Reference no: EM133000008

Financial institutions must have the assets available to cover liabilities when they arise. Many types of liabilities are known in advance. It is therefore possible to set up investments, like bonds, so that the inflow of cash from the bonds will match the outflow needed to cover the liabilities due at each point in time. This strategy is called "duration matching" or "immunization."

(a) A company has a $20,000 liability (payment to be made) due at the end of year 2. It can purchase 2-year zero coupon bonds at 9% spot rate. What is the cost of financing your liability by holding the 2-year bond that would pay $20,000?

(b) Recall that the formula for modified duration is D* = D/(1+r), where D is the duration. Also know that the modified duration of a portfolio of assets is the weighted average of the modified durations of the underlying assets where the weight is the portfolio weights on the assets. How can you invest in only the 1-year zero-coupon bond and 3-year zero coupon bond to match the modified duration of the 2-year zero-coupon bond?