Maria VanHusen, CFA, suggests that using forward contracts on fixed income securities can be used to protect the value of the Star Hospital Pension Plan’s bond portfolio against the possibility of rising interest rates. VanHusen prepares the following example to illustrate how such protection would work:
• A 10-year bond with a face value of $1,000 is issued today at par value. The bond pays an annual coupon.
• An investor intends to buy this bond today and sell it in 6 months.
• The 6-month risk-free interest rate today is 5% (annualized).
• A 6-month forward contract on this bond is available, with a forward price of $1,024.70.
• In 6 months, the price of the bond, including accrued interest, is forecast to fall to $978.40 as a result of a rise in interest rates.
a. Should the investor buy or sell the forward contract to protect the value of the bond against rising interest rates during the holding period?
b. Calculate the value of the forward contract for the investor at the maturity of the forward contract if VanHusen’s bond-price forecast turns out to be accurate.
c. Calculate the change in value of the combined portfolio (the underlying bond and the appropriate forward contract position) 6 months after contract initiation.