FUNDING PENSION LIABILITY AT NEW MUMBAI ASSURANCE

New Mumbai Assurance needs to make total payments worth Rs 32.6 lakhs on January 1 st
each year for the next 15 years. How must they fund these payments? They are
considering three corporate bonds. All three have a coupon rate of 10%. Bond 1 has a
maturity date of three years, Bond 2 has a maturity date of 13 years and Bond 3 has a
maturity date of 15 years. Assume that the face value of each unit of bond purchased is
Rs 10,000.0. Assume for now, that at the time of purchase the yield for all three bonds is
10%. Hence the bonds are at par.

Supposing that the pension liabilities are to be funded by Bond 1 alone, how many units
of Bond 1 need to be purchased initially? If they are to be funded by Bond 3 alone, how
many units need to be purchased?

Assume that immediately after the purchase of Bond 1, its yield dips to 9%. Can the
payments obligations be fulfilled?

Similarly, if Bond 3 alone were purchased, and the yield dips to 9%, can the payment
obligations be fulfilled?

Assume that the change in the interest rate follows a normal distribution with a mean of
zero and a standard deviation of 3% (a highly volatile scenario!). What impact will this
have on the company’s ability to fulfill the payment obligations? Answer this question for
the case where Bond 1 alone is used, and Bond 2 alone is used.

If you were to immunize the company’s portfolio, what will it look like?

What will be the impact if the company were to use the immunized portfolio?

Accompanying Excel File: Bonds.xls