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CMA Final · Strategic Financial Management · Interest Rate Derivatives

Rao Mutual Fund holds a bond portfolio of ₹80 crore with a modified duration of 5.4 and fears a rise in interest rates. It decides to hedge using interest rate futures, each contract having a value of ₹1 crore and a modified duration of 4.5. Which hedge uses the duration-based hedge ratio correctly?

The fund should sell 96 futures contracts. The hedge ratio equals portfolio value times duration divided by contract value times duration, which is 432 divided by 4.5. Selling is required because futures prices fall when rates rise, offsetting the portfolio's loss.

  1. ASell 96 futures contractsCorrect
  2. BBuy 96 futures contracts
  3. CSell 80 futures contracts
  4. DSell 67 futures contracts

Explanation

Number of contracts = (Portfolio value × Portfolio duration) / (Futures value × Futures duration) = (80 × 5.4)/(1 × 4.5) = 432/4.5 = 96. Because rising rates would reduce portfolio value, futures must be sold so gains offset losses. Selling 80 ignores the duration ratio, and 67 inverts the duration ratio.

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