We have been told the following information: Liabilities Assets PV 100m 90m Duration 20 22 Yield 1.5% 1.55% Discuss the effectiveness of this strategy for hedging interest rate risk? I calculated the PV01 of assets and liabilities, then a interest rate ratio of just less than 1 - concluding it is a good hedge. There are no calculations in the answers. Would this sort of calculation gain any credit in the exam?
Hi Oliver As a broad principle I think it is always good to see what can be done with numbers given in the question because it may gain credit. However, as you say, there are no calculations in the Examiners Report, so it may be that they wouldn't have awarded credit for a calculation on this occasion. Gresham
Out of interest, how is the PV01 calculated here? I believe we had a similar question on the most recent paper.
Good question - it is not in SP5. But if you search for "PV01 formula duration" you will find that it can be calculated as Modified duration x PV /10,000. So if you have 90m assets, 22 duration, then PV01 is about 0.198m. The same calculation for the liabilities gives 0.2m so they are indeed well hedged. Duration and modified duration are almost the same thing. (There is a formula in SP5 chapter 13 that shows how to convert the duration to the modified duration). in this case the examiners just wanted students to notice that the assets were slightly less than the liabilities, so the assets were made slightly more interest rate sensitive than the liabilities. Then talk around that as a strategy.
