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A pension fund has an average duration of its liabilities equal to 14 years. The fund is looking...

Question:

A pension fund has an average duration of its liabilities equal to 14 years. The fund is looking at 6-year maturity zero-coupon bonds and 5% yield perpetuity to immunize its interest rate risk.

How much of its portfolio should it allocate to the zero-coupon bonds to immunize if there are no other assets funding the plan?

Portfolio Immunization:

A portfolio is immunized from interest rate risk if the value of the portfolio is not affected by small changes in interest rates. This is done by matching the duration of interest-earning assets with the duration of interest-bearing liabilities.

Answer and Explanation:

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The portfolio should allocate 70% of the fund to zero-coupon bonds.

The immunize the portfolio, the fund should set the total duration of the...

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Interest Rate Risk: Definition, Formula & Models

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Chapter 3 / Lesson 6
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Interest rate risk is really the risk of two different events (price reduction and reinvestment rate reduction) caused by a change in interest rates. Interest rate risk affects bond investments, but the good news for bond investors is that it can be mitigated or eliminated.


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