Your company holds $2 million in cash and $5 million worth of ten-year government bonds at the interest rate of 1.5 percent. This portfolio has been carefully arranged based

Question

Your company holds $2 million in cash and $5 million worth of ten-year government bonds at the interest rate of 1.5 percent. This portfolio has been carefully arranged based on the assumption that the Fed will not raise the interest rates this year. Now, while the financial market participants continue to act on the assumption of no rise in interest rates, you come to believe that the trends in the economy will soon change and the Fed will have to adopt a tighter monetary policy in next couple of months, raising the interest rates on one-year government bonds to 3 percent. Assume that the Fed’s decision will not affect the future prospects of your company’s input or output markets. If your company does not need to use any part of its cash and bond portfolio mentioned above, which one of the following strategies will yield a higher value for the portfolio if indeed the Fed raises the interest rates in the next couple of months?

a.

Keep the portfolio unchanged.

b.

Sell some of the bonds and hold more cash.

c.

Use some of the cash to increase bond holdings.

d.

Sell some of the bonds and reduce cash holdings.

e.

Keep the cash holdings constant and buy more bonds with money from other sources.

 



In the above question, suppose that in addition to its dollar holdings, your company has €1 million worth of one-year German government euro bonds. Which one of the following would be a better strategy regarding the dollar and euro holdings if you come to believe that the US interest rates will rise in the next couple of months, but other market participants continue to assume no change in US monetary policy? Assume that euro interest rates and other policies will not change in this year; and that you are acting on this strategy now (prior to a possible Fed action you are expecting).

a.

Keep the portfolio unchanged.

b.

Sell some of the euro bonds to buy more dollar bonds.

c.

Use part of the dollar cash to increase the euro bond holding.

d.

Sell some of the euro bonds and increase the dollar cash holding.

e.

Sell some of the dollar bonds and use the proceeds to buy more euro bonds.

Answer 1

In the first 10, for simplicity, assume the ten year Bonds are zero coupon. They have a duration of 10. If rates rise to 3% flat across the curve the Bond position will lose. A 10 year zero coupon bond priced to yield costs (1./1.105)¹⁰. = 86.167% of face. so 5mm invested at 1.015% controls a notional face value of

If Yields rose to 3% today. The present value of the bond position falls to 1/(1.03)¹⁰ * 5,802,704.to 4,317,756 for a loss of 682,243. The 7 million dollar portfolio is now a 6,317,756 dollar portfolio dropping almost 10% in value. If this portfolio was constructed to take into account the opportunity cost of liquidity with no potential capital loss (rates won't change) The positive probability of a rate hike the larger the probability of a capital los and the more you need to bee in cash. The stronger your conviction the fewer bonds you want to hold. B is the only good answer

The second piece is interesting. I will assume that they are holding 1 year Euro paper because it has an attractive yield to US paper and they do not expect exchange rate to Change.If That is the case then a Fed tightening will strengthen the dollar and weaken the Euro. 150 basis point would make the move quite severe. This would result in a huge dollar base capital loss. You could either sell the bonds and put into US Cash (not bonds you want to get out of dodge there). An alternative would be to sell Euros 1 year forward to mitigate any exchange rate risk and lock in the interest rate differential. This will effectively turn the foreign bond into a piece of 1 year US paper. You will still be exposed to US rate risk but with much shorter duration.

C is the only good answer here