Help-Schweser Exams V1 Exam1-Q 31

Hi Can some tell me why when interest rates decrease, there will be a gain in Long futures positin in Eurodollars (as mentioned in the answer explanation in the book) ! Thanks

think of eurodollar contract as a forward bond contract. there is inverse relationship between yield and price. hence, when int rate decrease, value of long futures postion in Eurodollar increase.

Thats it Thanks buddy One more thing guys / gangsta In the same item set…How can we know whether the portfolio manager is an issuer(borrower) or investor so that we can answer questions like Q35 ? Its not mentioned clearly in the vignette !!

I have been assuming the unqualified positions are long. A short needs a specific mention. Is there a better convention?

Am not sure man My problem is that its not mentioned wether the guy is an investor or an issuer (borrower) of the bond since its clearly mentioned in the item set! Any help ?

UP Anybody is there !

HELP ! :slight_smile:

the question states “his long position in a floating rate bond”. That means he has bought the bond and is an investor. Also, in the vignette (i hate that word), it says “one of his bonmds”. and “hedging his fixed income portfolio”. All signs he is an investor. Finally, there is no company named. I dont think Reichmann would issue a floating rate bond for himself to raise capital haha. I think it will be clear if someone is an issuer by mentioning sa company that needs capital or saying X issues a bond. Hope this helps.

HELP ! :slight_smile:

Sorry guys my last post was by mistake @spanish Thanks man But as per my knowledge, a borrower is the one who usually buy a cap and sell a floor to hedge borrowing cost The investor however hedge for his returns by buying a floor and selling a cap The answer, assuming he is an investor, will give us opposite situation Or what do u think?

So in this case, reichmann owns a floating rate bond. He wants to hedge agiant interest rate risk. Since it is a floating rate, his risk is if interest rates drop (his payments will decrease). To hedge against a drop in rates, you would need a floor. if rates fall below the floor, yuowould get payment and offset some of the lost income from the floating rate note. You could sell the cap to make a collar, and use the cap to help fund the floor. In this case, he has the option to go long or short a eurodollar contract. Since he is hedging against decreasing rates, he would go long the eurodollar contract (which pays off when interest rates drop). This is from Wikipedia, i thought it was useful. Want to make sure I cite it so i dont break Standrd 1C, misrepresentation :wink:

Man…but the answer says he buys a cap and sells a floor meaning he is hedging against the increase in interest rates not a decrease ! Hedging against increase in interest rates is performed by the borrower not the investor Right?

i think you are referring to question 32 not 31? that might have been our confusion. In this case, he is hedging the entire portfolio, not just the floating rate, from an increase in rates. This is done by buying a cap (so if rates increase, bond values decrease but the cap pays off). This could also be done by buying a call option on rates. i dont see where the answer says buy a cap and sell a floor.

You guys are thinking about it too much…it’s really simple. Since he’s got a long floating position (he’s getting paid a floating coupon), he’s going to inherently lose if interest rates drop. In order to hedge this, he needs to go long on a eurodollar futures contract, which, like Spanish said, will gain if interest rates go down. Either an investor or borrower can hedge. In #32, since he’s the investor (in fixed rate debt this time), he’s going to lose if interest rates go up. Prices drop when interest rates go up as we all know. So to hedge this, he’d go long an interest rate cap (which would pay him if interest rates went up) or he’d go long a call on interest rates, which would pay him if interest rates when up too. He could also go short a call on bond prices, but that’s complicating things…

Appreciate your inputs guys But if u look @ the third post of this thread, ull knw that I was talking about Q35 (previously 31 then 2nd Q is 35) in which the answer says buy a cap sell a floor and hedge for Increase in rates Thats why am saying the guy is a borrower not an investor.

Well… my memory is sketchy these days but I don’t have the book with me but my memory from that vignette is the following: He has a portfolio of both fixed and floating rate bonds. Some questions ask about float and some ask about fixed. he is the investor. Then the question says something about if you want to use a collar using floors and caps how would your hedge the fixed portion of the portfolio (and not the floating part). So you are hedging the fixed part which your logic works for buy cap and sell a floor.

Yeah man Just noticed the fixed portion part In Q31 he said floating … Thats why it was confusing Thanks all