Suppose that a bond portfolio with a duration of 12 years is...

Name: Problem 15, Chapter 6: Options, Futures, and Other Derivatives
Uploaded: 2023-09-21T14:32:08-08:00
Duration: 2 min 40 s
Channel: Anand Jangid
Description: Suppose that a bond portfolio with a duration of 12 years is hedged using a futures contract in which the underlying asset has a duration of 4 years. What is likely to be the impact on the hedge of the fact that the 12-year rate is less volatile than the 4-year rate?

Suppose that a bond portfolio with a duration of 12 years is hedged using a futures contract in which the underlying asset has a duration of 4 years. What is likely to be the impact on the hedge of the fact that the 12-year rate is less volatile than the 4-year rate?

Key Concepts

Duration

Duration is a measure of the sensitivity of a bond's price to changes in interest rates. It represents the weighted average time until a bond's cash flows are received, and a higher duration indicates greater exposure to interest rate movements. In this context, the portfolio's 12-year duration suggests it is less volatile with respect to rate changes compared to an instrument with a shorter duration.

Hedging with Futures

Hedging with futures involves taking positions in futures contracts to offset the risks associated with movements in the value of an underlying asset. When using a futures contract with an asset that has a different duration than the hedged portfolio, the effectiveness of the hedge may be compromised due to the mismatch in sensitivity to interest rate changes.

Interest Rate Volatility

Interest rate volatility refers to the degree of variation in interest rates over time. In this scenario, the 4-year rate underlying the futures contract is more volatile than the 12-year rate of the bond portfolio, which means that the futures price moves more aggressively relative to changes in interest rates compared to the portfolio.

Basis Risk

Basis risk arises when the hedge instrument does not perfectly track the price movements of the underlying asset being hedged, often due to differences in characteristics such as duration or volatility. The disparity between the 12-year portfolio duration and the 4-year futures contract can lead to imperfect hedging, as the futures' higher volatility does not exactly reflect the price movements of the lower volatility portfolio.

Transcript

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