You have just been given 100,000,000 currency units which you are invest in orde

Question

You have just been given 100,000,000 currency units which you are invest in order to service your fund’s liabilities. The present value of the liabilities is 100,000,000 currency units, and their duration is five years.

Select four bonds for your fund. Discuss the risks associated with each of the bonds, and what steps you would take to reduce or eliminate these risks.

Design a portfolio which would eliminate basis risk.

Now, assume you believe that interest rates will increase in the next five years, by more than the market consensus.

What difference does it make if your forecast of interest rates differs from the market’s?

What steps would you take to take advantage of your forecast?

Note: Doing nothing with your forecast is also acceptable if you are very risk averse, but I’d still like to see how you would take advantage of your forecast if you were willing to do so.

Explanation / Answer

4-types of US bonds are listed below:

US government treasuries bond: The bond is risk free, since it is issued by the US government. The value of the bond is almost stable till its maturity. The approximate discount rate for 1-year is 0.36%.

Agency bond: This type of bonds are issued by institutions and backed by US government. The purpose of this bond is to provide loans to students. The approximate discount rate for 1-year is 0.59%.

Municipal bond: This is issued by state and local governments. The fund is utilized for various government departments’ activities like police, fire, etc. This bond is tax-free. The approximate discount rate for 1-year is 0.38%.

Corporate bonds: Sometimes corporations also issue bonds to meet the internal financial crisis. This bond is taxable in the federal and state level. It has the highest credit risk among the all. The approximate discount rate for 1-year is 1.02%.

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