If you are receiving fixed and paying floating in an interest rate swap, which of the following is the LEAST appropriate hedge for the position: A) Interest Rate Calls B) Interest Rate Futures C) Forward Rate Agreements This is from Schweser Book 5 Pg 335. I said C, as you would profit from the calls and rate futures as rates rise, but I didn’t really like the answer because B and C should have similar payoff structures. The answer was actually A, based on the reasoning that the payoff from the calls is asymmetric. In my mind, that is why they are best suited. They neutralize your loss on the pay floating if rates rise, and don’t negate the payment you would receive if rates drop. In my job, hedging means protecting from downside risk, but here it seems like ‘hedging’ is interpreted as neutralizing the loss AND profit from a position. Is that right?
For an interest rate call, you have to pay a premium to purchase the call. If rates go down, you lose your premium. The other 2 instruments do not require an initial payment.
But don’t the last two prevent both losses and profits? That seems less like a hedge and more like neutralizing your exposure completely.
Hedging is neutralizing the exposure.
True, but your priority should be to reduce your exposure. If you can reduce your exposure and reduce your cost to reduce that exposure, then that is the better hedge. Whether or not you profit from it is irrelevant.
Lurky Wrote: ------------------------------------------------------- > Hedging is neutralizing the exposure. See, this is where the real world conflicts with the curriculum. When we hedge a position at my job, we are mitigating downside exposure, e.g. buying a put to cover a long stock position. Thanks for the help.
Yeah, that’s cuz individual investors don’t care about volatility as long as it is to the upside. Institutional investors and/or those with fixed liabilities are concerned with volatility in general be it up or down.