Joe must pay liabilities of 1,000 due one year from now and another 2,000 due three years from now. There are two available investments:
Bond I: A one-year zero-coupon bond that matures for 1000. The yield rate is 6% per year
Bond II: A two-year zero-coupon bond with face amount of 1,000. The yield rate is 7% per year.
At the present time the one-year forward rate for an investment made two years from now is 6.5%
Joe plans to buy amounts of each bond. He plans to reinvest the proceeds from Bond II in a one-year zero-coupon bond. Assuming the reinvestment earns the forward rate, calculate the total purchase price of Bond I and Bond II where the amounts are selected to exactly match the liabilities.
Copyright 2023 . The Society of Actuaries, Schaumburg, Illinois. Reproduced with permission.
Solution: A
Bond I provides the cash flow at time one. Because 1000 is needed, one unit of the bond should be purchased, at a cost of 1000/1.06 = 943.40.
Bond II must provide 2000 at time three. Therefore, the amount to be reinvested at time two is 2000/1.065 = 1877.93. The purchase price of the two-year bond is 1877.93/1.072 = 1,640.26.
The total price is 2583.66.
Copyright 2023 . The Society of Actuaries, Schaumburg, Illinois. Reproduced with permission.