Interest rate collar- Practice exam V1 p200

…Reichmann would like to hege the interest rate risk of one of his bonds, a floating-rate bond(indexed to LIBOR)… Q: What would be the most appropriate way for Reichmann to construct an interest rate collar to hedge his fixed income portfolio using the 2 year 6% floor and a 2 year 12% cap? 6%floor 12% cap A Buy Buy B Buy Sell C Sell Buy D Sell Sell

C Sell floor and buy cap to lock in the rates T/G

thanks T/G but i think there is difference between hedge LIBOR-based liability and asset when using interest rate collar. for LIBOR based liability, we have to buy cap and sell floor to lock in rates, but how about LIBOR based asset??

Right - if you have a Libor based asset you buy floor/sell cap.

I missed that - good spot and good Q T/G

the answer is C

Nope. Not if he’s the bond owner.

i got it. its a floating-rate bond. investor will sell floor to hedge the risk of interest rate downward and buy cap at the same time to get a zero cost collar. Alternatively, investor can go LONG a eurodollar futures contract to hedge risk.

I am still not getting it. How is C the correct answer? Anyone care to elaborate?

I would still buy/sell (B). If he buys the floor at 6% and sells the cap at 12%, then (the columns in my analysis are from A-D, and they are the int. rates, payments to floor, and so on. the net payment/income is the sume of columns a-c): A. Interest rates. B.payment to floor C.payment to cap payment/income 4.00% 2.00% 0.00% 6.00% 5.00% 1.00% 0.00% 6.00% 6.00% 0.00% 0.00% 6.00% 7.00% 0.00% 0.00% 7.00% 8.00% 0.00% 0.00% 8.00% 9.00% 0.00% 0.00% 9.00% 10.00% 0.00% 0.00% 10.00% 11.00% 0.00% 0.00% 11.00% 12.00% 0.00% 0.00% 12.00% 13.00% 0.00% -1.00% 12.00% 14.00% 0.00% -2.00% 12.00%