Reference no: EM133072822

a.) The economy has been showing steady growth: employment and inflation have been growing steadily over the past several years. In response, the Fed has regularly been raising interest rates to slow the expansion and possibly induce a recession in the near future. What shape of the yield curve would you expect to see at this point in the cycle? Concisely explain why.

b.) Based on your analysis, you expect the recession to begin soon and at the same time the Fed to cut rates to try to stimulate the economy. It you were uncertain by how much interest rates were going to uniformly fall across the entire term structure but wanted to profit from short-term rates falling relatively more than long-term rates, what trade should you put on to profit from this view? A one-word answer is sufficient.

c.) Your choice of assets are a two-year zero with a YTM of 4.5% and a ten-year zero with a YTM of 4%. With these two assets describe your positions (long and short) you would take in each to implement your trade?

d.) Assume annual compounding and that each asset has a face value of $100. Calculate the dollar duration of each asset.

e.) What is the correct hedge ratio to immunize the portfolio of the two assets against parallel changes in the level of interest rates? I'm looking for both an equation and the solution to the equation. Interpret the hedge ratio.

f.) Assume now until to the end of this question that the hedge ratio you calculated in e.) equals -4 (this might be different than what you calculated in e.)). Assume your trading position involves 10 units of the ten-year zero. How many units of the two-year zero should you buy or short? And how much does this portfolio cost you to put on?

g.) After putting on this trade, suppose the YTM on the two-year zero falls "overnight" to 2.5%. What's your portfolio value now? What is your dollar profit?