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The Varela family is looking for an investment to perfectly immunize a $2,000,000 liability due in exactly 8 years. They are considering a zero-coupon bond with a 10-year maturity and a zero-coupon bond with an 8-year maturity.
Which bond is the better instrument for immunization, and why?
- The 8-year zero-coupon bond, because its effective duration is linear while the 10-year bond's duration is curved. Under the facts given in the stem
- Neither, because immunization requires a portfolio of coupon-bearing bonds to ensure cash flow for reinvestment.
- The 10-year zero-coupon bond, because its higher convexity provides a 'cushion' against interest rate drops.
- The 8-year zero-coupon bond, because its Macaulay Duration is exactly equal to its maturity, providing a precise match for the liability.
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