Question

An investor holds $500,000 worth of US $ Treasury bonds. These bonds are being quoted at 105% of par. The investor is concerned, however, that rates are headed up in the next six months. He/she is advised by his/her broker to set up a hedge using Tbond futures contracts. Assume these contracts are now trading at 111’06

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

b) After 6 months the rates go up. The investor’s Treasury bonds are now being quoted 93 ½ and the T-bond futures contracts used in the hedge are now being traded at 98’00. 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 your answer.

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 5 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: (93.5%-105%) * 500000

therefore, loss on Bond portfolio = -57,500

Profit on futures contract = (111.1875%-98%)*5*100000 = 65937.5

(Note: 111-06 = 111 + 06/32 = 111.1875)

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

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