You manage a pension fund, which provides retired workers with lifetime annuities. The fund must pay out $1 million per year to cover these annuities. Assume for simplicity that these payments continue for 20 years and then cease. The interest rate is 4% (flat term structure). You plan to cover this obligation by investing in 5- and 20-year maturity Treasury strips.
(a) What is the duration of the funds 20-year payout obligation?
(b) You decide to minimize the funds exposure to changes in interest rates. How much should you invest in the 5- and 20- year strips? What will be the par value of your holdings of each strip?
(c) After three months, you reexamine the pension funds investment strategy. Interest rates have increased. You still want to minimize exposure to interest rate risk. Will you invest more in 20-year strips and less in 5-year strips? Explain briefly.