The Scenario

A UK based bond Portfolio Manager holds the following (long) positions
Amount	Security Type	Security	Data	
$100,000,000	US Treasury Note	3.25% 31/12/2017	YTM 3.114%	
$50,000,000	Corporate Bond	GSK 4.85% 15/5/14	YTM 2.02% Price 108.30,
Accrued Int. 2.38
MD 2.75 Rating A+	
€25,000,000	Schatz	4% 04/07/2013	YTM 0.89%	

They think there is an elevated risk of extreme volatility in the markets during the next 3 months and wish to fully hedge their portfolio against all risks. However, they are mandated to remain fully invested at all times so selling securities is not an option.

The Portfolio Manager wants to fully hedge the primary risk on the bonds but thinks that there is some possibly that the currency markets could move in their favour and so ideally would like some degree of participation in any favourable move, whilst being fully protected against adverse moves.

They want to minimise the cost of hedging and they report and account in GBP.

DATA

Spot FX Rates

GBP/USD	EUR/USD	GBP/EUR	
1.5115	1.3030	1.1650	

LIBOR

Maturity	GBP	USD	EUR	
1 Month	0.55469	0.28469	0.37938	
3 month	0.67844	0.35313	0.61500	
6 month	0.92844	0.54578	0.91750	
12 month	1.37188	1.04000	1.22188	

FX Option Volatility

Maturity	GBP/USD	GBP/EUR	
1 month	11.00	10.50	
2 month	11.50	10.75	
3 month	11.60	11.00	
9 month	11.80	11.25	
12 month	11.95	11.50	

Bond Futures

CME Group
June 2011 UST Note Future	Price (32nds)	YTM	CF	
	117-13			
CTD	3% 28/2/2018	3.143%	0.8405	

EUREX
June 2011 Schatz Future	Price	YTM	CF	
	109.13			
CTD	1% 16/3/2013	0.79%	0.9185	

Required

2. Decide which hedging instruments are most appropriate and explain why?

Notes
You will be required to calculate the risk characteristics of the Cheapest-to-Deliver (CTD) bonds and the bond futures from the information provided.
You may also wish to price FX options using the volatility data provided and so an Excel based FX Options calculator will be made available to you.
FX forwards can be valued using the data provided.
You may also wish to consider what other risks are present and what could be done about them.