CFA Q3 says, if a pension fund has no clear opinion about the interest rates, selling interest rate future would be a good strategy and if the fund manager believes the interest rates are headed upwards then buying puts is a good strategy. However i think buying put should be a good strategy when one has no clear opinion about the interest rates diretion becuase with that he would not only be able to hedge the interest rates risk but also participates in the gain when when interest rates go down and let the option expires. Please explain if you understood the reason, its Q3 of Part II in CFA. Thanks
Why would you invest in something when you are not sure of the outcome? You are paying a premium for the option.
I did not write the whole question, it has response from 4 consultants based on their believes. And it ask you to match which response relates to which believes. Please read Q3 on Page 148 Book 4.
I agree with CFA on these points. Futures will amplify the duration effect of your bet , which is the fixed income market will exhibit no marked volatility and you will collect the general effects of the fixed income market with bigger leverage. If the belief is that the markets will be volatile , buying puts is a good idea , as their value will increase with volatility at the same time giving you insurance for you main bond portfolio
idreesz is right. buying puts you pay a premium. if you have no opinion, why lock yourself into paying when you very well may be better off unhedged if interest rates move down? selling the futures is the sure bet- you lock yourself in. think of, i dunno, an airline trying to hedge out gas prices. maybe they don’t want to speculate, they just want to know their costs. lock it in.
janakisri Wrote: ------------------------------------------------------- > I agree with CFA on these points. Futures will > amplify the duration effect of your bet , which is > the fixed income market will exhibit no marked > volatility and you will collect the general > effects of the fixed income market with bigger > leverage. > > If the belief is that the markets will be volatile > , buying puts is a good idea , as their value will > increase with volatility at the same time giving > you insurance for you main bond portfolio I think you have not read the questions from the book, he is short on the future therefore leverage effect is lower and not higher as duration will decrease. Please read. Here is the complete questions to better clarify: The trustees of a pension fund would like to examine the issue of protecting the bonds in the fund’s portfolio against an increase in interest rates using options and futures. Before discussing this with their external bond fund manager, they decide to ask four consultants about their recommendations as to what should be done at this time. It turns out that each of them has a different recommendation. Consultant A suggests selling covered calls, Consultant B suggests doing nothing at all, Consultant C suggests selling interest rate futures, and Consultant D suggests buying puts. The reason for their different recommendations is that although all consultants understand the pension fund’s objective of minimizing risk, they differ with one another in regards to their outlook on future interest rates. One of the consultants believes interest rates are headed downward, one has no opinion, one believes that the interest rates would not change much in either direction, and one believes that the interest rates are headed upward. Based on the consultants’ recommendations, could you identify the outlook of each consultant? CFA Answer is : “Covered call writing is a good strategy if the rates are not going to change much from their present level. The sale of the calls brings in premium income that provides partial protection in case rates increase. The additional income from writing calls can be used to offset declining prices. If rates fall, portfolio appreciation is limited because the short call position is a liability for the seller, and this liability increases as rates go down. Consequently, there is limited upside potential for the covered call writer. Overall, this drawback does not have negative consequences if rates do not change because the added income from the sale of calls would be obtained without sacrificing any gains. Thus, Consultant A, who suggested selling covered calls, probably believes that the interest rates would not change much in either direction. Doing nothing would be a good strategy for a bondholder if he believes that rates are going down. The bondholder could simply gain from the increasing bond prices. Thus, Consultant B, who suggested doing nothing, likely believes that the interest rates would go down. If one has no clear opinion about the interest rate outlook but would like to avoid risk, selling interest rate futures would be a good strategy. If interest rates were to increase, the loss in value of bonds would be offset by the gains from futures. Thus, Consultant C, who suggested selling interest rate futures, is likely the one who has no opinion. Paying the premium for buying the puts would not be a bad idea if a bondholder believes that interest rates are going to increase. Thus, Consultant D is likely the one who believes that the interest rates are headed upward.” However i think buying put should be a good strategy when one has no clear opinion about the interest rates diretion becuase with that he would not only be able to hedge the interest rates risk but also participates in the gain when when interest rates go down and let the option expires.
if you BUY the put, you do let the option expire worthless if interest rates go down, but you have paid $$ for said option, so you would’ve made more money unhedged not buying the put. this is why if you have no clue up or down, you’d prefer just sell the future and be done with it. lock it up, sure thing.
janarski/bannisja are correct …start from here …if u believe interest rates are going down what is the optimal strategy? well long a put isnt relevant here because u r paying a premium on a strat that goes agaisnt your forecast…the strat that you employ should match your forecast… the way ur looking at it is in case your forecast is wrong then the puts will payoff but this isnt the theme of the question
If he is sure that the interest rates are going up then why not sell the future, he won’t be loosing because he has no expectation of rates to go down. But if sells the future when he has no direction which way the interest rates would go, though he is hedging its risk when rates go up but he will not be able to take advantage of any gain when interest rates go down because he locked in. Does it make sense?