Simon manages a large bond portfolio and wishes to hedge against interest rate risk. His portfolio includes Government of Canada bonds and high-grade Canadian corporate bonds.
The correlation between the returns on his fund and the Government of Canada 6-percent
10-year bond is 1.00.
a. Describe how Simon can hedge against changes in interest rates.
b. Your analysis has just shown that the actual correlation between the returns on Simon’s portfolio and the 6-percent 10-year Government of Canada bond is only .65. What are the implications for the hedge described in part (a)?
c. Simon strongly believes that interest rates will fall in the near future. Describe how he can speculate on that belief. What risks are inherent in that position (i.e., what happens if interest rates rise?)