A junior portfolio manager has been asked to establish a fund that will be worth $175 million in four years' time. Her supervisor has suggested to her that an appropriate investment would be 5-year 15% coupon bonds at a yield of 7.6% pa. Although the junior manager has some knowledge of bonds, she does not understand the reason for this suggestion. Why suggest a 5-year bond maturity when the money is really needed in 4 years?
(a) Explain the reason to the junior manager in simple terms.
(b) How much should she invest to establish the fund? What annual coupon interest will this investment produce? If the par value of one bond is $10 million, how many actual bonds should be bought?
(c) Immediately after the fund is established, yields increase by 100 basis points. Show that, if no further yield shifts occur, the fund will still achieve its original target in four years’ time.