Question

A hedge fund is holding a three-year, $10 million face value 6 percent annual coupon bond selling at par. a. What is the impact on the total asset value of the fund of a 1 percent decrease in interest rates? b. What is the impact of a 75-basis point increase in interest rates on the net asset value of an open-end bond mutual fund holding a seven-year, $100 million face value 7 percent annual bond outstanding? c. In addition to interest rate risks what is one other risk associated with this type of bond and why?

Answer 1

a

A

Face Value

$10,000,000

B

Coupon rate

6%

Pmt=A*B

Annual Coupon

$600,000

Rate

Decreased interest Rate

5%

(6-1)

Nper

Number of years to maturity

3

Fv

Amount to be received on maturity

$10,000,000

Expected Market value =Present Value of Future Cash Flows

PV

Expected Market value

$10,272,325

(Using PV function of excel with Rate=5%, Nper=3, Pmt=-600000,Fv=-10000000)

I=PV-A

Impact will be increase in total asset value by

$272,325

b

A

Face Value

$100,000,000

B

Coupon rate

7%

Pmt=A*B

Annual Coupon

$7,000,000

Rate

Increased interest Rate

7.75%

(6-1)

Nper

Number of years to maturity

7

Fv

Amount to be received on maturity

$100,000,000

Expected Market value =Present Value of Future Cash Flows

PV

Expected Market value

$96,061,612

(Using PV function of excel with Rate=7.75%, Nper=7, Pmt=-7000000,Fv=-100000000)

I=PV-A

Impact will be DECREASE in total asset value by

$3,938,388

Other Risks associated with these type of Bond :

Default Risk- Not receiving the coupon payment and/or payment of principal on maturity

Inflation Risk-Earning on investment is less than inflation rate

Market Risk-Bond market declining which will reduce the value of Bonds