Maturity T Yield r2 (0, T)

0.50 6.49%

1.00 6.71%

1.5 6.84%

2 6.88%

• Portfolio A – 40% invested in 1.5-year zero coupon bond – 60% invested in 1.5-year coupon bond paying 9% annually

• Portfolio B – 50% invested in 2-year zero coupon bond – 50% invested in 1.5-year floating rate bond with zero spread and annual payments.

Suppose the investor has chosen portfolio A in Q2 above, but the investor is still worried about the losses that the portfolio may suffer from an upward shift in the term structure of interest rates.

(a) Consider duration hedging using 1-year zero coupon bonds. Find the dollar position.

(b) Consider duration+convexity hedging using both 1-year and 5-year zero coupon bonds. Find the dollar position on each bond.