Question

June Klein, CFA, manages a $200 million (market value) U.S. government bond portfolio for an institution. She anticipates a small parallel shift in the yield curve and wants to fully hedge the portfolio against any such change.

PORTFOLIO AND TREASURY BOND FUTURES CONTRACT CHARACTERISTICS
					Conversion Factor	Portfolio Value /
	Modified		Basis Point		for Cheapest to	Future Contract
Security	Duration		Value		Deliver Bond	Price
Portfolio	9 years		$180,000.00		Not Applicable	$200,000,000
U.S. Treasury bond     futures contract	6 years		$99.50		1	92-04

1. Formulate Klein’s hedging strategy using only the futures contract shown. Calculate the number of futures contracts to implement the strategy. Do not round intermediate calculations. Round your answer up to the nearest whole number.

   Klein’s hedging strategy is to (buy/sell) (number of) futures contracts.

2. Determine how each of the following would change in value if interest rates increase by 12 basis points as anticipated. Use the rounded value of the number of futures contracts from part a. Round your answers to the nearest dollar. Enter your answers as positive values.
   1. The original portfolio.

      The market value of the original portfolio will SELECT (decline/increase/not change) by  $_____ .

   2. The Treasury bond futures position.

      The total cash SELECT (inflow/outflow) from the futures position will be $_____ .

   3. The newly hedged portfolio.

      Theoretically, the change in the value of the hedged portfolio is SELECT (zero/the change in value of the original portfolio/the cash flow from the hedge position)

3. State three reasons why Klein’s hedging strategy might not fully protect the portfolio against interest rate risk.
   1. The duration will change as time passes, so risk will arise unless continual rebalancing takes place
   2. If interest rates decrease Klein’s hedging strategy can not be applied. It means that the strategy protects the portfolio only against increase in interest rate.
   3. Immunization risk would remain even after execution of the strategy, because of the possibility of non-parallel shifts in the yield curve.
   4. This may still be a cross-hedge, because the government bonds in the portfolio may not be the same as the cheapest-to-deliver bond.

Answer 1

(a)

.

We use Modified duration methods to calculate the number of contracts:

(b)

• Original Portfolio:

• Treasury Bonds future position:

• Newly Hedged Portfolio:

(C) Three reasons