Given a zero coupon bond maturing in 8 years and yield of 3% Form a duration neu

Question

Given a zero coupon bond maturing in 8 years and yield of 3%

Form a duration neutral portfolio and a positive convexity

Suppose you pay an interest of 3% on any short or loan you’re taking. Assume the yield of the bond moves by 1% down in parallel

Calculate the performance of the portfolio using direct calculation ignoring the interest component

Calculate the performance of the portfolio using duration and convexity calculation

Assume that the 1% move down took place in 3 months. Calculate the interest expense you will pay on a loan in this period

Given of what you see will you recommend implementing this strategy to your trader?

Explanation / Answer

There is a inverse relation between a bond price and interest rates. When one goes up, the other goes down.

Duration Neutral Portfolio: A portfolio is duration neutral when it does not shows the direction or timing of change in interest rate.

Positive Convexity: If the duration of a bond rises and yield decreases, the bond is known to have a positive convexity. If a bond has positive convexity, it will experience an increase in price if yield falls, in relation to decrease in price if yield rises. A Zero coupon bond has the highest degree of convexity since they do not offer any coupon payments.

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