Question

In August, a fund manager has $10 million invested in a long portfolio of government bonds with a duration of 6.80 years and wants to hedge against interest rate risk between August and December. The fund manager may use December T-bond futures. The futures price is 93-02 and the duration of the cheapest to deliver bond is 9.2 years. Suggest a risk management strategy to the fund manager and show your calculation.

Answer 1

Duration of a bond refers as measure of the sensitivity of the prices of bond to change in interest rates. So if the duration of government bond is 6.80 years then it means that on rising by 1% interest rate there will be decline in the price of bond by 6.80% and vice-versa The fund manager has an option to use the T-Bond futures as hedging tool against risk of interest rate. So as risk management strategy to hedge the risk of interest rate fluctuation, Fund manager should go for that security that is risk averse or which has fluctuation reaction against the fluctuation of government bonds. If fund manager has an expectation of rise in interest rate which will ultimately reduce the value of government bond then Fund Manager should enter into T-bond future selling contract. And if Fund manager expect to reduce in interest rate which will ultimately increase the value of government bond then Fund Manager should enter into T-Bond future buying contract.