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Question 1 (16 marks) Assume the face value of bond is $100 and the term...

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Question 1 (16 marks) Assume the face value of bond is $100 and the term structure/yield curve is flat at 5%. Please use annual compounding and annual discounting in your calculations and 3 decimal places in your workings. a) If you had $1 million invested in the 3-year 5% coupon bond, how many of the 4-year zero-coupon bonds would you need to short-sell to hedge your interest rate risk? (8 marks) b) Without doing any calculations, discuss what actions you would need to take with your short position in the zero coupon from part a) to ensure your interest rate risk remains hedged until the maturity of the 3-year coupon paying bond. (4 marks) o Explain how to use duration to protect financial institutions against relatively small parallel shifts in the yield curve? What are the limitations of the duration measure? (4 marks)

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