Principles of Corporate Finance (Mcgraw-hill/Irwin Series in Finance, Insurance, and Real Estate)
Principles of Corporate Finance (Mcgraw-hill/Irwin Series in Finance, Insurance, and Real Estate)
12th Edition
ISBN: 9781259144387
Author: Richard A Brealey, Stewart C Myers, Franklin Allen
Publisher: McGraw-Hill Education
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Chapter 26, Problem 22PS

a.

Summary Introduction

To compute: The duration of securities when the rate of interest is 8%.

a.

Expert Solution
Check Mark

Explanation of Solution

The formula to calculate duration of securities is as follows:

Duration = ( 1V){[PV(C1)](1) + [PV(C2)](2) + [PV(C3)](3)}

PV=Present value C=Cash flow

The calculation of duration of securities is as follows:

Security A:

V=40(( 1.08 )  {1 [.08(1.08)3]} )=103.08

DurationA=  1103.08 {[( 401.08 )(1)] + [( 401.082 )(2)] + [( 401.083 )(3)]}=1.95 Years.

Security B:

VB=  1201.08=111.11 

DurationB=  1111.11 [( 1201.08 )(1)]=1.00 Year

Security C:

VC= 10(( 1.08 )  { 1[.08(1.08)3] } +  100 1.083)=105.15

DurationC=  1105.15 {[( 101.08 )(1)] + [( 101.082 )(2)] + [(110 1.083 )(3)]}=2.74 Years.

b.

Summary Introduction

To compute: The mixture of B and C will hedge this investment against changes in interest rates.

b.

Expert Solution
Check Mark

Explanation of Solution

The formula to calculate mixture of B and C is as follows:

DurationA= [x(DurationB)] + [(1x)(DurationC)]

The computation is as follows:

1.95 = 1.0x+ [(1x) (2.74)]x=.4555(1x)=.5445

So that the following positions will protect the investment:

Investment B = .4555($10m) = $4.555 million (Short)Investment C = .5445($10m) = $5.445 million (Short)

c.

Summary Introduction

To discuss: The manner in which the person X will hedge.

c.

Expert Solution
Check Mark

Explanation of Solution

DurationB= [x(DurationA)] + [(1x)(DurationC)]1.00 = 1.95x+ [(1x) (2.74)]x=2.1955(1x)=1.1955

So that the succeeding positions will protect the investment.

Investment A = 2.1955($10m) = $21.955 million (Short)Investment C =1.1955($10m) =$11.955 million (Long)

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