Today is 1st February 2013. A US based investor holds the following portfolio and believes there is a risk of higher yields during the next 3 months. However, they are mandated to remain fully invested at all times so selling their bond is not an option.
Their portfolio currently comprises the following positions.
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Notional/Amount
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Security
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Term
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€5,000,000
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Bund 2%25/8/23
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10 year on-the-run
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€50,000,000
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EURIBOR Interest Rate deposit
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3 month (fixed rate for term).
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1. The investor wants to fully hedge the interest rate risk on the bond by using bond futures. Discuss how bond futures work, the risks in using them and how they might be most appropriate in this situation. Then calculate the appropriate number of bond futures that should be sold.
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- You should start by calculating the dirty price and DV01 of €5M nominal of the bund. Assume a yield to maturity of 1.90%
- You can assume that 2% bund is the cheapest-to-deliver and has a conversion factor of 0.92.
2. The investor would like to hedge the receipt of €50,000,000 to be received in 3- months' time from the maturity of the 3-month interbank deposit. Describe the currency risk and explain how currency forwards could be used to hedge the position. Calculate a 3-month €/$ forward rate.
3. You may assume an exchange rate of €/$ 1.3000 and a 3-month USD LIBOR of 0.45% and a 3-month EURIBOR of 0.65%. Three months can be assumed to be 92 days.
4. Following on from Q2, the investor thinks that there is some possibly that the currency markets could move in their favour and so ideally would like some degree of participation in any favourable move, whilst being fully protected against adverse moves. Discuss and provide examples of alternative hedging choices by using options.
5. The investor is concerned about a default by the Bank to which it has lent €50,000,000 (unsecured) in the interbank market. Discuss how credit derivatives could be used to hedge this risk.