“To most effectively hedge his long position in the floating rate bond against declining rates: A. go short a Eurodollar futures contract B. go long in a Eurodollar futures contract C. go long in a Treasury futures contract” I know the answer is B, but don’t you hedge a bond against increasing rates, not declining rates? Doesn’t a libor-based bond do better when interest rates decrease?
Eurodollar contract -> inverse to interest rates
it is an add on yield contract right – that’s what you meant ali?
ok so normally if it’s a libor bond though, int rates decreasing is good for the value of the bond, right? It’s only because here it’s an add-on yield that Eurodollar bonds are increasing when interest rates increase? Right?
Eurodollar futures contracts are calculated the same way you would T-Bill futures. cpk123 is correct is saying that the underlying is an add-on interest time deposit, but as I understand, the Eurodollar future is calculated (1 - intrate*(t/360))*principal So if interest rates go up, your Eurodollar futures position goes down, and vice versa. This is the opposite effect of FRAs Please verify, I haven’t reviewed derivatives in a long time
But the bond we’re hedging against is a floating-rate bond, meaning LIBOR, right? So why would a floating-rate LIBOR bond need to be hedged against decreasing interest rates in the first place?
Suppose you issued a bond (short a bond)…and you pay Libor. You liability is LIBOR. If libor increases, you need to pay more. So you need a hedge whereby, if Libor increases, you recieve. If you are long EURODOLL FUT, and rates increase, you lose…so thats no good since you lose on your bond when the rates increase as well (by having to pay more for the floating rate coupon). So you short the EURO DOLL FUT, and if rates go up, you will make cash. SHORT-SHORT LONG-LONG
But urymoto Schweser says the answer is B. Buy a Eurodollar futures contract.
in this case the concern, i believe, is from he point of view of an ivestor who really needs the coupons, not the priincipal If you are long the bond, you are long the coupon, if the rate goes down, so does your coupon…so you hedge… its always very ambigious