Context: A floating rate bond with Dollar value = $30million Spread over LIBOR = 0.50% Time to Maturity = 1 year Cap strike rate = 6% Floor strike rate = 5% Interest payments Part 2) Miller asks Johnson to hedge a hypothetical short position in above floating rate bond. Which of the following is the best hedge for this position? A) Sell an interest rate cap B) Buy an interest rate floor C) Buy an interest rate cap Your answer: B was incorrect. The correct answer was C) Buy an interest rate cap. An interest rate cap provides a positive payoff when interest rates are above the cap strike rate. Therefore, the buyer of this instrument is able to hedge himself against rising interest rates. Incorrect answer explanations: Selling an interest rate cap is not a hedge against rising interest rates. Buying an interest rate floor hedges the risk of decreasing interest rates I dont understand. Doesn’t a SHORT position in a floating rate bond mean I am receiving floating rate payments and hence would want to hedge against decreasing interest rates? Or am I overthinking this??
no, a short position in a floating rate bond means i am paying floating rates.
Right smiley! to hedge a short float, pay float, you need to protect the IR with a cap Sell A Float: Enter into contract to PAY float Buy A Float: receive float *i try to think of everything as long and if a question says short, just take opposite
Thanks guys… not sure why I thought that? ~Sigh! Seems pretty clear to me now…
I had a similar confusion when I first read the question . To simplify: Short a bond means paying the rate Long a bond means receiving the rate. I know the latter , so I guess the way to remember the former is to invert the latter
right, thats the way i do it - if i’m gonna invest and go long in a bond, i’ve bought the bond and i am receiving the coupons - short is the other way around