Question

Explain the concept of duration and describe how it is used in hedging interest rate futures. Be sure to discuss the limitations of duration.

Answer #1

Duration measures the sensitivity of bond's price to interest rate changes. It is calculated by taking the weighted average of the Present values of cash flows.

Longer the duration of a bond, more is its sensitivity to interest rate changes. Thus, a portfolio of bonds, having a longer duration is more sensitive to interest rate changes than that of a portfolio having shorter duration.

Thus, interest rate futures can be used to hedge the risk of the bond portfolio. An interest rate future based on a lesser duration portfolio can be used to hedge a portfolio of longer duration and vice versa.

Though Duration is a very good measure of the price sensitivity to interest rate changes, but it has some limitations.

- The relationship between price and interest rate is non-linear.
- Duration changes with the passage of time.

How can futures be used to manage interest rate risk in a fixed
income portfolio? How can futures be used to manage beta in an
equity portfolio? Explain the mechanics of a fixed-floating swap,
describing the rationale for each participant.

Hedging instruments (i.e. futures contracts, forward contracts,
and currency swaps) are used by MNCs to:
a. speculate on fluctuating currency exchange rates
b. speculate with risk management
c. insulate the firm from some risk
d. swap currency risk for interest rate risk

3. . Mod. 5: Hedging with
Interest Rate Futures (Chapter 8, pp. 191 to 193).
[Hints: $ Price for
T-bills and Eurodollar Futures:
$ Price = $
Amount {1 – [(d x n)/360]}
where d = discount
yield as a fraction; n = maturity, usually 90 days]
In March, a
bank short-term investment manager has $1 million in 90 day T-bills
on its balance sheet that it plans to sell in June for
liquidity purposes, and is worried...

Explain how to use duration and convexity of a 100 year bond for
interest rate risk management.

How do you trade interest rate futures and why?

Explain the time value of money concept. What is meant by
the effective interest rate. How are time value of money concepts
applied to accounting applications in determining the present value
of expected cash flows and in valuing bonds?

Explain the time value of money concept. What is meant by the
effective interest rate. How are time value of money concepts
applied to accounting applications in determining the present value
of expected cash flows and in valuing bonds?

explain the concept of interest for us? Be sure to distinguish
between “simple interest” and “compound interest.”

Explain how forwards or futures can be used to manage risk.
Provide an example of a hedge that uses a short futures
position. Why might you chose to use a put option
instead of a short futures position?

Discuss the opportunities and limitations of using
generalizations, and explain how they should be used.

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