The question indicates that Lehigh intends to synthetically modify the duration of corporate bond component of the portfolio to a target of 3.0 in anticipation of rising interest rates. A table then provides three different pay-fixed interest rate swap options with maturities of 2, 3, and 3.5 years. The current duration of A rated corporate bonds totaled 5. The question has for the notional principal. My question is why did the Institute utilize the swap with a 3.5 year maturity as opposed to a 3 year maturity? The answer was close enough that I got it right but I don’t understand the selection here. Thanks.
You choose the highest duration bond to minimize the notional principal required. It is a rule of thumb.