When answering the question, state any additional assumptions you may need to make. Show all working/calculations.
You have been hired to advise an investment management firm. The firm currently has assets held as cash worth £100 million and liabilities that consist of payments of £15 million in 2 years, £20 million in 3 years, £30 million in 4 years, and £50 million in 5 years. The term structure is flat at 4% per year.
What is the present value of the liabilities?
What is the Macaulay duration of the liabilities?
In terms of risk management, explain what your concern is for the investment man- agement firm from holding all their assets in cash.
The following portfolios all have a present value of £100 million. Which one of the portfolios do you recommend the investment management firm invest its cash in to manage interest rate risk? Explain.
Portfolio A Portfolio B Portfolio C Portfolio D Portfolio E Modified Duration 4.7 3.5 4.2 3.8 2.4
Explain why the strategy you recommend in part (iv) is not a perfect hedge.
