Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

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

image text in transcribed
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

Step by Step Solution

There are 3 Steps involved in it

Step: 1

blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image

Step: 3

blur-text-image

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

International Corporate Finance

Authors: Mark R. Eaker, Frank J. Fabozzi, Dwight Grant

1st Edition

0030693063, 9780030693069

More Books

Students also viewed these Finance questions