When funding liability, why do you need to take the par value of the liability and divided it by the coupon rate of the government bonds to find a par value to buy? I may be overthinking it - is there a simpler explanation on this? Fixed income section is killing me…
You don’t divide it by the coupon rate; you divide it by one plus the coupon rate (1 + rc).
“Why?” you ask?
Answer me this: what’s the last payment you receive on a coupon-paying bond?
ya I meant 1+coupon. sorry I was not clear.
So to retire a liability, you need to buy a bond. To determine how much bond to buy, you divide the par value of the liability by (1+coupon rate of the government bond you are matching your liabilities with). That gives you the par value of the government bond you need to buy.
I think I sort of get it. Fixed income section is still better than derivatives to me.
You didn’t answer my question; once you answer it correctly, you’ll get it completely, not merely sort of.
What’s the last payment you receive on a coupon-paying bond?
haha ok. The last payment you receive are coupon and principal.
So . . . coupon plus principal must equal the amount required to pay off the liability:
EUREKA! THANK YOU!! This is going into my notes! So simple but CFAI never breaks it down for candidates to absorb contents easily. Thank you so much!!
Back in 2016 I wrote an article on cash flow matching, detailing the process step-by-step: http://www.financialexamhelp123.com/cash-flow-matching/
(Full disclosure: as of 4/25/16, there is a charge to read the articles on my website. You can get an idea of the quality of the articles by looking at the free samples here: http://www.financialexamhelp123.com/sample-articles/.)