Question
Hedging a 3-year foreign currency bond Rebecca Shapiro is the PM at Mercer Street Advisors, USA. On May 15, 2020 she buys a 3- year
Hedging a 3-year foreign currency bond
Rebecca Shapiro is the PM at Mercer Street Advisors, USA. On May 15, 2020 she buys a 3- year UK Treasury bond at par (1,000,000 GBP) with a 5% coupon that is paid annually. The bond matures on May 15, 2023. This seems like a good investment decision because Rebecca forecasts that the 2-year UK interest rate will fall to 4% in one year.
Assume that these currency rates were available to Rebecca:
Spot (5/15/2020) = 1.30 USD/GBP
1-year Forward (5/15/2020) = 1.32 USD/GBP
Spot (5/15/2021) = 1.28 USD/GBP
a. If her interest rate forecast is correct, what will the value of Rebecca's UK bond be in 1 year on May 15, 2021?
b. Assume that Rebecca has 100% confidence in her interest rate forecast. What should Rebecca do to fully (completely) hedge the USD value of her entire GBP position for the next value date on May 15, 2021? Include a number (numerical answer), the name of a currency, words like buy/sell or long/short, and a maturity. Be specific in your answer.
c. Now assume that Rebecca's interest rate forecast was wrong, and that the 2-year GBP interest rate remains unchanged at 5%. What will the USD value of Rebecca's entire GBP position be in 1 year on May 15, 2021?
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