Have a doubt in the below question
Bond A Bond B Bond C
Par Value $50,000 $60,000 $40,000
Market Value $52,000 $61,000 $40,000
Effective Duration 8.2 6.8 5
Richards wishes to investigate the use of leverage to increase return. Cupp says Richards should consider doubling her position in Bond C to $80,000 using the proceeds from a loan. Richards asks about sources of funds for such a leveraged position. Cupp says Richards could use the proceeds from a 3-month repurchase (repo) agreement, or Richards could sell short zero-coupon bonds with a duration of 3. Richards asks Cupp to estimate the value of the leveraged portfolio in each case after a 25 basis point downward parallel shift in the yield curve.
Q1: Using the repo agreement, what is the effective duration of the equity invested? A) 8.05. B)8.28. C)6.22.
Answer: (A) The repo agreement described has a duration of 0.25. Duration of bond positions = (52/193) × 8.2 + (61/193) × 6.8 + (80/193) × 5 = 6.43 The duration of the equity invested can be found as: D E = (D i I -D B
/E where: D E = duration of equity D i = duration of invested assets D B = duration of borrowed funds I = amount of invested funds B = amount of borrowed funds E = amount of equity invested Using the information provided in the question: D E = [(6.43)(193,000) − (0.25)(
40,000)] / 153,000 = (1,230,990 − 10,000) / 153,000 = 8.05 (Study Session 10, LOS 22.a & b)Doubt here is why did he use duration of 0.25 when the question specifies duration as 3?
Q2) If Richards uses the zero-coupon bonds to leverage her portfolio, what is the change in value of the leveraged portfolio for a 25 basis point change in interest rates? A)$4,300.
Answer: (C) Change in Bond A = $52,000 × 8.2 × 0.0025 = $1,066
Change in Bond B = $61,000 × 6.8 × 0.0025 = $1,037
Change in Bond C = $80,000 × 5 × 0.0025 = $1,000
Change in zero-coupon bond = $40,000 × 3 × 0.0025 = $300
Total change in the portfolio = $1,066 + $1,037 + $1,000 − $300 = $2,803 Doubt: Why should we subtract change from zero coupon bond. Is it because there is leverage here?@Alta12