Protecting against rise in bond yields

[yogesh167]

Hello

Hope you are doing well.

Question on Page 12 of ch23
1. Investor B expects bond yields to fall by 1%pap by all terms, what futures strategy he should adopt to protect his portfolio?
my question is fall in bond yield will increase the price of bond and there is no reason for him to hedge his portfolio here. Could you please confirm my understanding?

2. Investor A expects yields to rise by 2% and B expects yields to fall by 1%. Why this magnitude is not considered in the solution of this question?

 

[Gresham Arnold]

Hi Yogesh

Re Q1: I agree that if bond yields fall the price of the bonds will rise. However, investor B may still wish to hedge risk eg because, although they expect bond yields to fall, they are unlikely to be certain this will happen and may be concerned that bond yields will rise instead.

So this question is illustrating that the direction of an expected interest rate movement is irrelevant - in order to protect a long position in an asset, you need to be short in the future

Re Q2: In order to hedge a change in the value of an underlying asset we need a derivatives position that changes in value by the same amount as the underlying asset. So if the bonds held fall in price by, say, 4% for each 1% rise in yield, we need to hold derivatives that will rise in price by the same amount per 1% rise in bond yield. Then it doesn't matter how much the yield actually changes, our derivatives position will change by an equal but opposite amount.

 

[yogesh167]

Okay thank you