Assume that you own 10,000 semi-annual pay $100 par value bonds with a coupon rate of 7%, a YTM of 5%, and a maturity of 10 years. Assume that you are concerned about rates rising in the future and you want to protect (hedge) the value of your portfolio from this situation. For your hedging bond, you choose a semi-annual pay 10-year maturity, 10% coupon bond with the same credit quality as your long position.

a. State your balance sheet at the moment you do the hedge. Round the bond prices to the nearest dollar, and round the number of bonds used for the hedge to the nearest bond. Also assume that when you short-sell a bond you do not earn interest on the cash that the short sale generates.

b. Assume that YTMs on these bonds rises to 6% in two weeks. Restate your balance sheet, by actually repricing the bonds, assuming that no coupons were paid during the 2-week period. Also ignore the fact that the maturity of your bonds has changed by 2 weeks -- assume that the maturity is still 10 years, for simplicity.

c. Was your hedge successful? Why or why not?