weights you choose after the initial
allocation. Under more general conditions, we should rebalance the assets
frequently to ensure that the Duration of the Assets tracks the Duration
of the Liabilities closely.

Exercise 2
Repeating the previous exercise, assume that:
1. The liabilities are the same.
2. At the initial moment (time t = 0), everything is the same. The insurance
company decides to buy the same notional values: NF RB = 114 929.71
and NCBB = 74 311.96.
3. One year after that, at time t = 1, interest rates are still at r∞ (0, T ) =
2.40%, ∀T . The current value of the portfolio of assets is still the same,
VA (1) = 202 478.70.
However, now the company wants to rebalance the portfolio at time t = 1
to immunize against possible further changes in interest rates.
Furthermore, now there are more assets available. In addition to the two
bonds already in the portfolio, the following can also be traded:
• 6-month Zero Coupon Bond (ZCB)
• 2-year Coupon Bearing Bond, paying 2% annually.
The rebalancing procedure should satisfy the following:
• Minimize transaction costs
• The total amount of assets will be fully reinvested, without adding or
subtracting any funds at this moment.
• Satisfy both the duration and convexity conditions.
• No asset should represent more than 50% of the portfolio
Determine the optimal new immunizing portfolio at time t = 1 (indicate the
new Notional of each asset).

2 What you need to submit


1. Your answers should be submitted through Moodle.
2. The main report should be a pdf file with all the answers. You will get
points for being both concise and complete. That is, write everything that
is relevant, and nothing more. Additionally, you will get points for writing
a clean, well organized report, that is easy to follow.
3. You may submit an auxiliary excel file (or similar) showing your detailed
calculations. This should be regarded only as an “appendix” to the pre-
vious pdf file.

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