Principles of Corporate Finance_ 12th Edition

(lu) #1

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%.


  1. 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

  2. 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.)

Free download pdf