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Suppose you are a strategist for a hedge fund. Your research indicates that the quality spread for BBB bonds and AAA bonds is 150 basis

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Suppose you are a strategist for a hedge fund. Your research indicates that the quality spread for BBB bonds and AAA bonds is 150 basis points in periods of economic slowdown and only 100 BP in periods of economic expansion. Currently, the economy is in a recession, and annual compounding zero coupon bonds for AAA and BBB bonds are trading at 6% and 7.5%. Both bonds are two year ZERO COUPON bonds. Leading economic indicators, though, strongly point to the economy hitting its trough relatively soon and then expanding over the next year. Given the economic growth forecast, construct a quality spread (zero cost portfolio, i.e. 1 unit of long bond, and X units of short bond) for your hedge fund formed by going short in one of the bonds with the proceeds used to purchase the other. Assume perfect divisibility. Show what your hedge fund's profit or loss could be if you closed you position a year later and the economy were graving and yields on AAA bond had increased to 7% and he quality yield spread narrowed to 100 BP as you predicted. Assume afloat yield curve. Suppose you are a strategist for a hedge fund. Your research indicates that the quality spread for BBB bonds and AAA bonds is 150 basis points in periods of economic slowdown and only 100 BP in periods of economic expansion. Currently, the economy is in a recession, and annual compounding zero coupon bonds for AAA and BBB bonds are trading at 6% and 7.5%. Both bonds are two year ZERO COUPON bonds. Leading economic indicators, though, strongly point to the economy hitting its trough relatively soon and then expanding over the next year. Given the economic growth forecast, construct a quality spread (zero cost portfolio, i.e. 1 unit of long bond, and X units of short bond) for your hedge fund formed by going short in one of the bonds with the proceeds used to purchase the other. Assume perfect divisibility. Show what your hedge fund's profit or loss could be if you closed you position a year later and the economy were graving and yields on AAA bond had increased to 7% and he quality yield spread narrowed to 100 BP as you predicted. Assume afloat yield curve

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