Question

A hedge fund is holding a three-year, $10 million face value 6 percent annual coupon bond selling at par.

1. What is the impact on the total asset value of the fund of a 1 percent decrease in interest rates?

Answer 1

Tenure of Bond = 3 years, Face Value = $ 10 million, Coupon Rate = 6 % with annual payment

As the bond sells at par, the current interest rate must equal the bond's annual coupon rate of 6 %. If interest rates decrease by 1%, then the applicable interest rate will be (6-1) = 5 %

Annual Coupon Payment = 0.06 x 1000000 = $ 60000

Therefore, Bond Price post decrease in interest rate = 60000 x (1/0.05) x [1-{1/(1.05)^(3)}] + 1000000 / (1.05)^(3) = $ 1027232.48

Earlier Value of Bond = $ 1000000 and Current Value = $ 1027232.48

Therefore, Change in Total Asset Value = 1027232.48 - 1000000 = $ 27232.48