Question

A financial institution has a portfolio of bonds with a face value of $15 million. The bonds have an average maturity of 8.5 years and an average annual coupon of 4.375% with semiannual payments. The yield to maturity on the portfolio is 4.90%. The financial institution wants to use 5-year treasury bonds to hedge the interest rate risk associated with the portfolio. The treasury bonds have a face value of $250,000, a 2.875% annual coupon, paid semiannually, and trade at par. What position should the financial institution take in these bonds?

b. If the financial institution were to enter a forward contract on the same treasuries, what position should it take in the forward market?

Answer 1

a). As the institution is long on Bond Portfolio for $ 15Mn, to hedge the interest rate risk can be done through Forwards or Interest Rate derivatives like Futures, Options, Rate Caps, Floors, Collars and Swaps.

In the present case, we can hedge the long bond position by taking a short position on 5yr Treasury bonds

As the bonds and T bonds are having different yields and maturities we need to cross hedge.

b). If the institution were to enter a forward contract on the treasuries, it should short the same on forward market.

we need to calculate the Hedge Ratio to find out how many treasury bonds to be shorted as the portfolio bonds and treasury bonds are having different maturities and yields.

Hedge Ratio =