CFAI EOC Question 3 under Fixed Income Part II- Four different consultant’s opinions are given - IR expected to rise, IR expected to decrease, no opinion, IR expected to be flat. Four stratgegies are given- sell covered call, do nothing, sell IR futures, buy put. The question asks which consultants with given opinions would choose which strategy.
Answer- 1) IR expected to be flat, choose selling covered call 2) IR expected to rise- buy put, 3) IR expected to fall- do nothing, 4) no opinion- sell IR futures.
I don’t understand the fourth one- no opinion- sell IR futures. Why would one sell futures when there is no opinon about IR. Also, my understanding is that when IR is expected to increase, you should reduce the duration and hence sell futures. Should we map ‘IR expected to increase’ to ‘sell IR futures’ ?
Okay. Just naming EOC Q3 without the section I am too lazy to find the question. From my understanding however, it seems like you have a bond and your given choices of what you do to hedge for the bond. IR rise bond value falls sell put to hedge. IR decrease bond value rise you do nothing to hedge. IR flat, no change in prices, so your enhancing return by selling a call. Finally your question no Opinion for IR, so what we want is to sell the future in order to lock in the price of the bond cause we aren’t sure of what’s going to happen. I don’t really feel like there is anything to do with duration this question. Just optimal strategy to hedge (that’s why the covered call was weird cause that’s an return enhancement thing…).
Sorry that I didn’t mention the section. I have edited the question now.
Thanks for you reply. I was wondering since it is implied that we have to reduce duration in expectation of the increase in interst rates, shouldn’t we sell futures?
Well if you read the answer (should add Book 4 as well btw). The reason the no opinion person want to sell futures is because it’s an immunization strategy. If you sell a future which reduces your position duration of your bond portfolio to 0, then your immunization from interest rate changes (you basically don’t care/no opinion about interest). Think about it in another sense. In an ALM portfolio, in order to reduce risk (since you aren’t sure about future interest rates) you try to have asset that mimicks liability to eliminate risk. The quetion states that there are 4 analyst’s strategy (sell future, buy put, sell covered call and do nothing) and you have to match it with the analyst’s expectation (raise, fall, flat, no opinion/uncertain). The answer can be solve using a process of elimination. If your going to do nothing, the possible choice out of the 4 choices is because you think interest rate to fall. The reason for covered call is because you think it’s going to be flat and you want the extra income. Now which one would use a put and which one would sell a futures. If you expect interest rate to raise, you could buy a put with a strike price extremely high. You could earn increasing profit up until delta = -1. You have to pay for a put, so it reduces your return, but if your certain that interest rate will raise, that would yield the highest profit. All that’s left is selling futures because you have no opinion. You want to play it safe because you don’t know wtf is going to happen in the future, so you lock in the price.