50% AND EARN A RATE OF RETURN OF 5% PER YEAR ON THE INVESTED FUNDS....

1.50% and earn a rate of return of 5% per year on the invested funds.

Austin tells Houston that he is concerned about the potential for rates to rise and

wants to explore how the fund's duration can be changed using the futures market.

The fund currently has duration of 5, and he would like to eliminate all interest rate

risk. Houston uses the data in Exhibit 1 for her analysis.

Austin is intrigued by the incremental yield he could earn by buying an Italian

sovereign bond. A dealer provides a quote at a spread of 350 basis points over U.S.

Treasuries for a 5% coupon, 10-year maturity Italian Buoni Del Tesoro Poliennali

(BTP) bond with duration of 6.75. He asks Houston to assess how much this bond

spread could widen over the six-month period he intends to hold the bond before the

yield advantage relative to Treasuries would be eliminated.

Austin asks Houston whether the euro-denominated bonds they buy should be hedged

back to the U.S. dollar, the fund's domestic currency. Houston responds that they

should hedge back to the U.S. dollar because short-term interest rates are 2.50% in the

eurozone and 0.25% in the U.S. and her forecast shows that she expects the euro to

depreciate by 1.75% relative to the U.S. dollar.

There are U.S.-denominated and euro-denominated bonds in the fund; therefore,

Austin wonders whether the fund's duration is still simply an average of the durations

of each bond. Houston comments, "International interest rates are not perfectly

correlated. Currently, the fund has 80% of the portfolio in U.S. issuers with average

duration of 5.5 and the remainder in German issuers with average duration of 3.5.

Historically, the country beta of Germany - i.e., for German rates relative to U.S. rates

- is estimated to be 0.62."

Finally, Austin tells Houston that his models are showing mortgage securities as

having the most attractive spread relative to other fixed-income sectors. He believes

there are certain risks associated with mortgages and would like to hedge them. He

asks Houston to identify the risks and possible ways to hedge them. Houston replies

with the following statements:

Statement 1: Option-adjusted spread (OAS) is the risk premium for holding

mortgage securities; therefore, you don't want to hedge this spread risk.

If you do hedge against the spread widening, you'll also give up the

benefit from the spread narrowing. If you believe yield spreads are

wide, try to capture the OAS over time by increasing the allocation to

mortgage securities.

Statement 2: The durations of mortgage securities change in an undesirable way

when interest rates change. You can effectively manage this negative

convexity by buying options or by hedging dynamically. Hedging

dynamically with futures requires lengthening duration after rates have

declined and shortening it after rates have risen. The cost associated

with dynamically managing negative convexity is forgoing part of the

spread over Treasuries.

Statement 3: You can manage volatility risk by buying options or by hedging

dynamically. When the volatility implied in option prices is higher than

you believe future realized volatility will be, you should hedge by

purchasing options. When you believe future volatility will be higher

than implied volatility, you should hedge dynamically.