Intrest rates and protective puts

CFA Level III
#1

According to the text the purchase of a put protects bond investments from increases in interest rates. can anyone explain why? A put option gives you the right to sell something. So if strike is 100 and price is 50 you exercise. if price is 150 you don’t. If interest rates rise, shouldn’t it be disadvantageous to exercise at the higher rate? i thinking I’m missing something but can’t figure out what. cheers

#2

If interest rates go up, the price of your bond goes down…

#3

I guess the real question, is what kind of put are they referring to? If they mean interest rate put, then that statement is wrong.

#4

You are simply mixing up the strike price with the interest rate… your strike price is the price of the underlying… and as you remember, the price of the bond has an inverse relationship with the interest rates… so, like willispierre said, the price of the bond will go down as interest rates rise… hence, you protected yourself from falling prices… in your example, you said that the price went down from 100 to 50; well, that’s because interest rates have gone up… and when you exercise your options, your payoff will offset the loss in bond value…

#5

In the real world, you would have a puttable bond that gives the holder the right to put the bond back to the issuer at par. If rates go up such that it would be advantageous to sell it back at par (if rates go up substantially), the holder of the bond would in effect exercise his/her option.

#6

Hi, Let me confirm the definition of the “Interest rate put opiton”… Is underlying the “interest rate” ? not the “bond price” ? If you draw the payoff diagram, horizontal axis represent “interest rate” ? For example, below 1%(=strike rate), option value is negative(=-put premium), and above 1%, the value of the option rising. Or, “interest rate option” should be defined by underlying price(bond price) , not the “interest rate” ? Sorry for my poor writing… Any advice is appreciated…

#7

its talking about the price of the bond… so if the int rates go up, the price goes down, you exercise the put.

#8

Many thanks!!