Floating rate bonds...2 questions...getting confused

CFA Level II
#1
  1. I picked C because when we have short position on floating rate bond, we are not worried about increasing interest rates obviously. interest rate up, bonds down, good for us because we are short. we are worried about decreasing interest rates which will raise price of bonds and we are short so we want an interest rate floor…what am i thinking wrong? ======================= Miller asks Johnson to hedge a hypothetical short position in the floating rate bond. Which of the following is the best hedge for this position? A) Buy an interest rate cap. B) Sell an interest rate cap. C) Buy an interest rate floor. Your answer: C was incorrect. The correct answer was A) 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.
#2

there are 2 distinctions. you have issued the bond (liability) or you have an asset. for the liability you want a hedge against increasing interest rates for the asset you would want to not fall below a threshold the manager has a liability because he is short the bond. he issued it. therefore he does not want interest rates to increase.

#3

I think you are worried about interest rates increasing because this increases the value of the bond since it is paying a floating rate. If it is paying 400 bps + libor and libor is 2% you are short a 6% bond, if libor increases to 4% you are now short an 8% bond. since you are short the bond, to hedge against this you buy an interest rate cap

#4

Thanks man !! so close to exam and i am still getting these things wrong…sux !!

#5

drymartini Wrote: ------------------------------------------------------- > 1) > > I picked C because when we have short position on > floating rate bond, we are not worried about > increasing interest rates obviously. wrong. you are short the bond - you are paying the coupons! think company.