Suppose we have a zero coupon bond with maturity of 5 years and yield of 2% (in
ID: 2818647 • Letter: S
Question
Suppose we have a zero coupon bond with maturity of 5 years and yield of 2% (in annualized units)
Then, we add another zero coupon bond (Face value $1) maturing in 8 years and yield of 3%
a. Form a duration neutral portfolio and a positive convexity
b. 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
c. Calculate the performance of the portfolio using direct calculation ignoring the interest component
d. Calculate the performance of the portfolio using duration and convexity calculation e. Assume that the 1% move down took place in 3 months. Calculate the interest expense you will pay on a loan in this period f. Given of what you see will you recommend implementing this strategy to your trader?
Explanation / Answer
Answere: option(d)
percentage change in bond price: -duration/1+y*change in y
where y= yied rate
-13/1.02*0.001=-0.1274 or 12.74% decline in bond performance and it is negative convexity.