2019 Q1b (Immunization) Answer

A 5-year bond with annual coupons 4% of the face value is trading at yield-to-maturity 5%. What is the
duration of the bond?

You can assume an arbitrary face value, say $1, since the duration depends on yields, coupon rates and
maturity and not the face value of the bond. Then we find that the bond price is:
2019 Q7c (Immunization) Answer

A pension liability consists of annual payments according to the schedule in the table below:

The interest rate is 5% (assume at term structure). You seek to hedge the liability against changes in the
at term structure, taking positions in a bond portfolio with duration 10 years. How much do you need to
invest in these bonds to hedge the liabilities?

The present value (in million) of the pension liability is:

Using the definition of duration, we find it equals:

Next, we need to balance the duration by investing x in bonds.

Therefore, x * 10 = 49.14 * 2.99, or x = 14.71.

The `immunizing' investment in the bond portfolio is $14.71m.