medium · FRM Part 1 Financial Markets and Products
A Treasury bond portfolio is hedged against a parallel shift in interest rates using bond futures. However, the yield curve undergoes a 'twist' where short-term rates fall and long-term rates rise.
What is the most likely outcome?
- The hedge stays fully effective since duration captures all yield curve movements, parallel or not.
- The hedge will fail to perfectly protect the portfolio because it only accounted for a single, parallel shift in yields.
- The basis converges to zero at once, wiping out any chance of a hedging loss on the position.
- The portfolio gains overall, since falling short rates lift the value of every bond in the book regardless of maturity.
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