Hi everyone. I'm working through some review exam problems in preparation for the FM exam, and I've completely mystified by this one. Here is the original problem:
"An insurance company accepts an obligation to pay $100,000 at the end of each year for two years. The insurance company creates a portfolio from the following bonds at a total cost of $X in order to exactly match its obligation:
*One-year 8% annual coupon bond with an annual yield rate of 6%
*Two-year 3% annual coupon bond with an annual yield rate of 6%
*Three-year 6% annual coupon bond with an annual yield rate of 6%
Calculate X."
And here is how the solution in the answer manual begins:
First, we note that we do not need the 3-year bond since the final liability cash flow occurs at time 2 years.
That statement makes no sense to me. How exactly are we able to completely exclude the three-year bond from the problem? Even if the final repayment doesn't happen until after the liability is paid off, the insurance company is still receiving coupons for that bond in both years.
"An insurance company accepts an obligation to pay $100,000 at the end of each year for two years. The insurance company creates a portfolio from the following bonds at a total cost of $X in order to exactly match its obligation:
*One-year 8% annual coupon bond with an annual yield rate of 6%
*Two-year 3% annual coupon bond with an annual yield rate of 6%
*Three-year 6% annual coupon bond with an annual yield rate of 6%
Calculate X."
And here is how the solution in the answer manual begins:
First, we note that we do not need the 3-year bond since the final liability cash flow occurs at time 2 years.
That statement makes no sense to me. How exactly are we able to completely exclude the three-year bond from the problem? Even if the final repayment doesn't happen until after the liability is paid off, the insurance company is still receiving coupons for that bond in both years.
Question on Portfolio Assets Question