How come it says that if you are unsure about interest rate movements you would hedge with futures and if you sure if you think interest rates would go down you would buy options. Shouldnt it be the other way around?
no, because you need to remember these in the context of being long the bonds. If rates decrease the value of your bond rises right…but if you have a hedge with futures the decline in the futures offsets your bonds value. so you are neutral. So if you have no opinion on future rate movements you want to hedge away the risk of movements you go short futures and long bonds and then you’ll capture the coupon return while eliminating gains/losses of capital. for options, if you feel rates will rise you’ll want to go long put options and if you feel they’ll fall you’ll want to go long put options and short calls.
I am stuck with that problem as well…I am confused with all the 4 consultant choices. Does anyone have some better explanation for those ?
i think you are wrong. Not knowing implicitly assigns the same probability for rates going up or down, therefore you don’t want to give up upside by buying futures, on the other hand if you assume rates will go down (higher then 50%) probability, there is no reason to pay premium as upside < premium.
ok, so if you assign probabilities you’ll still take a position in futures but say you have $100mln in bonds and you think there is a 40% chance of rates down and 60% chance of rates up, you will take a position in futures that represents this discrepancy that would be less than $100mln, therefore exposing your portfolio to the amount of risk your view of probabilities entails. but since you don’t have an opinion on rates still, just probabilities, you’ll still hedge with futures. BUT if you have an opinion on rates (i.e they are going up or down, but not a probabilistic view) you’ll use options due to their assymetric payoff.
ek, i ment to say rates will go up, so there is no reason to pay premium. Think about it. Lets say you have a stock priced at spot S, lets say you know for 100% sure stock will decline to S1 if you buy put at price P your payoff will be -P, if you short future your payoff will be 0.
i see your point…i just looked up the answer and the CFAI doesn’t explain the option side well. the last case i could make for options that if rates increase, being long a put option will increase in value at least equal to the decrease in price. But you’re right, you’ll still be out the premium. If the volatility increases or the chances of future rate increases rises then being long the option would be better than the future at that point…but not i’m going a little further into the quesiton to build my case. so…i see your point in the context of this quesiton.
yea text doesn’t provide any explanation- that being said- i don’t think they’ll ask us to explain it. …just know which to do…“hedge dynamically” or “purchase options”
cfa, no no, hedging dynamically is different. Hedging dynamically is when implied vol > expected vol, and vice verso for hedging with options. This problem is different
I also think there is mistske in this answer. In SS 17 Currency risk management , both CFA and Schweser say if you don’t have opinion about the market -you buy options -so not to lose upside. If you strongly believe the market will go against you you buy forwards because its cheaper. It should be the same logic here. How we can report errata to CFA?
Personally I think both striker and atpr have good points. I put a star next to this question when I went through it because I felt the answer they gave was valid only in the context. They way I approached it (after I read the answer) was first I figured out which strategy would create +ve value in which int rate scenarios. It turns out each strategy resulted in two +ves except buying puts, which can only work if interest rates go up. By process of elimination, I could identify then which strategy belonged to which int rate opinion. Bottom line, I don’t think it’s an errata. But I just dismissed it as a bad question.
> if you feel rates will rise you’ll > want to go long put options and if you feel > they’ll fall you’ll want to go long put options > and short calls. Actually… if you feel interest rates will fall, you shouldn’t do anything… just stay long the bonds.
Additionally… with respect to have no opinion on rates, what you want to do is protect your position from a move either way. You’re already long bonds so essentially, you’re shorting interest rates. The CFAI book says you should short Interest Rate Future which I disagree with. Increase in Rates = Decrease in Bonds, therefore you need something that will offset this => Buy Interest Rate Future. Decrease in Rates = Increase in Bonds, therefore you need something that will offset this => Sell Interest Rate Future Do I have this right??? Seems right… If you buy an interest rate future, you make money if rates go up don’t you?