Reichmann would like to hedge the interest rate risk of one of his bonds, a floating-rate bond (indexed to L1BOR). O’Shea recommends taking a short position in a Eurodollar futures contract because the Eurodollar contract is a more effective hedging instrument than a Treasurybill futures contract. To most effectively hedge his long position in the floating rate bond against declining rates, Reichmann should: A. take O’Shea’s advice. B. go long in a Eurodollar futures contract. C. go long in a Treasury bill futures contract.
The proposed answer is B. Can someone explain to me why we have to go Long but not Short? Thanks
If you go short you are more exposed to the interest rate risk. Going long the investor will receive a higher coupon from the Eurodollar, in case of higher interest rates, reducing the impact on paying the LIBOR coupon. important to notice that this is a very common hedging strategy but the hedging (LIBOR/EURODOLLAR) is not perfect.
I think @Allanps is correct for an FRA but not a Eurodollar future.
I believe the reason is that Eurodollar futures are quoted as cash instruments. A price of 95 means the interest rate is 5%. So if you are long a floating rate bond you are worried about rates going down. If you are long Eurodollar futures you benefit if rates go down. If rates go from 5% to 2% the price of the future goes from 95 to 97.
Sorry for omission the previsous part. Note that this question is from Kaplan Practice exam 2 Morning question 31.
“Reichmann is a fixed income PM with Global Investment Management. A recent increase in interest rate volatility has caused Reichmann and his assistant, Mel O’shea, to begin investigatin methods of hedging interest rate risk in his Fixed income portfolio…”
My understanding is Reichmann has a LIBOR asset (i.e LIBOR floating rate bond) and it would reduce value when rates go DOWN. So go Long with Future contracts also reduces value when rate go down, isn’t it?
Eurodollar futures contracts increase in value when LIBOR decreases. So it’s a perfect hedge for a long float (indexed to LIBOR).