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# Municipal bond yields which are below t bond yields

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Municipal bond yields, which are below T-bond yields because of their tax-exempt status, are expected to close in on Treasury yields. Because yields and prices are inversely related, this means that municipal bond prices will perform poorly compared to Treasuries. Therefore you should establish a spread position, buying Treasury-bond futures and selling municipal bond futures. The net bet on the general level of interest rates is approximately zero. You have simply made a bet on relative performances in the two sectors. 19. The closing futures price will be: 100 5.20 = 94.80 The initial futures price was 94.9825, so the loss to the long side is 18.25 basis points or: 18.25 basis points × \$25 per basis point = \$456.25 The loss can also be computed as: 0.001825 × ¼ × \$1,000,000 = \$456.25 20. Suppose the yield on your portfolio increases by 1.5 basis points. Then the yield on the T-bond contract is likely to increase by 1 basis point. The loss on your portfolio will be: \$1 million × Δ y × D* = \$1,000,000 × 0.00015 × 4 = \$600 The change in the futures price (per \$100 par value) will be: \$95 × 0.0001 × 9 = \$0.0855 This is a change of \$85.50 on a \$100,000 par value contract. Therefore you should sell: \$600/\$85.50 = 7 contracts 21. She must sell: 8 . 0 \$ 10 8 million 1 \$ = × million of T-bonds 22. If yield changes on the bond and the contracts are each 1 basis point, then the bond value will change by: \$10,000,000 × 0.0001 × 8 = \$8,000 The contract will result in a cash flow of: \$100,000 × 0.0001 × 6 = \$60 Therefore, the firm should sell: 8,000/60 = 133 contracts The firm sells the contracts because you need profits on the contract to offset losses as a bond issuer if interest rates increase. 23-8

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23. F 0 = S 0 (l + r f ) T = 580 × 1.05 = 609 If F 0 = 620, you could earn arbitrage profits as follows: CF Now CF in 1 year Buy gold 580 S T Short futures 0 620 S T Borrow \$580 580 609 Total 0 11 The forward price must be 609 in order for this strategy to yield no profit. 24. If a poor harvest today indicates a worse than average harvest in future years, then the futures prices will rise in response to today’s harvest, although presumably the two-year price will change by less than the one-year price. The same reasoning holds if corn is stored across the harvest. Next year’s price is determined by the available supply at harvest time, which is the actual harvest plus the stored corn. A smaller harvest today means less stored corn for next year which can lead to higher prices. Suppose first that corn is never stored across a harvest, and second that the quality of a harvest is not related to the quality of past harvests. Under these circumstances, there is no link between the current price of corn and the expected future price of corn. The quantity of corn stored will fall to zero before the next harvest, and thus the quantity of corn and the price in one year will depend solely on the quantity of next year’s harvest, which has nothing to do with this year’s harvest. 25.
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Municipal bond yields which are below T bond yields because...

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