2019 Level 2 Mock Exam a_am_Problem 39: The solution states “Long put options hedge against rising interest rates”. I would have thought “Long call options hedge against rising interest rates” because they increase in value with rising interest rates (and rising borrowing costs). Anybody else disagrees w/ the official solution? I picked ‘A’, not ‘B’.
I don’t have access to the mock.
This is true if the instrument is a put option on bonds. When interest rates rise, bond value declines. Put option on bond is exercised when bond price drops below option strike price.
This is true if the instrument is an interest rate call option (or call option on interest rate). When interest rate rises above the strike rate, call option can be exercised.
Thanks fino_abama. The mock exam problem refers to the borrower’s protection against rising rates for a variable rate loan to be taken out 6 months later. Appears to me that long call options (or short puts) are the appropriate hedge, but not long puts as the solution states.
Okay. I got my student to show me the mock exam.
In usual cases you are right but take note that in this case and this question, the instrument is on Eurodollar futures options, and the specifications are different.
For Eurodollar futures, its price is defined as:
Futures Price = 100 - LIBOR3M
For example, if 3-month LIBOR = 4% then the futures price = 100 - 4 = 96
Let’s assume that 3-month LIBOR then increases to 7%, so the Eurodollar futures price would drop to 93 (= 100 - 7).
Conclusion: When interest rates increase, the Eurodollar futures price declines.
So the question is, how do you benefit from the option on Eurodollar futures when the futures price declines?
LONG PUT OPTIONS on EURODOLLAR FUTURES
Hope that clears the doubt.
Thanks very much, got it. It is a derivative on a derivative. The borrowers needs protection against rising rates i.e. against falling Eurodollar futures prices. --> correct option hedge = long put options.
You got it