Mr. Devine is a fixed-income portfolio manager. He forecast a cash outflow of $10 million in June and plans to sell his baseline bond portfolio. The fund currently is worth $10 million, has an "A" quality rating, duration of 7 years, weighted average maturity of 15 years, annual coupon rate of 10.25%, and YTM of 10.25% (note: the fund is selling at its par value). Suppose Mr. Devine is afraid that long-term interest rates could increase and decides to hedge his June sale by taking a position in June T-bond futures contracts when the June T-bond contract is trading at 80-16, and the T-bond most likely to be delivered on the contract has a YTM of 9.5%, maturity of 15 years, and a duration of 9 years. (1) Using the price-sensitivity model, show how Mr. Devine could hedge his June bond portfolio sale against interest rate risk.
(2) Suppose long-term interest rates increase over the period such that at the June expiration, Mr. Devine’s baseline portfolio (A-rated, 10.25% coupon rate, 15-year maturity, and 7-year duration) is trading at 96 of par, and the price on the expiring June T-bond contract (fT) is 76. Determine Mr. Devine’s revenue from selling his baseline bond portfolio, his profit on the futures contracts, and his total revenue.