Hedging with Forward Contracts - A naive hedge is a hedge of a cash asset on a direct dollar-for-dollar basis with a forward or futures contract - Managers can predict a capital loss, or change in bond portfolio values (P) from duration equation: PP=D1+RRwherePPDR1=Capitallossonportfolio=Initialvalueofportfolio=Durationoftheportfolio=Changeinforecastyield+R=1plusthecurrentyield - Hedging allows Fls to immunize assets against interest rate risk Practice Problem - Hedging with Forward Contracts - Suppose a financial institution holds a \$1 million face value portfolio of 30-year government bonds on the balance sheet. - At time 0 , the market values these bonds at $95 per $100 of face value, or $950,000 in total. - Assume that the financial institution receives a forecast that interest rates are expected to rise by 1% from the current level of 4% to 5% over the next three months. - If the 30-year maturity bond portfolio has a duration of 12 years, how could the financial institution use forward contracts to hedge the interest rate risk