A European asset manager is concerned about the possible imminent withdrawal of Central Bank support for asset prices which might result in higher yields on bonds and lower on stock markets during the next 3 months. Consequently, they wish to fully hedge their portfolio against all risks. However, they are mandated to remain fully invested at all times so selling securities is not an option. 

Current data for pricing and obtaining rates can be found at www.ft.com under data archive.  

1. The asset manager wants to fully hedge the interest rate risk on the bonds by using bond futures and to hedge the equity risk by using index futures. Calculate the appropriate number of bond and equity futures that should be sold. You may assume that the portfolio of German equities has a beta of one to the German DAX index (bond and index future data can be found at www.eurexchange.com ). (20 marks)
2. Explain the risks of the interest rate swap position and should it be hedged in this scenario? What impact might it have on the rest of the portfolio? (20 marks)
3. The asset manager would like to hedge the receipt of $50,000,000 to be received in one years' time from the maturity of the one year interbank deposit. Using current data from www.ft.com, calculate a one year €/$ forward rate and explain how it could be used to hedge the currency risk. (20 marks)
4. The asset manager thinks that there is some possibly that the currency markets could move in their favour and so ideally would like some degree of participation in any favourable move, whilst being fully protected against adverse moves. Discuss alternative hedging choices by using options. Currency option quotes on FX futures can be at www.cmegroup.com. (20 marks)
5. The interest rate swap counterparty is the same bank (Bank of America) to whom the asset manager lent $50,000,000 via the USD LIBOR deposit. The asset manager is concerned that a default by the Bank could give rise to substantial credit risk. Discuss how derivatives could be used to hedge this risk. (20 marks)

Introduction

In the assignment, the risk situation is described as due to the central bank activities impact on the portfolio return in next 3 months. This is the task of the asset manager to hedge the possible losses due to risks in all possible ways. In the portfolio, there are four types of assets. To answer the exercise question, it is required to first discuss the types of assets their characteristics and various risk factors that may come into the picture while hedging those assets.

Situation and Impact on asset value- It is given that, due to central bank actions the asset prices are being affected and, this causes a loss in value of the overall portfolio. This is a risky situation, which, the asset manager would like to manage by hedging (responsibility of asset manager). Additional input is that the selling of asset is not allowed, i.e. it is asked to hedge the portfolio maintaining the investment amount.

Answer -1.  

To answer the first question, it is required to focus only on two types of assets. 

1). BTP worth , '€2,000,000' = 2000 bonds worth € 1000 each. 

Risk arising due to having a position in BTP bonds worth, '€2,000,000' (2000) is the interest rate risk. When the central bank acts in such a manner that interest yields on bonds increases and price of bonds fall. In this case, when the price lowers down the asset manager is hit due to the loss in portfolio value. To hedge against this loss in value, an asset manager is likely (suggestible) to buy some bond futures. When due to increase in yield the bond price is decreasing, the bond futures price will go up and hence, the losses due to price fluctuations in the bond will offset by the increase in bond futures value. In this way hedging of interest rate risk in BTP bonds is done. This is the concept behind hedging the interest rate risk of bonds using bond futures. Here in the question, it is asked to find the number of bond futures to be sold to hedge the risk arising due to increase in yield. 

To find out the number of futures to short, I suggest following the following steps.