LOS i: Discuss the extensions that have been made to classical immunization theory, including the introduction of contingent immunization.

Q1. If interest rates rise sufficiently such that the dollar safety margin is negative in a contingent immunization strategy, which of the following statements is FALSE?

A)   The portfolio manager can no longer use contingent immunization.

B)   A switch to immunization is necessary.

C)   Contingent immunization is still a viable alternative.

Q2. A portfolio manager has decided to pursue a contingent immunization strategy over a four-year time horizon. He just purchased at par $26 million worth of 6% semiannual coupon, 8-year bonds. Current rates of return for immunized strategies are 6% and the portfolio manager is willing to accept a return of 5%. Given that the required terminal value is $31,678,475, and if the immunized rates rise to 7% immediately, which of the following is most accurate? The dollar safety margin is:

A)   negative (-$1,423,980) and the portfolio manager must switch to immunization.

B)   positive ($370,765) and the portfolio manager can continue with contingent immunization.

C)   positive ($6,158,602) and the portfolio manager can continue with contingent immunization.

Q3. A portfolio manager has decided to pursue a contingent immunization strategy over a three-year time horizon. He just purchased at par $93 million worth of 10.0% semiannual coupon, 12-year bonds. Current rates of return for immunized strategies are 10.0% and the portfolio manager is willing to accept a return of 8.5%. If interest rates rise to 11% immediately, which of the following statements is most accurate? The dollar safety margin is:

A)   positive ($303,066) and the portfolio manager can continue with contingent immunization.

B)   negative (-$2,489,748) and the portfolio manager must switch to immunization.

C)   positive ($303,066) and the portfolio manager must switch to immunization.

Q4. Which of the following is NOT a key consideration in implementing a contingent immunization strategy?

A)   Decide in advance about the frequency the portfolio will be rebalanced.

B)   Identifying a suitable and immunizable safety net.

C)   Establishing well defined immunized initial and ongoing available target returns.

Q5. In a contingent immunization strategy, which of the following is a reason why the minimum target return might NOT be realized? The minimum target return might not be realized because:

A)   interest rates move in a nonparallel manner.

B)   the yield volatility changes.

C)   there is a rapid market yield movement.

Q6. A portfolio manager has decided to pursue a contingent immunization strategy over a three-year time horizon. She just purchased at par $84 million worth of 9.2% semi-annual coupon, 10-year bonds. Current rates of return for immunized strategies are 9.2% and the portfolio manager is willing to accept a return of 8.5%. Given that the required terminal value is $107,829,022, and if interest rates rise to 11% immediately, which of the following is most accurate? The dollar safety margin is:

A)   negative (-$3,237,038) and the manager can continue with contingent immunization.

B)   positive ($1,486,948) and the manager can continue with contingent immunization.

C)   negative (-$3,237,038) and the manager must switch to immunization.

LOS i: Discuss the extensions that have been made to classical immunization theory, including the introduction of contingent immunization. fficeffice" />

Q1. If interest rates rise sufficiently such that the dollar safety margin is negative in a contingent immunization strategy, which of the following statements is FALSE?

A)   The portfolio manager can no longer use contingent immunization.

B)   A switch to immunization is necessary.

C)   Contingent immunization is still a viable alternative.

Correct answer is C)

If the dollar safety margin is negative, the present value of liabilities exceeds the present value of assets and the portfolio manager can no longer use contingent immunization. Equivalently, the portfolio manager must switch to immunization.

Q2. A portfolio manager has decided to pursue a contingent immunization strategy over a four-year time horizon. He just purchased at par $26 million worth of 6% semiannual coupon, 8-year bonds. Current rates of return for immunized strategies are 6% and the portfolio manager is willing to accept a return of 5%. Given that the required terminal value is $31,678,475, and if the immunized rates rise to 7% immediately, which of the following is most accurate? The dollar safety margin is:

A)   negative (-$1,423,980) and the portfolio manager must switch to immunization.

B)   positive ($370,765) and the portfolio manager can continue with contingent immunization.

C)   positive ($6,158,602) and the portfolio manager can continue with contingent immunization.

Correct answer is B)

We are given the required terminal value of $31,678,475.

Next, we calculate the current value of the bond portfolio: PMT = ($26,000,000)(0.03) = $780,000; N = 16; I/Y = 7/2 = 3.5%; and FV = $26,000,000; CPT → PV = $24,427,765.

Next, compute the present value of the required terminal value at the new interest rate: FV = $31,678,475; PMT = 0; N = 8; I/Y = 7/2 = 3.5%; CPT → PV = $24,057,000.

Alternatively $31,678,475 / (1.035)⁸ = $24,057,000

The dollar safety margin is positive ($24,427,765 ? $24,057,000 = $370,765) and the manager can continue to employ contingent immunization.

Q3. A portfolio manager has decided to pursue a contingent immunization strategy over a three-year time horizon. He just purchased at par $93 million worth of 10.0% semiannual coupon, 12-year bonds. Current rates of return for immunized strategies are 10.0% and the portfolio manager is willing to accept a return of 8.5%. If interest rates rise to 11% immediately, which of the following statements is most accurate? The dollar safety margin is:

A)   positive ($303,066) and the portfolio manager can continue with contingent immunization.

B)   negative (-$2,489,748) and the portfolio manager must switch to immunization.

C)   positive ($303,066) and the portfolio manager must switch to immunization.

Correct answer is A)

We must first compute the required terminal value: PV=$93,000,000, N=6, I/Y=8.5/2=4.25%, PMT=0, compute FV=$119,382,132.

Next, we calculate the current value of the bond portfolio: PMT=($93,000,000)(.05)=$4,650,000, N=24, I/Y=11/2=5.5%, and FV=$93,000,000, CPT → PV=$86,884,460.

Next, compute the present value of the required terminal value at the new interest rate: FV=$119,382,132, PMT=0, N=6, I/Y=11/2=5.5%, CPT → PV=$86,581,394.

Alternatively ($119,382,132) / (1.055)⁶ = $86,581,394

The dollar safety margin is positive ($86,884,460 ? $86,581,394 = $303,066) and the manager can continue to employ contingent immunization.

Q4. Which of the following is NOT a key consideration in implementing a contingent immunization strategy?

A)   Decide in advance about the frequency the portfolio will be rebalanced.

B)   Identifying a suitable and immunizable safety net.

C)   Establishing well defined immunized initial and ongoing available target returns.

Correct answer is A)

The frequency of rebalancing is determined (among other things) by the level of the safety net. So the rebalancing frequency is not exogenous to interest rate movements.

Q5. In a contingent immunization strategy, which of the following is a reason why the minimum target return might NOT be realized? The minimum target return might not be realized because:

A)   interest rates move in a nonparallel manner.

B)   the yield volatility changes.

C)   there is a rapid market yield movement.

Correct answer is C)

A rapid market yield movement might not give the manager enough time to shift from an active strategy to immunization mode to achieve the minimum target.

Q6. A portfolio manager has decided to pursue a contingent immunization strategy over a three-year time horizon. She just purchased at par $84 million worth of 9.2% semi-annual coupon, 10-year bonds. Current rates of return for immunized strategies are 9.2% and the portfolio manager is willing to accept a return of 8.5%. Given that the required terminal value is $107,829,022, and if interest rates rise to 11% immediately, which of the following is most accurate? The dollar safety margin is:

A)   negative (-$3,237,038) and the manager can continue with contingent immunization.

B)   positive ($1,486,948) and the manager can continue with contingent immunization.

C)   negative (-$3,237,038) and the manager must switch to immunization.

Correct answer is C)         

We are given the required terminal value of $107,829,022. Next, we calculate the current value of the bond portfolio: PMT=($84,000,000)(.046)=$3,864,000, N=20, I/Y=11/2=5.5%, and FV=$84,000,000, CPT → PV=$74,965,511.

Next, compute the present value of the required terminal value at the new interest rate: FV=$107,829,022, PMT=0, N=6, I/Y=11/2=5.5%, CPT → PV=$78,202,549.

Alternatively ($107,829,022) / (1.055)⁶ = $78,202,548

The dollar safety margin is negative ($74,965,511 ? $78,202,549 = -3,237,038) and the manager can no longer employ contingent immunization.

Therefore, a switch to immunization is necessary.