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Answer: The portfolio is likely to be over-hedged
A duration-based hedge assumes that yield changes move in a similar way across maturities. If the **3-year rate is more volatile** than the **9-year rate**, then the futures contract will tend to move more than the portfolio’s underlying interest-rate exposure. That means the hedge sized only by duration is likely to be **too large** relative to the portfolio’s true risk. So the portfolio is likely to be **over-hedged**. ### Why this matters Duration alone does not capture: - differences in volatility across maturities, - non-parallel shifts in the yield curve, - basis risk between the portfolio and the futures-hedged instrument. So the correct answer is **A. The portfolio is likely to be over-hedged**.
Author: Manit Arora
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Q-173.4. If a bond portfolio with a duration of 9.0 years is hedged with futures contracts in which the underlying asset has a duration of only 3.0 years, but the volatility of the 3-year interest rate is greater than the volatility of the 9-year interest rate, what is the likely impact on a duration-based hedge?
A
The portfolio is likely to be over-hedged
B
The portfolio is likely to be under-hedged
C
The portfolio will be correctly hedged because volatility does not enter into the duration hedge
D
The portfolio will be correctly hedged because more hedge contracts (~3X) will simply equate the value (dollar) durations of the portfolio and the hedging instruments
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