QUESTION 9

(a) Suppose you own a bond portfolio and that interest rates are forecast to increase.

(i)You decide to protect the value of your portfolio by implementing a hedge that involves short-selling.Carefully explain what steps are needed to implement this short-selling hedge.

(ii) Carefully explain what happens to the value of your bond portfolio (after taking into account any short-selling transactions) if interest rates increase.

(iii) Carefully explain what happens to the value of your bond portfolio (after taking into account any short-selling transactions) if interest rates subsequently decrease.

(b)You are working at a fixed income hedge fund and your manager says to you that they believe interest rates will increase.They suggest that an appropriate strategy is to increase the convexity of your portfolio.Carefully explain whether you agree or disagree with this statement.