Answer: Short 38 of Bond A and buy 56 of Bond B

## Explanation To hedge the portfolio's interest rate risk, we need to set up a system of equations that will eliminate the portfolio's Key Rate 01 (KR01) exposures to both the 2-year and 5-year spot rates. ### Given Information: - Portfolio 2-year KR01: +1,600 INR (portfolio decreases by INR 1,600 when 2-year rate increases) - Portfolio 5-year KR01: -3,450 INR (portfolio increases by INR 3,450 when 5-year rate increases) - Bond A: 2-year KR01 = 48, 5-year KR01 = 5 - Bond B: 2-year KR01 = 4, 5-year KR01 = 65 ### Hedging Equations: We need to find positions A and B such that: For 2-year rate exposure: ``` 1,600 + 48A + 4B = 0 ``` For 5-year rate exposure: ``` -3,450 + 5A + 65B = 0 ``` ### Solving the System: From the first equation: ``` 48A + 4B = -1,600 12A + B = -400 (dividing by 4) B = -400 - 12A ``` Substitute into the second equation: ``` -3,450 + 5A + 65(-400 - 12A) = 0 -3,450 + 5A - 26,000 - 780A = 0 -29,450 - 775A = 0 775A = -29,450 A = -38 ``` Now solve for B: ``` B = -400 - 12(-38) B = -400 + 456 B = 56 ``` ### Interpretation: - A = -38 means we need to **short** 38 units of Bond A - B = 56 means we need to **buy** 56 units of Bond B Therefore, the correct hedging strategy is to **short 38 of Bond A and buy 56 of Bond B**, which corresponds to option C.

Author: LeetQuiz .