Jennifer McAfee recently received her university Master’s degree and has decided

Question

Jennifer McAfee recently received her university Master’s degree and has decided to enter the mortgage brokerage business. Rather than work for someone else, she has decided to open her own shop. Her cousin Finn has approached her about a mortgage for a house he is building. The house will be completed in 3 months, and he will need the mortgage at that time. Finn wants a 25-year, fixed-rate mortgage for the amount of £500,000 with monthly payments. Jennifer has agreed to lend Finn the money in 3 months at the current market rate of 8 per cent. Because Jennifer is just starting out, she does not have £500,000 available for the loan, so she approaches Ian MacDuff, the president of IM Insurance, about purchasing the mortgage from her in 3 months. Ian has agreed to purchase the mortgage in 3 months, but he is unwilling to set a price on the mortgage. Instead, he has agreed in writing to purchase the mortgage at the market rate in 3 months. There are Treasury bond futures contracts available for delivery in 3 months. A Treasury bond contract is for £100,000 in face value of Treasury bonds. 7. IM Insurance wish to hedge themselves against interest rate risk by ensuring that the average duration of their assets equals the average duration of their liabilities. This strategy is known as duration matching or portfolio immunization. Explain how duration matching can protect a portfolio of assets and liabilities against a shift in interest rates. 8. Describe a situation when the duration of assets doesn’t match the duration of liabilities. When do you make a profit (loss) on your portfolio? 9. In which situation does duration matching fail to perfectly immunize a portfolio?

Explanation / Answer

7. Duration matching is a strategy used to minimize the risk of portfolio. Since duration is a measure in determining a bond's sensitivity to interest rates, duration matching is used to manage a portfolio so that changes in interest rates will influence price and reinvestment risk at the same rate, hence, keeping the portfolio's rate of return constant.

Since price and reinvestment risk is at the same rate, the portfolio is maintained at same level of risk which is against shift in interest rates

8. Duration matching cannot protect a portfolio from some kinds of financial risks such as Default. If a borrower has defaulted the payment, then portfolio will go for a toss and the strategy of duration matching fails. In this case there is a loss on the portfolio.

The disadvantage associated with duration matching is that it assumes the durations of assets and liabilities remain unchanged, which is rarely the case.

9. If a borrower has defaulted an interest payment of a bond then the bond price will decline which changes the duration of the bond. This makes duration of assets not equal duration of liabilities. The strategy will fail.

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