Q2 : Why retirees can be mimicked using real bonds? Why not use nominal bonds? Q3: Why not include retirees 10M? Can anyone explain it? thx in advance.
I don’t have the books in front of me. Your question should have been more explicit. Retirees income can be mimicked using real bonds if their income is expected to be inflation adjusted. If the income is not inflation adjusted then nominal bonds will be used. I don’t understand Q3…
Q2. Nominal Bonds do not adjust for CPI increases . The coupon is fixed at the time of issue.In the question , it is given that the company provides reitrees with COLA based on CPI in Brazil. So nominal bonds would not be sufficient to mimic the liability. You need real bonds which adjust the coupon for inflation Q3. Same reason as Q2. If you must use real bonds , you obviously cannot use nominal bonds . Q3 asks which liabilities can be mimic’d with nominal bonds. The only ones that can be modeled on nominal bonds are Future wage inflation ( the half that is not covered by COLA , read the problem) Future real wage growth the half that is not covered by COLA , read the problem) this is a pre-retirement increase ,more or less linked to GDP increases . After retirement , the amount is no longer changing , so no need to cover it with real bonds Deferreds ( i.e. bonuses paid in later years , but estimated now : no need to Cost of Living increase these, not inflation adjusted payments)
- Because of the COLA adjustment that only applies to retirees. 3. Because you are using real bonds (see question 2)