Assignment (measuring exposure to interest rate risk) In financial risk management, duration as a measure of interest rate risk is usually applied to bonds. Still, the slope of the price-yield curve can be determined for any financial asset. However, it has been shown that the simple duration (D) is an inadequate measure of interest risk exposure of an asset or portfolio of assets. While the duration can accurately predict the sensitivity of the price of a financial asset to small changes in yield, it over-predicts or under-predicts changes in the price of financial assets to large variations in yield; this is largely because for large changes in interest rate, the priceyield curve is non-linear, that is, the relationship exhibits what is generally referred to as convexity. While duration measures the slope of the price-yield curve, convexity measures the changes in the slope of the curve. The principal attraction of convexity is that combining it with duration provides a more comprehensive measure of the interest rate risk of an asset or portfolio of assets. The incorporated convexity implies the accuracy of the estimate of interest rate risk, as it has been found to significantly reduce the error associated with using a simple duration model alone. As a financial risk consultant in the middle office of your company, you are required to do the following: 1. Select three financial assets of your choice; however, your selection must include one commodity asset, one equity asset, and a bond asset. Justify your asset selection (10 marks) 2. Estimate the duration and the convexity of the price-yield curve of the chosen financial assets using the following equation. Rt=0+1(rt)+2(rt)2+jXt+jXt1+et Where Rt is the rate of change in the price of the financial asset, rt is the change in the interest rate, and Xt is a vector of control variables while j and j are vectors of parameters. - In estimating equation (1) for each financial asset, choose the estimation technique, the sample period, and the control variables (35 marks). - Correct for serial correlation (20 marks) 3. Discuss the implications of your results for the hedging of interest rate risk. Do this for each financial asset (35 marks)