Caps and Floors

This stuff is so counter intuitive to me. Short a floating rate bond= risk against interest rates decreasing correct?? This risk coulud be hedged by buying a floor? No?

Miller asks Johnson to hedge a hypothetical short position in the floating rate bond in Table 2. Which of the following is the best hedge for this position?

A) Sell an interest rate cap. B) Buy an interest rate floor. C) Buy an interest rate cap.

Your answer: B was incorrect. The correct answer was C) 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.
  • Buying an interest rate floor hedges the risk of decreasing interest rates.

(Study Session 17, LOS 52.a)

No. You’re short the bond: you’re paying the interest. You’re worried that interest rates might rise. You want to buy a cap.


magic sir my query also plz

So how does this fit with the idea that interest rates and value of bonds are negatively related? Short a floating rate bond, to me, means you want the value of the bond to go down. Which would be accomplished by interest rates rising.

I’m obviously mixed up here…

Thanks for your help.

if we buy a CDS we are long or short on a bond ?

We will be happy if bond falls . So that means we are short ?

Floating-rate bonds generally have close to zero (effective) duration; the value doesn’t go up or down much (and, if they’re paying market rates (i.e., without a spread), resets to par at each coupon date).

In essence, we’re short the bond.

Here’s how to look at this.

Miller is short a floating rate bond. The more rates go down, the better off he is: the more rates go up, the more he loses.

To hedge such a postion, he needs an instrument that will do the opposite i.e. the more rates go up, the more he wins. Buying an interest rate cap does that. If rates rise he wins. That’s the hedge he is looking for.