Try this one on for size: A portion of a pension plan is being gradually phased out and plan trustees have determined that a one-time payment of 3,139,027,000 in 12 years will pay off liabilities related to that portion of the plan. To fund this payment they have purchased (At par) 1,560,000,000 of 8% 20 year bonds with a duration of 12. Assuming the 1,560,000,000 face value bond in the portfoilo pay annual coupons, compute the minimum required return (safety net), the cushion spread, and the appropriate strategy if the immunization rate immediately jumps to 9%.
I was under the impression, correct me if I am wrong, that we dont have to calculate anything for contingent immunization - per the LOS.
schweser said that i think, but then had several problems on it in a mock exam.
Schweser also tests the hell out of it, calcs and all, in the practice exams. I know b/c I got them all wrong.
Yeah i’m playing it safe on this one. The LOS says discuss, but if you look at LOS f, it says “design a bond immunization strategy that will ensure funddinig of a predetermined liability…” …guess they could always ask it based on this one.
Do we need to know the calculations for this?? The LOS says discuss, so I would think no. I wish they were more clear sometimes.
Ok, just got it down(i think) yesterday. 1) Req return = 6% PV = 1560000000 FV = 3139027000 PMT = 0 N = 12 2) Terminal Value per question = 3139027000 PV of TV at 9%, for 12 yrs = 116033102 PV of bond at 9% environment, N = 20, PMT = 8% /yr = 1417594688 Safety net = 301.56 million 3) Active Management.
Do we need to know the calculations for this?? The LOS says discuss, so I would think no. I wish they were more clear sometimes. Does anyone have any input on this?
I think the LOS says design…
Discuss the extensions that have been made to classical immunization theory, including the introduction of contingent immunization.
To address the deficiencies in classical immunization, four extensions have been offered: (1) multifunctional duration, (2) multiple liability immunization, (3) relaxation of the minimum risk requirement, and (4) contingent immunization. The first modification or extension to classical immunization theory is the use of multifunctional duration (a.k.a. key rate duration). To incorporate multifunctional duration into our immunization strategy, the manager focuses on certain key interest rate maturities. For example, the manager’s portfolio might contain mortgage-backed securities, which are exposed to prepayment risk. Unlike other fixed income securities that increase in value when interest rates fall, MBS act like callable corporate bonds that are retired when rates fall. Thus, MBS and callable corporates do not increase in value as much as non-callables when rates fall below their coupon rates (or when they rise after falling), so the portfolio’s sensitivity to changes in different interest rate maturities can be unique, making the analysis of its exposures to key rates very important. The second extension is multiple liability immunization. The goal of multiple liability immunization is ensuring that the portfolio contains sufficient liquid assets to meet all the liabilities as they come due. That is, rather than monitor the value of the portfolio as if the liability is its minimum target value at a single horizon date, there can be numerous certain or even uncertain liabilities with accompanying numerous horizon dates. The third extension is allowing for increased risk, or otherwise relaxing the minimum risk requirement of classical immunization. As will be demonstrated below when we discuss contingent immunization, as long as the manager does not jeopardize meeting the liability structure, he can pursue increased risk strategies that could lead to excess portfolio value (i.e., a terminal portfolio value greater than the liability). The fourth extension is contingent immunization, which mixes active and passive (i.e., immunization) strategies. Contingent immunization is the combination of active management strategies and passive management techniques (immunization). As long as the rate of return on the portfolio exceeds a prespecified safety net return, the portfolio is managed actively. If the portfolio return declines to the safety net return, the immunization mode is triggered to “lock in” the safety net return. The safety net return is the minimum acceptable return as designated by the client. Key considerations in implementing a contingent immunization strategy: Determining accurate immunized initial and ongoing available target returns. Identifying an appropriate safety net return. Establishing effective monitoring procedures to ensure adherence to the contingent immunization plan.
the safety net return could be higher than the immunization return right? the difference being the cushion spread?
cdogstu77, do you have the answer for this Q?
Corrupted, i think you got it down. Safety Net Return = 6% PMT=0, N=12, PV =1560000000, FV=-3139027000, CPT I/Y Cushion Spread = 8% Current Return - Safety Net of 6% = 2% If rates go to 9%, the value of the bonds fall to 1,417,594,688 Calculating the value necessary to fund the minimum target at the immunization rate 3,139,027,000/1.09^12 = 1,116,033,102 Therefore your current bond portfolio exceeds the required amt necessary to fund the target value. Therefore a switch to immunization is not necessary.