A corporation plans to issue $10 million of 10-year bonds in three months. At current yields the bonds would have modified duration of eight years. The T-note futures contract is selling at F0 = 100 and has modified duration of six years. How can the firm use this futures contract to hedge the risk surrounding the yield at which it will be able to sell its bonds? Both the bond and the contract are at par value.
Sale 133 contracts to offset losses
Bond value = $10,000,000
Modified duration = 8 years
Since the contracts and yield changes on bond are 1 basis point, hence the change in bond value = $10,000,000 x 0.0001 x 8
The cash flow on account of contract = $100,000 x .0001 x 6 (given)
This implies that the manager should sell 8000 / 60 = 133 contracts
This sale would offset losses in case the interest rates increase.
Use the following case in answering Problems 10 – 15 : Mark Washington, CFA, is an analyst with BIC. One year ago, BIC analysts predicted that the U.S. equity market would most likely experience a slight downturn and suggested delta-hedging the BIC portfolio.
As predicted, the U.S. equity markets did indeed experience a downturn of approximately 4% over a 12-month period. However, portfolio performance for BIC was disappointing, lagging its peer group by nearly 10%. Washington has been told to review the options strategy to determine why the hedged portfolio did not perform as expected.
Washington considers a put option that has a delta of .65. If the price of the underlying asset decreases by $6, then what is the best estimate of the change in option price?
estion: A member of an investment committee interested in learning more about fixed-income investment procedures recalls that a fixed-income manager recently stated that derivative instruments could be used to control portfolio duration, saying, “A futures like position can be created in a portfolio by using put and call options on Treasury bonds.”
a. Identify the options market exposure or exposures that create a “futures-like
position” similar to being long Treasury-bond futures. Explain why the position you created is similar to being long Treasury-bond futures.
b. Explain in which direction and why the exposure(s) you identified in part (a) would affect portfolio duration.
c. Assume that a pension plan’s investment policy requires the fixed-income manager to hold portfolio duration within a narrow range. Identify and briefly explain circumstances or transactions in which the use of Treasury-bond futures would be helpful in managing a fixed-income portfolio when duration is constrained.
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