 Once we know the pricing of triary bonds and forward contracts on triary bonds and the process of futures and forward contracts and the hedging process. Then we can easily understand the process of hedging in interest rates future. Now let understand this process using a short hedge in interest rate futures. We have an example of a mortgage banker known as Ron. On March 1, Ron has a mortgage loan commitment of $1 million at par on May 1 for a terms of 20 years at 12% annual rate of interest. In fact, Ron is buying forward on mortgage. This means that he is agreeing on March 1 to lend $1 million on May 1 in exchange for receipt of principal and interest payment every month for a total period of 20 years. Now this loan is sold to an insurance company named as Aceman. The Aceman in fact will be actually paying the funds to the borrowers. This means that now it is the Aceman that is lending money to the home borrowers and Aceman will be getting principal and interest payments on this lending for the next 20 years. We can say that Ron has sold mortgages to Aceman on April 15. So in this case, how we can determine the price that Aceman is required to pay to Ron who is the mortgage banker. Now we see that if on the payment date the rate of interest goes above 12% the Aceman will buying this mortgage at a discounted price. And if on that particular date the rate of interest falls down below 12% the Aceman will be buying this mortgage package at a premium price. So we assume that there is inability of Ron to forecast interest rate movements in the days to come. Now let's see that on April 15 what will happen if the interest rate is varying and we have two types of interest rate situation. One is above 12% and the other is below 12%. So in case of above 12% the mortgage loan payment buy the Aceman will be below 100 million dollars. In case of 12% Aceman will be paying over 1 million dollars. So the sale price will be below 1 million if the interest rate is above 12% and it will be greater than 1% if the interest rate is below 12%. The effect on mortgage banker is that in case of rising the interest rate there will be loss to the mortgage banker or to the loan as he must pay the full amount of 1 million dollars and in case the interest falls below 12% there will be gain to the mortgage banker or to the loan as he will also he will again paying a maximum of 1 million dollars. So if we determine the gain or loss in these two situations in case the rate is 12% beyond then there will be loss of 60,000 dollars to the mortgage banker and in case the interest rate goes below 12% there will be again of 50,000 dollars to the mortgage banker then the question arises that what Ron get out of this loan to offset his risk bearing if Ron is going to take a risk then what is his interest are benefit in this risk game. The benefit to him that he will be receiving two types of fees from the Aceman. The first type is the origination fee from the Aceman on April 1 and that is let's say 1% of the loan so he will be receiving 10,000 dollars as a origination fee. The second is the collection fee as the Ron will be working as a collecting agent for the Aceman so he will be collecting an amount of a certain percentage on the outstanding balance each month so although Ron is earning certain amount of fees for bearing the interest rate risk still there is a loss or an unknown gain for him like if the interest rate rises after one after May 1 he will be the loser and interest rate falls after May 1 he will be the gainer he will be in profit so Rose can hedge this interest rate positions in a way that he can write tri-reborn future contracts on March 1 and if Rose goes for writing this future contract then what will be the effect of this hedging on the rose earning. Let's see if the interest rate goes higher then to tri-reborn future contracts value will go down this means that he will gain on the contract with the falling value this means that further with the rising interest rates his loss on the loan is offset by a gain in the future markets and in second situation if the interest rate falls down then the tri-reborn forward future contracts value will go high this means that the rose will gain on the contract with the falling value and this means that with falling interest rates his profit on the loans is offset by the loss in the futures market now we have two comparative markets the first is the cash market and the second is the futures market cash market because Ron transacted off its mortgage market deal in the futures market in an exchange he if in fact is entering into forward contract on March 1 and simultaneously he is writing ten tri-reborns of hundred thousand dollars each in a total of one million and that is equal to the whole value of the mortgage loan the rose in effect is a preferring to may write made tri-reborn forward contracts and we see that the tri-re delivery of these tri-reborns on forward future contracts during same month the loan is funded to the barbersome as there is no made tri-reborns so the Ron achieves the closest month and that is a June so he is contact he has a contract in the June this means that if held to maturity the June contract would obligate Ron to deliver tri-reborn in June so the loans sale in cash market ends interest rate risk that is determinated in future markets at the same time in this way Ron nets out his position in the futures market while selling its mortgage loans to the asme has Ron eliminated his risk totally we can see that his risk has not eliminated in total because to eliminate risk in total is possible if losses in the cash markets were exactly offset by gains in the future markets and vice versa to this risk cannot be eliminated totally in deal with tri-reborns and the mortgage loan because there exist some dissimilarities between these two financial instruments like that there is a dissimilarity on maturity pattern there is a dissimilarity of payment stream for loans the payment stream is at once and for tri-reborns it is periodic and for default risk mortgage has more chances of default risk as compared to that tri-reborns whose default is default risk is much lesser so far as the expected maturity expected maturity is possible in case of mortgage loans whereas it it seems impossible in case of tri-reborns so mortgage and tri-reborns being unidentical instruments there is no identification identically these are these are not identically affected by interest rates movements if we talk about the volatility between the tri-reborns and the mortgage loans we see that bonds are less volatile than mortgage then the rose need to write more than 10 tri-reborns in the forward contract future contracts and if bonds are more volatile then the tri-re then the mortgage rose needs to write lesser than tri-reborns in the future contracts being unidentical financial instruments there is not a perfect correlation between the price movements of the bond prices and the mortgage prices this means that bonds hedging strategy then cannot eliminate the total risk in these financial instruments and finally the hedging strategy cone is adopting in this case is the short hedge because in a short hedge strategy a cone is selling the future contracts to reduce his risk associated with the mortgage loans