Bond A is a 4-year bond with a 10% coupon rate and Bond B is a 2-year

bond with a 20% coupon rate. Both bonds have a face value of 100,

and all coupons are paid annually, starting in year 1. Consider a portfolio

that consists of one unit of Bond A and one unit of Bond B. The yield

curve is flat at = 5%.

a) What is the Macaulay duration of this portfolio?

b) Compute the approximate percentage change in the value of the

portfolio if the interest rate increases by 200 basis points.

c) Suppose a pension fund holds this portfolio and is worried about

fluctuations in its price. Explain how the fund can hedge its interest

rate risk using 3-year zero-coupon bonds with a face value of 100.