You are in charge of the bond portfolio of STEVENS Investments Inc. and have to buy $100 million of bonds on or after February 7, 2017 and on or before May 7, 2017. You are concerned that interest rate might fall between now (January 26, 2017) and May 7, 2017 and decide to use T-bond futures contract to set up the hedge.
The current May 17 T-bond futures are 95-04. On May 7, 2017 the average duration of the targeted bond portfolio will be 9.0 years. The cheapest to deliver T-bond futures contract expected to be 20 years, 8% coupon bond whose duration is 11.2 years at maturity of the futures contract.
(i) Explain which risk you are exposed to if you do not set up the hedge. Separately consider the scenarios where interest rate rises and declines.
(ii) Demonstrate the size and direction (short or long) of a position in May 17 T-bond futures that would provide a hedge for the underlying bond portfolio.