You are a financial manager and you have bonds worth 3000000...

You are a financial manager and you have bonds worth $3,000,000 in your portfolio which have a 7 percent coupon rate and will be maturing in 10 years from now. The market rate is also 7 percent. Suppose a futures contract on these bonds is available with a standard contract size of $300,000 per contract. What type of risk are you exposed to and how will you hedge your exposure? If the market interest rates change to 9 percent, show through relevant calculations, how your hedge will protect you from loss. What if the interest rate in the market went down to 5%? Do you think you would have hedged better if you had used an options contract on these bonds with an exercise price of $3,140,000? The options contracts are available in the size of 100 options per contract at a price of $5 per contract. Show detailed workings.

Transcript

00:01 The scenario you are exposed to in interest rate risk specifically the risk of changes in market interest rates affecting the value of your bond portfolio who hedge the exposure you can use future contracts on these bombs.

00:19 So to calculate the number of future contracts needed to hedge your bond portfolio to calculate to calculate the number of future contracts needed to hedge on portfolio one divide the value of the bond portfolio by the contract size with the number of future contracts equals to equals to value of one foot follow divided by contract size.

01:38 So the number of future contracts equals to dollar divided by dollar v.

01:53 Lack the number of future contracts equals to 10 contract was to 10 contract by taking a short position in 10 future contracts.

02:12 One can effectively hedge exposure to the interest rate.

02:18 If the market interest rate increases to 9 % the value of the bond portfolio will decrease.

02:23 However short position in the future contract will generate a gain to offset the loss the gain in the future position can be calculated as follows gain in future position number of contracts into contract size initial future price minus new future price.

03:26 So it is equals to 10 in $3 laughs into 1 minus 1 0 .09 in 2 minus 10 gain in future position is equals to dollars 6 back again in the future position will help offset the loss in the value of bond portfolio due to increase in interest rate.

04:02 If the interest rate in the market goes down to 5 % the value of the bond portfolio will increase.

04:09 However, the short position in the future contract will generate a loss the loss in the future can be calculated using the same formula, but with a new interest rate of 5 % to the loss in the future position equals to laws in the future...

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