Please answer as soon as possible, I will upvote if it is answered in 40 minutes....

Please answer as soon as possible, I will upvote if it is answered in 40 minutes.

Suppose that a bond portfolio with a duration of 5 years is hedged using a futures contract in which the underlying asset has a duration of 14 years.

What is likely to be the impact on the hedge of the fact that the 14-year rate is less volatile than the 5-year rate?

Expert Solution

14 year rate will be having a lower volatility than this 5 year rate because it is having a higher duration and the hedge will not be perfectly executed because it can be seen that Bond portfolio which has a lower duration of five years is hedged with the future contract which is having a underlying asset that has a duration of 14 years and hence there will be a mismatch of duration while we are considering the hedging.

It is to be considered that hedging is primarily based upon matching of the duration of both the securities so the securities can have their risk synchronised with each other and there could be a similarity in the movement of both the securities so it would not be providing the bond portfolio with optimal security because when there will be a higher volatility of change in the portfolio due to lower the duration of the portfolio, the hedge will not be providing us with same rate of return on the upside and hence it would be leading to more risk for the investor in relation to the matching of inappropriate duration so there will not be appropriate hedging because of this method of the duration of securities and derivative contracts.

The duration of both the maturity have to be matched and when the volatility of Bond portfolio will be increasing, the value of Bond portfolio will be decreasing the hedge which has been taken in the future market should be increasing at the same rate in order to protect the depreciation of Bond portfolio and hence, investors should always be trying to take the proper matching of duration before entering into the heading position

So, it will be leading to an imperfect hedge because of mismatch of duration of bond portfolio and adjacent hedging contract which has been taken in the future market.

jeff jeffy answered 1 year ago

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