What is the basis used to define hedging portfolio? From getting a =-125 how are we able to deduce that we are short selling 2 bonds of A with nominal -250 and similarly for parameter b. Thank you
Hi kartikact, These are based on our original simultaneous equations. The first equation here is: 2a + 3b + 100r = 0 which is based on the relative nominal amounts of Bonds A and B, ie £2m and £3m. Once we solve this, we will have the number of Bonds A and B that we need to hold. a = -125 and so, we have 2*-125 = £250 nominal of the bond A. You could instead have set up the equation a + b + r = 0 so that you are working in monetary amounts. This would be solved to get a = -250 and so you don't have to think about the number of bonds held. It doesn't matter which equations you set up, the important point is to interpret them in the way you set them up. As long as you know which units you were using, you can interpret the answers in those units and give your hedging portfolio accordingly, Good luck! John
