Final answer:
The student's question centers on portfolio immunization and bond pricing in response to changing interest rates. Key concepts include adjusting investment proportions between bonds to achieve a target duration and calculating a bond's market price in the face of increased interest rates, emphasizing that the price of a bond will decrease if the market interest rate rises above the bond's coupon rate.
Step-by-step explanation:
The student is asking about how to immunize a portfolio using two types of bonds to achieve a target duration. The context involves decision-making in the presence of changing market interest rates and pricing bonds accordingly. To immunize the portfolio with a target duration of 10 years, the student would typically allocate investments between a zero-coupon bond and a perpetuity to match the portfolio duration with the liabilities duration. If interest rates rise, existing bonds with lower coupon rates become less attractive, and their market price will decrease. The bond's price is calculated based on the present value of its future payments, discounted at the new, higher market interest rate.
For example, if the bond initially pays $80 per year and will pay back $1,000 at maturity, and the interest rates increase to 12%, an investor would not pay more than the amount that would grow to $1,080 (the sum of the final interest payment and the principal) in a year at the 12% rate. Here, that amount is $964, as $964 invested at 12% for one year would amount to $1,080.