706 Part Eight Risk Management
bre44380_ch26_673-706.indd 706 09/30/15 12:09 PM
∙ A portfolio of Treasury notes with an average duration of 7 years.
∙ A portfolio of short-term Treasury bills and notes with an average duration of 1 year.
The term structure is flat, and the yield on all three portfolios is 5%.
- Sorry, you lost. SPX won and implemented its proposed strategy. Now the recession of 2018
has knocked down U.S. stock prices by 20%. The value of the Madison portfolio, after paying
benefits for 2018, has fallen from $90 million to $78 million. At the same time interest rates
have dropped from 5% to 4% as the Federal Reserve relaxes monetary policy to combat the
recession.
Mr. van Wie calls again, chastened by the SPX experience, and he invites a new pro-
posal to invest the pension assets in a way that minimizes exposure to the stock market and
changing interest rates. Update your memo with a new example of how to accomplish Mr.
van Wie’s objectives. You can use the same portfolios and portfolio durations as in Question - You will have to recalculate the PV and duration of the pension benefits from 2019 onward.
Assume a flat term structure with all interest rates at 4%. (Hint: Madison’s pension obliga-
tions are now underfunded. Nevertheless you can hedge interest rate risk if you increase the
duration of the pension assets.)