General Instrument Queries

[chiaaugu]

Hi all

I have a few general questions that i would like to consult you guys on:

1) What does it mean to hedge the bond duration? Why would we prefer a portfolio that has 0 net duration?
2) I undertand that in Banks, they usually hedge their Bonds with IRS. Am i right to say they do this in order to always receive the fixed payment since banks do not prefer vol in their earnings?
3) How does convexity help us compensate for large parallel shift in the IR? I have read the note + book but still don't quite get it
4) (Hall Chapter 5) Can you list the calculations for Hall 5.6 on Page 74 on how you got 0.6453 as your answer. I took F = 0.62 * E^((0,0058-0.0042)*24) and got 0.6443 instead of 0.6453?
5) (Hall Chapter 5). It is stated that the theory of normal backwardation assumes hedrs want to be net short and speculators want to be net long. Can you explain why this contributes to backwardation? I have been getting quite confused on the backwardation/contango thing. I just interpret Contango as the standard yield curve shape (upward slopping as T increases) and backwardation as inverted standard yield curve (downward slopping as T increase). Am i on the right track?

 

[brian.field]

These are good questions and not really beginner level questions. I would try to keep them in mind and continue your preparation. Many of the answers will come to you as you study.

 

[ShaktiRathore]

please use the search tab in the site you would find most of the answers.
thanks

 

[Nicole Seaman]

Hello @chiaaugu

Great job utilizing the forum to ask these questions! This is the best place for you to find answers to any concepts that you may not understand. First, I would recommend using the search function in the forum as Shakti suggested. A quick search can bring up many forum threads that should answer your questions.

Also, I would suggest going through the Practice Question sets associated with these concepts. On the answer page of each question set, there is a forum link associated with those specific questions. You can ask questions directly related to those questions on the corresponding forum thread. You may also find that your questions have been answered already while reading through the discussions on those threads. If you still have a specific question about that concept, you can post in that thread.

Thank you,

Nicole

 

[David Harper CFA FRM]

Hi @chiaaugu I just wanted to quickly reply to 4 and 5

• The Hull cost of carry example is not well explained. The difference is just rounding. It is supposed to refer to a forward contract here the interest rate is 7.0% per annum but the yield is 5.0% such that 0.645303 = 0.620*exp[(0.070-0.050)*2] = 0.620*exp[(0.070/12-0.050/12)*24]. The elegant feature of continuous compounding is illustrated in how we can use the 7.0% per annum rate over 2.0 years, or the 7.0%/12 over 24 months, without any difference.
  
• Contango is when F(2) > F(2) > S(0) but normal contango is when F(2) > E[S(2)] such that normal backwardation is when F(2) < E[S(2)] or generally when the forward price is less than the expected future spot price, F(T) < E[(T)]. Backwardation is an observable comparison between traded prices, but normal backwardation relates to an unobserved expected futures spot price. The theory of normal backwardation is really interesting. Why would F(T) < E[S(T)]? It implies the long futures contract position has an expected future profit of F(T) - E[S(T)], but the short futures contract position has an expected future loss in the same amount. The theory explain that the short position must have a hedging motive, why else settle for negative expected profit? Like insurance, net expected loss would actually be a rationale expectation for a hedger. Because for the hedger, the forward contract trade is part of a portfolio (exposure + hedge). The seemingly irrational trade becomes rational when included in the portfolio. On the other side of the trade would be the rational speculator, who would naturally enter the trade with a positive expected profit.