Question: It is August 2 and a fund manager with $20 million invested in government bonds is concerned that interest rates are expected to be highly

It is August 2 and a fund manager with $20 million invested in government bonds is concerned that interest rates are expected to be highly volatile over the next 3 months. The fund manager decided to use the December T-bond futures contract to hedge the value of the portfolios. The current futures price is 94-04. Each contract is for the delivery of $100,000 face value of bonds. Suppose that the duration of the bond portfolio in 3 months will be 7.40 years. The cheapest-to-deliver bond in the T-bond contract is expected to be a 20-year 8% per annum coupon bond. The yield on this bond is currently 6%, and the duration will be 8.20 years at maturity of the futures contract. Discuss how the fund manager would hedge and show how he can avoid the interest rate risk.

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