Preview

Homework 3

Satisfactory Essays
Open Document
Open Document
671 Words
Grammar
Grammar
Plagiarism
Plagiarism
Writing
Writing
Score
Score
Homework 3
Finance Capstone Advanced Topics
Homework Three
AIJIA ZHOU

The general information of the two bonds are shown below: Coupon | 10.625% | 4.25% | Coupon frequency | Semi-annual | Semi-annual | Coupon type | Fixed | Fixed | Day count | Act/Act | Act/Act | Issue date | August 15, 1985 | August 15, 2005 | Maturity date | August 15, 2015 | August 15, 2015 | Amount issued | 7.15 billion | 32.47 billion | Amount outstanding | 4.02 billion | 32.47 billion |

Modified Duration Method
In order to create a long-short portfolio that had no exposure to changes in interest rates, we can use modified duration hedge ratio.
The following formula is the function to calculate modified duration hedge ratio. The term K is a measure of the responsiveness of the yield spread to changes in the two bonds. We assume K is 1. Meanwhile DL is the duration of the 10.625% bond and DS is the duration of the 4.25% bond. L and S are the price of the 10.625% bond and 4.25% bond, respectively.
N=DLLDSSK
According to the case, the modified duration of the 10.625% bond was 5.14, and the modified duration of the 4.25% bond was 5.84. The price of the 10.625% bond is $1,441.96 (= 1,418.28+23.68). The price of the 4.25% bond is $1,069.16 (= 1,059.69 + 9.47). Therefore, the modified duration ratio is:

N=5.14×1,441.965.84×1,069.16×1=1.1870
In order to hedge the risk, when Franey invest 1,000 10.625% bond, he should also short 1,187 4.25% bond.

Val01 Method
The 10.625% bond was priced at 141.8281 (per $100 face amount) and had a Val01 of 0.0741. The 4.25% bond was priced at 105.9688 and had a Val01 of 0.0625. To create a long-short portfolio that had no exposure to changes in interest rates, for each $1,000 face amount of the 10.625% bond, he would sell $1,1185.60 face amount of the 4.25% bond for $1,256.37+$11.23 accrual. The result from this method is very similar to the result from modified duration method.
1,185.60=1,000×0.07410.0625
1,2537 +

You May Also Find These Documents Helpful

  • Satisfactory Essays

    Acc/531 Week 3

    • 790 Words
    • 4 Pages

    A portfolio is formed as follows: sell short $1,000 of Stock 1; buy $1,500 of Stock 2; buy $1,500 of Stock 3. The investor uses $1,000 of his own equity, with the remaining amount borrowed at a risk-free interest rate of 4% (with continuous compounding).…

    • 790 Words
    • 4 Pages
    Satisfactory Essays
  • Satisfactory Essays

    Homework 3

    • 830 Words
    • 4 Pages

    Molecule x blocked the ion channel receptor site so acetylcholine could not attach therefor not allowing the muscle to ultimately contract.…

    • 830 Words
    • 4 Pages
    Satisfactory Essays
  • Satisfactory Essays

    Homework: Zero Coupon Bond

    • 1493 Words
    • 6 Pages

    the prices quoted in part B. Which bond has a higher yield to maturity at these prices?…

    • 1493 Words
    • 6 Pages
    Satisfactory Essays
  • Good Essays

    homework 3

    • 971 Words
    • 4 Pages

    Describe the atmosphere created by the combination of film elements and how they contributed to your liking or disliking of the movie.…

    • 971 Words
    • 4 Pages
    Good Essays
  • Good Essays

    We assume that cost of debt equals 11.25% as Dixon issue bonds at this rate for the purpose of this project financing.…

    • 1892 Words
    • 8 Pages
    Good Essays
  • Satisfactory Essays

    Fixed Inc

    • 295 Words
    • 2 Pages

    2. A. Since the original bond is overpriced, we will buy 0.6875 units of 12 May 05 bond at $129.91 and 0.3125 units of May 05 STRIP at $30.31. We will sell 1 unit of 8¼ May 00-05 at $101.125, which give us of a profit = 101.123-(129.91*0.6875+30.31*0.3125)=2.3418.…

    • 295 Words
    • 2 Pages
    Satisfactory Essays
  • Powerful Essays

    Nowadays, bonds are playing an increasing important role in investors’ portfolios, and which is defined as is a fixed interest type of investment option that would repay the principal and interest on a certain date in the future. By diversification, bonds also do a great contribution in reducing the risk of shares and property securities portfolio. The importance of the bond market has been realized by investors and bonds have been an important investment options.…

    • 1845 Words
    • 8 Pages
    Powerful Essays
  • Good Essays

    Pine Street Capital

    • 768 Words
    • 4 Pages

    Pine Street Capital is a market-neutral hedge fund in the technology field and is facing market risk and has to decide which way to use in order to hedge the risk. It can either use short selling of NASDAQ or options hedging strategy. Each strategy has its own advantage in different economic conditions. As the fund has just gone through a volatile period in NASDAQ’s history, PSC has to choose between two choices.…

    • 768 Words
    • 4 Pages
    Good Essays
  • Good Essays

    The modified duration of a bond portfolio is equal to the weighted average modified duration of the individual bonds, the weights being the present values of the bonds. Therefore, the modified duration of this bond portfolio is:…

    • 544 Words
    • 3 Pages
    Good Essays
  • Good Essays

    BOND VALUATION

    • 402 Words
    • 2 Pages

    Given a 4-yr treasury bond with a face value of $1,000, an annual coupon rate of 3.20%, which had a yield to maturity of 2.53%, this bond makes 2 semi-annual coupon payments. Thus has 8 periods until maturity and we are required to determine what the duration, modified duration, and convexity of this bond is, based on the Annual Percentage Rate (APR) and the Effective Annual Rate (EAR). Also, we are asked to explain an intuitive interpretation of duration.…

    • 402 Words
    • 2 Pages
    Good Essays
  • Satisfactory Essays

    Fin 535 answer

    • 854 Words
    • 7 Pages

    The forward hedge is superior to the money market hedge and has a 70% chance of outperforming the put option hedge. Therefore, the forward hedge is the optimal hedge.…

    • 854 Words
    • 7 Pages
    Satisfactory Essays
  • Good Essays

    Summer Training Project

    • 14997 Words
    • 60 Pages

    I hereby declare that the Project work entitled, RISK MANAGEMENT THROUGH DERIVATIVES submitted by me for the partial fulfilment of the Post Graduate Program (PGP) to IILM Institute for Higher Education, is my own original work and has not been submitted earlier either to IILM or to any other Institution for the fulfilment of the requirement for any course of study. I also declare that no chapter of this manuscript in whole or in part is lifted and incorporated in this report from any earlier / other work done by me or others.…

    • 14997 Words
    • 60 Pages
    Good Essays
  • Good Essays

    Bonds

    • 989 Words
    • 4 Pages

    904. A bond with a coupon rate of 8% is available at its face value of Rs. 1,000/-. The market rate of return on an instrument with similar risk goes down to 6%. The bond price will become:…

    • 989 Words
    • 4 Pages
    Good Essays
  • Satisfactory Essays

    Stock Market and Cost

    • 1084 Words
    • 5 Pages

    2) A 10 year, 8% Rs.1,000 per bond sold at Rs.950 less 4% underwriting commission. -C…

    • 1084 Words
    • 5 Pages
    Satisfactory Essays
  • Satisfactory Essays

    strategy operations

    • 521 Words
    • 2 Pages

    The fund manager alters the average duration of bonds according to his expectations of the future direction of interest rates. If the rate is expected to fall, the fund manager buys bonds with longer duration and sells those with shorter duration. This process continues until the fund's average duration rises above the market average duration. This strategy is akin to the timing strategy that is followed in equity markets.…

    • 521 Words
    • 2 Pages
    Satisfactory Essays