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GIC's (Guaranteed Investment Contracts) are often issued by the insurance companies and are widely used by individuals saving for their retirement. A GIC is essentially a zero-coupon bond (recall that in the U.S. the Zeroes are treated as semi-annuals) that pays a predetermined sum of money at its maturity. For instance, a three-year GIC carrying a guaranteed interest rate of 10% and a price of $10,000, will pay $13,400 at maturity. Therefore, the issuer knows in advance, that in three years, they will need $13,400 to cover that future obligation. Insurance companies often fund such future obligations by buying par-value coupon bonds and reinvesting the coupon payments, as they are received, at the then-prevailing interest rates.
a) Assume that the market interest rates remain at the current level of 10% for the next 3 years and assume that the issuer of the GIC referred to above, uses the $10,000 received to purchase a 5-year, par-value coupon bond. Calculate the future values of the coupon payments and the proceeds from the sales of the bond at the end of the third year to show how this obligation-matching strategy works.
b) Now assume that the market interest rates change to 12% and calculate the impact on the re-invested coupons and the market value of the bond at the end of three- year period. What do you conclude?
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