Computing hedge ratio: the modified duration method, Financial Management

Assignment Help:

Let us consider a situation wherein a position in an interest rate dependent asset such as a bond portfolio or a money market security is hedged by using an interest rate futures contract.

Let us assume that the change in the yield ?y, will be same for all maturities, i.e., only parallel shifts in the yield curve can occur. From the modified duration definition, we have,

         1187_hedge ratio.png

We can also say that to a reasonable approximation, it is also true that,

         1584_hedge ratio1.png

In the first equation, S0 represents value (decimal form) of the asset that is being hedged and MDrepresents modified duration of the asset. In the second equation, F0,T represents quoted price in decimals for the interest rate futures contract and MDrepresents modified duration of the asset underlying the futures contract (i.e., modified  duration of the cheapest to deliver bond).

As ?y is assumed to be the same for all maturities, we have ρΔSΔF = 1.  By combining first and second equation, we get,

         10_hedge ratio2.png

This can be written as,

         1520_hedge ratio3.png

Thus, we get,  

         1239_hedge ratio4.png

Finally, the optimal Hedge Ratio (HR) is used for hedging 

         1593_hedge ratio5.png

By using this equation we can equate the duration of the combined position equal to zero.

However, the hedge obtained using the above equation is not perfect because of following reasons:

  • It assumes that ?y is same for all yields. But, in reality short-term yields are generally more volatile and also have low correlation with long-term yields. Consequently, the performance of the hedge will not be appreciable, particularly when there is large variation between MDS and MDF.

  • It does not consider convexity. In case the convexity of the asset underlying the futures contract is remarkably different from the convexity of the asset being hedged, and at the same time if there is large difference in interest rates, then the performance hedge will be worse than is expected.

  • An assumption with regard to cheapest-to-deliver bond is essential to compute MDF. If the cheapest-to-deliver bond changes, then MDF   as well as optimal number of contracts also changes.

Now, as we know the hedge ratio, let us see the number of futures contracts to be purchased. We have earlier studied that the number of futures contracts required is given as

         651_hedge ratio6.png

In the above equation, NS indicates the number of units of spot asset to be hedged and k indicates the contract size.

We can estimate hedge ratio by using regression also. It can be interpreted as follows:

         1552_hedge ratio7.png

We have earlier studied that,  210_hedge ratio8.png   Here  2120_hedge ratio9.png   represents conversion factor of the cheapest to deliver bond at time 0 and SCTD,0  represents its price. If we replace F0,T in the above formula, we get,

         569_hedge ratio10.png

This can be interpreted as follows:

1461_hedge ratio11.png


Related Discussions:- Computing hedge ratio: the modified duration method

Discuss the process of maximise profits, Discuss the process of  Maximise ...

Discuss the process of  Maximise Profits Let's first look at profit maximisation.  Profit (also known as net income or earnings) canbe defined as the amount a business earns af

Caselet, suggestion regarding credit limit. should it be approved or not wh...

suggestion regarding credit limit. should it be approved or not what should be the amount of credit limit that electronics give to booth plastics

Elements of financial management, Elements of Financial Management: Fin...

Elements of Financial Management: Financial management is the term given to the overall management of an organisation's finances. It includes a number of elements, or systems,

Capital investment decisions, what are the key stages in capital investment...

what are the key stages in capital investment decision-making process and the role of investment appraisal in this process?

Leadership, AskThink back to a time when you have worked for a supervisor w...

AskThink back to a time when you have worked for a supervisor who moved from one leadership style to another based on situational variables described in the Long and Spurlock (2008

What is an agent? what are the responsibilities of an agent?, What is an ag...

What is an agent? What are the responsibilities of an agent? An agent is a person who has the actual or implied authority to act on behalf of another.  The owners whom the agen

Describe the basic career stages, Q. Describe the basic Career stages? ...

Q. Describe the basic Career stages? The proper way to analyze and discuss career is to look at them as made up of stages. We can identify five career stages that people most p

Show the sales forecasting, A niche market targets a well-defined and speci...

A niche market targets a well-defined and specific market segment. Firms that operate in niche markets will therefore cater for the precise and distinct needs of their customers. D

Rationale for corporate governance, Rationale for corporate governance ...

Rationale for corporate governance The organization of the world economy (particularly in present years) has seen corporate governance gain prominence mostly since: Insti

Deseasonalizing a time series, Deseasonalizing a Time Series The Ratio...

Deseasonalizing a Time Series The Ratio to Average Method allows us to identify the component of the seasonal variation in time series data and the indices themselves help us

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd