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Hedging Interest Rate Risk with Bonds

The document describes a money manager who will receive a $100,000 inflow in 4 years and have a $100,000 outflow in 5 years. They want to hedge against interest rate risk when investing part of the inflow for 1 year. The yields on 4-year and 5-year zero coupon bonds are given. The manager is asked to calculate the forward rate for 4 years from now and determine how much to invest vs pay out assuming a forward rate agreement exists, and how to replicate such an agreement if not available.

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Aparajita Chandel Singh
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48 views1 page

Hedging Interest Rate Risk with Bonds

The document describes a money manager who will receive a $100,000 inflow in 4 years and have a $100,000 outflow in 5 years. They want to hedge against interest rate risk when investing part of the inflow for 1 year. The yields on 4-year and 5-year zero coupon bonds are given. The manager is asked to calculate the forward rate for 4 years from now and determine how much to invest vs pay out assuming a forward rate agreement exists, and how to replicate such an agreement if not available.

Uploaded by

Aparajita Chandel Singh
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd

The yield on a default-free four-year zero-coupon bond is 3%; the yield on a

default-free five-year zero-coupon bond is 4.5%. The bonds have a face value of
$1000 and are traded in an open market. You are a money manager and know that
you will have a net inflow of $100,000 four years from now, and an obligation (i.e.
a net outflow) of $100,000 one year later (i.e. five years from now). Once you get
your inflow, you plan to invest part of this inflow (as much as necessary) in risk-
free bonds for a year, and immediately pay the rest to your investors in the form of
a profit. You would like to hedge the interest-rate risk that is involved in this future
bond investment, in order to be able to pre-announce your expected profit today,
but also ensure that your obligation is covered.

(a) Based on today’s yields, what is the no-arbitrage yield of a one-year forward-
rate agreement starting four years from now?

(b) Assuming you can obtain such a forward-rate agreement, how much of your
inflow will you need to re-invest, and how much will you be able to pay to
investors?

(c) Now assume that no such forward-rate agreements are being offered in the
market. How can you construct one yourself (i.e. replicate one), in order to hedge
your interest-rate risk? Carefully describe your strategy, and show that the resulting
cash flows mirror those of the forward-rate agreement you are trying to create.
Assume you can go either long or short in either bond, and you can also buy or sell
fractions of bonds.

Price of $1000 4-year zero coupon bond at 3% yield = $1000/ (1+3%) ^4 = $888.48705

Price of $1000 5-year zero coupon bond at 4.5% yield = $1000/ (1+4.5%) ^5 = $802.45105

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