Table 2 Interest Rate Instruments Dollar Amount of Floating Rate Bond $42,000,000 Floating Rate Bond paying LIBOR + 0.25% Time to Maturity (years) 8 Cap Strike Rate 7.00% Floor Strike Rate 6.00% Interest Payments quarterly Bower shorts the floating rate bond given in Table 2. Which of the following will best reduce Bower’s interest rate risk? A) Shorting Eurodollar futures. B) Buying an interest rate floor. C) Shorting an interest rate floor. Your answer: B was incorrect. The correct answer was A) Shorting Eurodollar futures. If he adds a short position in Eurodollar futures to the existing liability in the correct amount, he is able to lock in a specific interest rate. A short Eurodollar position will increase in value if interest rates rise because the contract is quoted as a discount instrument so increases in rates reduce the futures price. (Study Session 17, LOS 62.a) My reasoning was Here is Shorting a bond, that means interest rates rises, he likes it. If interest rates fall, he will be losing. Shouldn’t he buy a interest rate floor then?
I think B is still correct but the question asks which option will BEST reduce their i risk. Shorting Eurodollar futures would probably better hedge his position that the interest rate floor. With the floor he will lose money until rates hit the 6.00% floor.
Thanks…this makes sense
he issued a floater , his risk is rates up no floor will help here only the future
Ok. Since he sold a floating rate bond. His risk is going rates up. How is this equivalent to Short Euro Dollar?
Im gonna guess: being long eurodollar futures is a right to lend at X. thus being short would be right to borrow at X. Since you are borrowing when you issue a note, and want to hedge against increasing interest rates, short the futures. Am I right?
^^long eurodollar future=right to BORROW at X not lend. Am I right?
It is kind of counter-intuitive, going long a Eurodollar future gives you the right to lend USD at X and going short allows you to borrow USD at X. So as interest rates rise (eurodollars are based on libor) the short makes money and offsets the money you lose on having to pay more interest on the floating rate bond.
bhans2 Wrote: ------------------------------------------------------- > It is kind of counter-intuitive, going long a > Eurodollar future gives you the right to lend USD > at X and going short allows you to borrow USD at > X. So as interest rates rise (eurodollars are > based on libor) the short makes money and offsets > the money you lose on having to pay more interest > on the floating rate bond. Good explanation. Thanks