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Duration and Convexity
Your research department reports continuously compounded interest rates as
Maturity (Years) ---Interest Rate (%)
0.5---1.00
1.0---1.50
1.5---2.00
2.0---2.00
(1) Construct a hedge portfolio of 1 coupon bond, and k1 one-year zero coupon bonds and k2 two-year zero coupon bonds, that has zero duration and convexity. What are the values of k1 and k2?
(2) Suppose that the yield curve shifts upward with dr = 1%. Recalculate Pc(0,2), Pz(0,1) and Pz(0,2) and use this to calculate the change in the values of the hedge portfolios constructed in (1) and (2). Comment on the result.
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