T-bond hedging

ankuragrawal.nit
Finance Junkie
Posts: 64
Joined: Sun Apr 01, 2012 10:52 am

T-bond hedging

Postby ankuragrawal.nit » Sun Feb 12, 2012 7:57 pm

“When the hedging instrument is a Treasury bond futures contract, the hedger must base DF(Duration of the asset underlying the futures contract at the maturity of the futures contract) on an assumption that one particular bond will be delivered. This means that the hedger must estimate which of the available bonds is likely to be cheapest to deliver at the time the hedge is put in place. If, subsequently, the interest rate environment changes so that it looks as though a different bond will be cheapest to deliver, then the hedge has to be adjusted and its performance may be worse than anticipated”
How can the hedge be adjusted at a later point in time. Isn't it that we are hedging once according to a certain Interest rate scenario, If the scenario changes at a later pt of time what happens to the original hedge?
It would be great if an example can be given with explanation

“When bond yields are in excess of 6%, the conversion factor system tends to favor the delivery of low-coupon long-maturity bonds. When yields are less than 6%, the system tends to favor the delivery of high-coupon short-maturity bonds.”

- John Hull

Why should it favor the delivery of low-coupon long-maturity bonds when bond yields are in excess of 6%?


Thanks!

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ankuragrawal.nit
Finance Junkie
Posts: 64
Joined: Sun Apr 01, 2012 10:52 am

Re: T-bond hedging

Postby ankuragrawal.nit » Wed Feb 15, 2012 10:59 pm

“When bond yields are in excess of 6%, the conversion factor system tends to favor the delivery of low-coupon long-maturity bonds. When yields are less than 6%, the system tends to favor the delivery of high-coupon short-maturity bonds.”

- John Hull

Why should it favor the delivery of low-coupon long-maturity bonds when bond yields are in excess of 6%?


Please help me understand this part

ankuragrawal.nit
Finance Junkie
Posts: 64
Joined: Sun Apr 01, 2012 10:52 am

Re: T-bond hedging

Postby ankuragrawal.nit » Fri Feb 17, 2012 2:06 am

I thought there was some fundamental reason behind it. This spreadsheet clears the concept quantitatively though.
Thnx


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