Solved: Risk Reduction through the Active Management of

a Bond Portfolio

1. What does an equipment trust certificate imply?

2. What is the cost of each bond if it is priced to yield 8 percent?
3. How much will have to be invested in the zero coupon bond to meet the objective?
4. Assuming that the amount determined in (3) is invested in each bond and that yields do not
change, will each bond meet the objective? Can the answer be verified? Corcoran’s answers
do not satisfy Bjornsund’s concerns and he asks the following questions.
5. Can the prices of the bond change?
6. If interest rates rise to 10 percent and remain there for ten years, will each bond meet the
objective?
7. If interest rates decline to 5 percent and remain there for ten years, will each bond meet the
objective? Corcoran points out that bond management is not limited to the pricing of bonds and
tells Bjornsund that it is also important to know a bond’s duration. Duration is important
because it reduces interest rate and reinvestment rate risk and facilitates selecting bonds to
meet a financial objective.
8. Given the current prices of each bond, what is the duration of each bond?
9. Given the durations, which bonds, if any, will meet the investment objective? Can the answer
to this question be verified?

MINI CASE

Fiona Corcoran is responsible for meeting distributions for EEM Health and Life
Insurance Company. An actuary, Robert Bjornsund, has forecasted that a specific policy
will require $210,000 after ten years. Current interest rates are 8 percent, and RPM
Restoration equipment trust certificates (i.e., collateralized bonds) are available for
possible investment. Their terms are
Bond A: zero percent coupon with maturity in 10 years,
Bond B: 8 percent coupon with maturity in 10 years,
Bond C: 8 percent coupon with maturity in 18 years.

Risk Reduction through the Active Management of a Bond Portfolio

ANSWER
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