When changing the proportion of bonds and stock in the portfolio (decreasing equity exposure and increasing bond exposure), we are shorting equity futures to create cash and then using that cash to buy bond futures, right? So why is it that we subtract the effective duration of cash equivalents from the target duration to find out how many bond futures contracts to buy? Why is the cash created from the first transaction considered cash equivalents and not just cash with a duration of 0?
I’ve never seen an example where the beginning (existing) duration on the synthetic cash position is anything other than zero. Do you have an example?
The title of this post!
Target Modified Duration (bond portion): 4.3
Effective Duration (cash equivalents): .25
Implied Modified Duration of Bond Futures: 5.2
In the answer sheet the answer of contracts to hedge the position is (4.3-0.25)/5.2
If I’d had access to the practice exam itself, I wouldn’t have asked. Snippiness doesn’t encourage generosity.
If they give you (explicitly) a number to use, use that number. That’s a good general rule.
If they don’t give you a number (explicitly), use the common number: zero for cash beta or cash duration, one for yield beta, one for beta of equity futures, and so on.