Nova School of Business and Economics

Fixed Income – 2248 - Master’s in Finance – Spring’ 22

Bernardo Escada - 32354

Gonçalo Fernandes Teixeira – 32067
Tiago Pereira Sequeira - 29338

Assignment #2 – Bond Portfolio

Management: Immunization
Exercise 1
The insurance company has the following portfolio management solving problem, it needs to
immunize two liabilities composed of two Guaranteed Investment Contracts. It needs to pay $100 000,
in 2 years, and to pay another $110 000, in 3 years, corresponding to GIC1 and GIC2, respectively. To
do it, the company has two available assets to invest in, a Floating Rate Bond (FRB) with 4 years to
maturity paying annual coupons, and a Coupon Bearing Bond (CBB) with 5 years to maturity paying
fixed and constant annual coupons of 5%.
1. To immunize the pending liabilities, the company has to build a portfolio of assets that guarantees
the payment of those liabilities, at maturity, regardless of changes in interest rates until the discharge
date. In order to do it, the company must fulfill two conditions:
i. Present Value of Liabilities = Present Value of Assets.
ii. Duration of Liabilities = Duration of Assets.
Starting with the first condition, the present value of liabilities was calculated by discounting the Face
Value (FV) of each liability from their corresponding maturity (2 and 3 years, respectively) to the
present (t=0), using the continuously compounded flat interest rate of 2%. This process resulted in a
combined present value of liabilities of approximately $199 673.04, as expressed in Table 1.1 - Present
Value and Duration of the Liabilities.

Liabilites Maturity FV PV Liabilities

GIC 1 2 $ 100 000,00 $ 96 078,94
GIC 2 3 $ 110 000,00 $ 103 594,10
1. Sum $ 199 673,04
2. Duration 2,52
Table 1.1 – Present Value and Duration of the Liabilities Portfolio Duration Formula.

In the second condition, the company is required to match the duration of the assets and liabilities, in
order to expose both, assets and liabilities, to the same variability in value given changes in the interest
rates. In this case, the duration of the liabilities was estimated accordingly to the above Portfolio
Duration Formula. In this specific situation, since each liability is composed of a single payment
(GIC1: $100 000, in 2 years, and GIC2: $110 000, in 3 years), the duration will be its maturity, 2 and
3 years, respectively. After applying the above formula with the correct weights, the duration of
liabilities was, approximately, 2,52, as stated in Table 1.1 - Present Value and Duration of the
Liabilities.
Following this, we needed to compute the duration of each asset. Starting with the Floating Rate Bond,
we directly know that the duration of the FRB is 1, which is the time until the next reset date, given

Fixed Income - 2248 | Spring’ 22 | Assignment #2 1

the assumption that a floating rate bond has a value of 100% at the next reset date. The duration of the
Coupon Bearing Bond was calculated as the duration of a portfolio of ZCBs. Summing up, the duration
of the FRB was 1, as expressed in Table 1.2: Price and Duration of the FRB, and the duration of the
CBB was 4.58, as stated in Table 1.3: Price and Duration of the CBB.

Floating Rate Bond (FRB)

1. Price 100%
2. Duration 1
Table 1.2 – Price and Duration of the FRB

Coupon Bearing Bond (CBB)

T 1 2 3 4 5
Cash Flow 5% 5% 5% 5% 105%
Discounted CF 4,9% 4,8% 4,7% 4,6% 95,0%
(DCF / Price) * T 0,04 0,08 0,12 0,16 4,17
1. Price 114,04%
2. Duration 4,58
Table 1.3 – Price and Duration of the CBB

From the previous calculations, we find the total amount that must be invested, from the present value
of the liabilities, and we also know the duration of liabilities and the duration of each asset (FRB and
CBB, respectively). However, we still need to guarantee the fulfillment of the two conditions, and in
order to match the present value and duration, we are left with a system problem of two equations with
2 unknowns, which are the weights of each asset in the portfolio (w1 – FRB and w2 – CBB). The
solution was reached using the Goal Seek functionality in Excel, where we got roughly 57.55% as the
weight for the FRB, and around 42.45% as the weight for the CBB. To get the necessary investment
in each asset, we only need to multiply its respective weight in the portfolio by the total notional
amount, which is the present value of liabilities ($199 673.04). In the end, we will need to invest near
$114 919.59 (57.55%) in the FRB and about $84 753.45 (42.45%) in the CBB, as shown in Table 1.4.

Goal Seek - Excel Functionality Investment FV

w1: FRB 57,55% $ 114 919,59 $ 114 919,59
w2: CBB 42,45% $ 84 753,45 $ 74 320,83
Sum 1 $ 199 673,04
Duration of Liabilities 2,52 PV of Assets $ 199 673,04
Duration of Assets 2,52 PV of Liabilities $ 199 673,04
Table 1.4 – Respective Bond Weights and Investment in the Immunized Portfolio of FRB and CBB.

Fixed Income - 2248 | Spring’ 22 | Assignment #2 2

With this process, we have effectively immunized the portfolio. However, is important to mention that
this immunization strategy (infinitesimal parallel shift) only works if interest rates shift in an
infinitesimal parallel way immediately after setting up the portfolio and the forward rates implied at
the time of the shift will become the future spot rates.

2. Immediately after immunizing the portfolio, with the above specs, the interest rate increased by
0.4% to 2.4%. With this situation, we have the opportunity to test whether our immunization strategy
worked successfully or not. For the strategy to work successfully, the insurance company must be able
to pay the liabilities at their discharge dates in full, using the portfolio of an asset. The first liability,
GIC1: $100 000, comes at year 2, which means that we must calculate the value of our portfolio at that
time, year 2.
Starting with the CBB, its value in year 2 will be equal to the market value of the bond (sum of the
future discounted cash flows – Coupons and Principal) plus the coupon received in year 1 reinvested
at the new interest rate, 2.4%. Applying the same approach for the FRB, its value in year 2 will be
equal to the market value of the bond (sum of the future discounted cash flows – Coupons and
Principal, which can be computed since the term structure of interest rates is assumed to be flat) plus
the coupon received at year 1 compounded at the old interest rate, 2% since it was established before
the shift in interest rates. With this said, the value of the CBB at year 2 will be approximately
$87 307.87 and the value of the FRB at year 2 will be approximately $120 088.95, as expressed in
Table 1.5: Coupon Bearing Bond (CBB) Value, at year 2, and Table 1.6 – Floating Rate Bond (FRB)
Value, at year 2.

T 1 2 3 4 5
FCF 5,00% 5,00% 5,00% 5,00% 105,00%
5,12%
4,88%
4,77%
97,71%
Sum 117,47%
Value at Year 2 $ 87 307,87
Table 1.5 – Coupon Bearing Bond (CBB) Value, at year 2

Fixed Income - 2248 | Spring’ 22 | Assignment #2 3

T 1 2 3 4 5
FCF 2,02% 2,43% 2,43% 2,43% 102,43%
2,07%
2,37%
2,32%
95,31%
Sum 104,50%
Value at Year 2 $ 120 088,95
Table 1.6 – Floating Rate Bond (FRB) Value, at year 2

Both bonds combined to give a total value of the portfolio of roughly $207 396.82. We know that the
first liability is paid in year 2 by $100 000, leaving our portfolio with $107 396.82 at the end of year
2, that will be will be reinvested at the new current interest rate of 2.4% for the next year, resulting in
$110 005.52. This amount is more than enough to pay the upcoming liability of $110 000, in year 3,
leaving the insurance company with a positive balance of $5.52. This methodology is expressed in
below Table 1.7 – Value of the Portfolio at year 3, after paying all liabilities.

Total Value Year 2 $ 207 396,82

Liability at Year 2 $ 100 000,00
Remaining Value $ 107 396,82
Total Value at Year 3 $ 110 005,52
Liability at Year 3 $ 110 000,00
Remaining Value $ 5,52
Table 1.7 – Value of the Portfolio at year 3, after paying all liabilities

The above result could have also been reached with a different methodology, where the company could
have sold just the FRB at year 2 to pay the first liability of $100 000 while leaving the CBB untouched
and reinvesting the remaining amount after the liability at the current interest rate of 2.4%. At year 3
both bonds would be liquidated to satisfy the last liability of $110 000, and the insurance company
will finish with the exact positive balance of $5.52.
The positive balance of $5.52, at the end of year 3, can be explained by the concept of convexity.
Contrary to duration, convexity always impacts the value of the portfolio positively regardless of the
direction of the interest rate shift. In this specific situation, assets had a convexity of 9.94 while
liabilities had a convexity of 6.59. Given that the interest rate increased by 0.4%, the value of both
assets and liabilities decreased. However, the value of the assets decreased by less than liabilities
resulting in a positive balance at maturity.

Fixed Income - 2248 | Spring’ 22 | Assignment #2 4

Exercise 2
To determine the optimal new immunizing portfolio at time t = 1, we needed to repeat the previous
exercise. As such, firstly we determined the price of the bonds (both previous and new bonds), at time
t=1. Having calculated the price of the bonds, since we need to know the new duration and the new
convexity of the portfolio of assets as a whole, we must calculate it individually beforehand. Thus,
Table 2.1 – Bonds Price, Duration, and Convexity summarizes the obtained results:

Bonds Price Duration Convexity

CBB (4y) 109,7% 3,74 14,51
FRB (3y) 100,0% 1 1
ZCB (6m) 98,8% 0,50 0,25
CBB (2y) 99,2% 1,98 3,94
Table 2.1 – Bonds Price, Duration, and Convexity

With this information calculated, the next step is determining the Present Value of the portfolio
Liabilities and the respective Duration and Convexity. Doing the appropriate calculations, it was
achieved a present value of $202 473, a Duration of 1,52, and a Convexity of 2,55, as Table 2.2 –
Portfolio Liabilities, Duration, and Convexity shows.

Total Liabilities $ 202 473,29

Duration 1,52
Convexity 2,55
Table 2.2 – Bonds Price, Duration, and Convexity

Finally, now we want to immunize the stream of liabilities against a parallel change in the term
structure of interest rate, by rebalancing the portfolio at time t=1. It should be noted that to achieve
such a result, we need to incorporate the new bonds as well. From the assumptions of the question, we
understand that the value of the portfolio of assets, at time t=1, is VA(1) = $202 478.70, and the term
structure is maintained at 2.40%, continuous compounding, meaning r∞ (0, 𝑇) = 2.40%, ∀𝑇. The
duration matching we did previously works for infinitesimal changes right after defining the portfolio
of assets, but for more large discrete changes, we need to verify more conditions. It should be noted
that to do the rebalancing procedure, some procedures must be respected, such as 1) Minimize
transaction costs; 2) The total amount of assets will be fully reinvested, without adding or subtracting
any funds at this moment; 3) Satisfy both the duration and convexity conditions; and 4) No asset should
represent more than 50% of the portfolio. In Table 2.3 – Initial Asset Portfolio at t=1 we can see the
initial asset portfolio, at time t=1.

Fixed Income - 2248 | Spring’ 22 | Assignment #2 5

At t=1
Initial Portfolio Notional Invested Weights
CBB (4y) $ 74 311,96 $ 81 511,65 40,3%
FRB (3y) $ 114 929,71 $ 114 929,71 56,8%
1st Coupon CBB $ 3 715,60
1st Coupon FRB $ 2 321,73
Sum $ 202 478,70
TRUE
Table 2.3 – Initial Asset Portfolio at t=1

To minimize the transaction cost, we must certify that we minimize the difference between notionals,
that is, the difference between the previous notional and the new notional, for us to be able to minimize
the number of transactions as possible. So, we used the Excel tool Solver to obtained the weights of
each bond (see Table 2.4 – Bonds Weight that allows Minimization), in order to be able to minimize
the squared difference subject to the procedures that must be respected, and announced previously, as
well as 1) equal duration between the portfolio of assets and liabilities, justified previously in Exercise
1, and 2) asset convexity bigger than liability convexity, because if there is an interest rate change
positively or negatively, this condition will certify that the value of assets will be bigger than the value
of liabilities regardless the change. It is imperative to say that, to increase Solver accuracy, the previous
weights were used primarily. The result achieved can be seen in Table 2.5 – Squared Residuals
Minimized.

Duration Convexity Weights

CBB (4y) 3,74 14,51 21,17%
FRB (3y) 1,00 1,00 50,00%
ZCB (6m) 0,50 0,25 23,25%
CBB (2y) 1,98 3,94 5,58%
Portfolio 1,52 3,85 100,00%
Table 2.4 – Bonds Weight that allows Minimization

Old Notional Old Investment New Notional Squared Difference of Notionals

CBB (4y) $ 74 311,96 $ 81 511,65 $ 39 074,82 $ 1 241 656 223,22
FRB (3y) $ 114 929,71 $ 114 929,71 $ 101 239,35 $ 187 425 956,93
ZCB (6m) $ - $ - $ 47 652,62 $ 2 270 772 244,27
CBB (2y) $ - $ - $ 11 388,85 $ 129 705 876,14
*Assumptions $ 3 829 560 300,56

Value we minimized!

Table 2.5 – Squared Residuals Minimized

Fixed Income - 2248 | Spring’ 22 | Assignment #2 6

After calculating the weights of each bond, we could now calculate the investment in the portfolio
individually. Hence, we must invest $42 861 in the 4-year CBB, $101 239 in the 3-year FRB, $47 084
in the 6-month ZCB, and $11 295 in the new 2-year CBB. The summary can be seen in Table 2.6 –
Investment after rebalancing in each bond.

Investment after rebalancing

CBB (4y) $ 42 860,57
FRB (3y) $ 101 239,35
ZCB (6m) $ 47 084,21
CBB (2y) $ 11 294,57
Total $ 202 478,70

Table 2.6 – Investment after rebalancing in each bond

Be aware that, as time goes by, interest rates will change, implicating that the immunization conditions
may no longer be satisfied. Consequently, it may be necessary to take an active rebalancing of the
portfolio to correct for changes in the interest rate.

Fixed Income - 2248 | Spring’ 22 | Assignment #2 7