Question

A wealthy investor holds $600,000 worth of U.S. Treasury bonds. These bonds are currently being quoted at 104% of par. The investor is concerned, however, that rates are headed up over the next six months, and he would like to do something to protect this bond portfolio. His broker advises him to set up a hedge using T-bond futures contracts. Assume these contracts are now trading at 111-12.

a. Briefly describe how the investor would set up this hedge. Would he go long or short? How many contracts would he need?

b. It's now six months later, and rates have indeed gone up. The investor's Treasury bonds are now being quoted at 92.5% of par, and the T-bond futures contracts used in the hedge are now trading at 96-24. Show what has happened to the value of the bond portfolio and the profit (or loss) made on the futures hedge.

c. Was this a successful hedge? Explain.

Answer 1

a) If Rates go up, the price will fall down, to safeguard he as to short the shares

To hedge, he will short 6 T-Bond Futures contract since lot size of each contract is 100000

b) as we have already expected, Rates have gone up and prices have come down

Loss on Bond portfolio: (92.5%-104%) * 600000

therefore, loss on Bond portfolio = -69,000

Profit on futures contract = (111.375%-96.75%)*6*100000 = 87750

(Note: 111-12 = 111 + 12/32 = 111.375, 96-24 = 96 + 24/32= 96.75)

c) Yes, this was a successful hedge as loss on portfolio has been covered by Futures contract

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