how do you use these?

When would you employ the following as a hedge and how do they work? Exchange traded interest rate put option Treasury bond option Treasury futures

cfahead Wrote: ------------------------------------------------------- > When would you employ the following as a hedge and > how do they work? > > Exchange traded interest rate put option > > Treasury bond option > > Treasury futures I have combined the first two queries in the next paragraph. The only difference between the two is with the underlying asset. The first one (Exchange traded interest option) is any bond, while for second one (Treasury bond option) it is a Treasury bond If I expect interest rates to rise in the future, I enter into a treasury bond put option which will give me the right to purchase the bond at a particular interest rate (or price). If the interest rate is less than or equal to 5%, I do nothing, if it is more than 5%, then I exercise my right and get a bond for 5% when the prevailing market rate is more than that. Do remember that price has an inverse relationship with yield. So if yields go up, price goes down. Interest rate futures have the same methodology, but in this case, I have to sell the bond today when I have made the contract. When interest rates rise , I purchase the bond (as its price has fallen) when closing the contract, thus making a profit. In this case when compared to the treasury bond option, I have to purchase the bond, i.e., I have an obligation to do so.

when you expect rates go up - why would you want to buy a bond with a lower interest rate? If the rate goes up above 5% say to 6% - the bond will cost less for you to buy at the market rate. So why would you buy it at that lower rate that existed before? You own the bond already. Rates are going up - so your market value is going down. Now you have the right to put it back to the company at 5% – then you benefit - as you do not lose on your position - is how I think it would be. You are the investor in the bond, and already own the bond.

The put option allows the holder to sell the bond in a rising interest rate environment. If interest rate was falling then the call option would be the one to use.

if interest rates were expected to fall , there is no need to hedge( for the holders or investors) The value of the security would rise on its own. Why give up some gains to pay premium ?

Matrix Corporation has decided that since the company has sufficient liquid resources to make any required contribution in the future, it will maintain its current asset mix in the defined benefit plan which is approximately 60% equities and 40% bonds. Matrix officers believe that interest rates are temporarily low and they do not want to increase the bond allocation for this reason. Concerns remain, however, that if they are wrong, further decreases in interest rates will worsen the unfunded status of the plan and require even greater funding by Matrix over the next several years. Matrix has decided to hedge this risk by taking a position in derivative security. Matrix is considering three derivative security: Exchange traded rate put option Options on Treasury Bonds Futures on Treasury Bond which of the three will provide the most appropriate strategy and why.

Let us say current interest rate is 4%. your expectation was rates would go up to 5%. so you bought a future on a t-bond expected to settle at 5%. when rates fell to 3% - your DB Plan liabs fell more in value - so your funded status becomes more negative. you received a boost thru the futures - since you got market bonds rated at 3% at 5% prices. – these two would hedge each other. Funded status going down vs. bonds going up. if rates actually increased - your bonds would be essentially market value - but you gained on the liabs since they fell in value - and your funded status improved. Futures - the entire position is obtained with a zero cost. In the case of the options - a. to buy them you need to pay a premium. b. they are unidirectional. (will not work in the opposite expectation). so futures on t-bond is the choice.