Reference no: EM132756184
Question: An endowment has made a commitment to fund two initiatives as described below. As a hedge to these commitments, it entered into three forward contracts with cash flows also described below.
- Initiative 1: $8 mil dollar per year for the next four years plus $100 mil in year 4
- Initiative 2: pay $100 mil in scholarships next year
- Forward Contract 1: Fund borrows $108 mil next year and repays the loan in year 4 locking in a 10% borrowing rate. In other words, the endowment receives $108 in year one and repays the loan in year 4 assuming a 10% annualized interest rate.
- Forward Contract 2: Fund borrows $8 mil in year 2 and re-pays the loan in year 4 locking in a 10% borrowing rate. In other words, the Fund receives $8 mil in year two and repays the loan in year 4 plus all accrued interest at 10% per year.
- Forward Contract 3: Fund borrows $8 mil in year 3 and re-pays the loan in year 4 locking in a 10% borrowing rate. In other words, the Fund receives $8 mil in year three and repays the loan in year 4 plus accrued interest at 10% per year.
The current value of the endowment's assets are $1,184.57. The endowment's CIO want to invest the assets in a fixed income portfolio so that the net equity has an interest rate exposure equal to that of a 2-year zero - e.g. DMac = 2. The current term structure is flat at 10% for all maturities.
a) What is the present value of the liabilities? Hint: there is a long way and a short way to solve the problem. To simplify your calculations, you should consider the net cash flows in each year of the initiatives and the forward contracts before you begin.
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