Miller asks Johnson to hedge a hypothetical short position in the floating rate bond… Which of the following is the best hedge for this position? A) Buy an interest rate floor. B) Buy an interest rate cap. C) Sell an interest rate cap. D) Sell an interest rate floor. T/G
Short bond means he is paying floating. Buy an interest rate cape to limit how much he will have to pay when rates increase. The short benefits from a rate decrease.
B?
B.
Niblita exactly my thought. you need to limit the upside risk if you pay floating then you buy a cap limit the risk at the cap rate
The correct answer was B) Buy an interest rate cap. An interest rate cap provides a positive payoff when interest rates are above the cap strike rate. Therefore, the buyer of this instrument is able to hedge himself against rising interest rates. Incorrect answer explanations: * Selling an interest rate cap is not a hedge against rising interest rates. * Selling an interest rate floor does not hedge the risk of increasing interest rates. It will only generate an option premium that the seller is able to keep if the option is not exercised. * Buying an interest rate floor hedges the risk of decreasing interest rates. T/G
I’m going bananas here with the language … when I read the question I thought that he had shorted the bond meaning that for him rising rates would be perfect as the bonds’ value would decline meaning that he would not need to pay as much to purchase the bond in due time… so I thought that he’d be worried about rates that would fall too low…