In Volume 1, exam 1 morning session, question #7 on fixed income/derivatives asks to describe and choose the best hedging strategy for a DB pension plan: 1) Exchange traded interest rate put option 2) Treasury bond options 3) Treasury bond futures. While reading the suggested answers, there are few points which although I understand but I am not able to trace back anywhere in schweser material. e.g disadvantage of using the exchange traded interest rate put is that these are based on short term interest rates. Pension liabilities on the other hand have long duration. This disadvantage of interest rate put is no where mentioned in scheweser material (or may be i have missed it). Also while looking at the pattern of questions in the practice sets,most Fixed income question involve use of derivative. However SS 9, 10 on FI and SS15 on derivatives are discussed as two different worlds. SS15 talks about all the option strategies but does not link it to Fixed income. SS10 on fixed income covers fixed income and explains the use of protective put and covered call (on interest rate future contracts). Anybody else also feeling lost like me or am i the only one? Reading CFA text book the answer to it or doing more practice sets will help?
The thing about this question is that you are asked to choose the best option to hedge the portfolio. As you already found, interest rate options do not provide the best alternative because they are based off of short-term rates. Futures were not the best option because any gain the underlying portfolio would be offset by a loss on the futures contract. The Treasury Bond options work because of the one sided payoff. Now, I think your question really had to do with the linking of material throughout all of the exams. Unfortunately, all of the material is fair game and anything that can be combined, most likely will be in some fashion. Look at the old CFAI exams and you should get an idea of how they link things, but it is not unlike what you saw in Schweser.
thanks MarkWD. L3 now seems a different ball game altogether…There are so many relationships and almost anything can be combined. I hope doing more and more practice sets will give me some confidence. Thanks again.
Why any gain on futures will be offset by a loss on the future contract? How do treasure future works? I thought its kind of like a call option, the higher the underlying asset price, the more valuable the call option…
Eastview, Futures have both upside potential as well as downside risk. (So we can say any gain potential is offset by downside risk.) Call option on the other hand is one side payoff. Hence treasury futures are not like call options.