assuming it is now august 2008, with the recent ANSWER ALL QUESTIONS QUESTION 1

Question

assuming it is now august 2008, with the recent

ANSWER ALL QUESTIONS QUESTION 1 a) Assuming it is now August 2008, with the recent increase in fuel prices, fund managers are concerned about a rise in interest rates between now and when the as are issued in the coming weeks. Current interest rate is at 4.5% pa. and the s September futures contract is 103.15. Inovest Trust Fund plans to switch RM10000000 MGS from the old S-year MGS to a new 5-year MGS with higher interest rates. i) What should the company do in order to avoid selling its existing bond at a lower price? (3 marks) i) What happens to the price of the bond if interest rate does go up? (2 marks) iii) If in September 2008, the interest rate has risen to 5% pa. and the September FMG5 is priced at 102.95, show the effect of your hedging strategy. (10 marks)

Explanation / Answer

a) The company in order to avoid selling its bond at lower price should enter into futures contract at 103.15 to hedge itself.

b)If the interest rate goes up the price of the bond tends to fall due to inverse relation between bond price and its interest rate and the same is not linear but is convex to the origin.

c)If the interest rate rises to 5% and the price is 102.95 then it is a profitable situation as the company has hedged itself of selling at 103.15.

Profit = (103.15-102.95)=0.20 per unit.

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