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Consider the following problem: A corporation plans to issue 1 million of 5-year bonds in 3 months. At current yields, the bonds would have a

Consider the following problem:

A corporation plans to issue 1 million of 5-year bonds in 3 months. At current yields, the bonds would have a modified duration of 4 years. The corporation desires to hedge their interest rate exposure with 20-year T-bond futures which have a modified duration of 9 years. Each futures contract has a par value of 100,000 and currently sold at 90,000. The corporation estimates that the yield on 20-year bonds changes by 1 basis points for every 1.5-basis-point move in the yield on 5-year bonds

(i) How can the firm use this T-bond futures contract to hedge the risk surrounding the yield at which it will be able to sell its bonds? [20 marks]

(ii) Suppose that the yield on 20-year bonds actually changes by 1 basis points for every 1-basis-point move in the yield on 5-year bonds. Does the corporation have to review their decision on futures position?What should they do?

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