Show as much work as you need to demonstrate your understanding of the material.
1. As an analyst for the prominent Fixed Income Investment management firm Fredericks and Sons, you are asked by the Senior Partner to model the yield curve. He would like you to show the current Zero Coupon Yield Curve as it is now and how it will be in 18 months.
In 18 months he says the short-end of the yield curve will be at least 250 basis points higher, and will taper off as maturities increase. The 250 basis points higher reflects the firm’s opinion that the Fed will start increasing rates during the summer and continue through til the end of next year.
He says he is missing data and would like you to fill-in the data using coupon paying yield curve to extrapolate the zero coupon yield curve. Additionally, he has provided adjustment factors to use to project the yield curve in 18 months.
Please use the following data:
a. Using the technique we learned in class called “Bootstrapping”, and the data provided, determine the yields for the current zero coupon yield curve.
b. Plot the yield curve on a line graph, clearly labeling the yields at the specific maturities.
c. Add the adjustment factors to the yields you have calculated.
d. Using the same graph, plot the expected yield curve as you expect it to be in 18 months.
e. In more than 3 words, and less than a full page, describe how the shape of the yield curve has changed, and interpret what the yield curve is saying.
2. Using the data from the hedging example reviewed in class, change the interest rate scenarios to an increase of 150 basis points and a decrease of 175 basis points. Also change the desired amount of hedging to first 100 percent hedged and then to 25 percent hedged. In other words, you want ΔV to be 0% and 75%.
Therefore you need to calculate hedging for two interest rate scenarios at two different target hedges or a total of four (4) scenarios.
a. What were the gains, losses and net for your long, short, and total positions?
b. Were you successful in obtaining the targeted participation?
c. What is the key point to remember when hedging?
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