Case 1: ALM. Hedging interest rate risk
This example constructs a bond portfolio to hedge the portfolio of Sensitivity of Bond Prices to Changes in Interest Rates. It assumes a long position in (holding) the portfolio, and that three other bonds are available for hedging. It chooses weights for these three other bonds in a new portfolio so that the duration and convexity of the new portfolio match those of the original portfolio. Taking a short position in the new portfolio, in an amount equal to the value of the first portfolio, partially hedges against parallel shifts in the yield curve. Recall that portfolio duration or convexity is a weighted average of the durations or convexities of the individual bonds in a portfolio. As in the previous example, this example uses modified duration in years and convexity in years. The hedging problem therefore becomes one of solving a system of linear equations.
