I don’t get this… You are short a floating rate bond. Between these choices, how would you best reduce your interest rate risk: A. Buy interest rate floor. B. Short interest rate cap. C. Short Eurodollar futures. D. Short interest rate floor. Can you briefly explain the why too?
d?
I would say D. If you are short a floating rate bond, rising interest rates would be negative to you, so you can sell an interest rate floor which would help hedge your rising interest rate risk, but not perfectly. I could be way off on this, but I think it would be like selling a covered call, where you haven’t hedged your downside risk, but you’ve given up some of your upside in return for some downside protection… Its been a long day so who the hell knows
Tough one. In fact I would like to buy a cap but that isn’t an option. D would reduce your risk but isn’t what you would expect as the right answer. I don’t quite see why C would be right so I go for D.
C Short the eurodollar, as rates increase, eurodollar will decrease in value = gain to short.
Nib, that makes sense now. Is my thinking along the correct lines on thinking that selling the floor will provide some protection, but not the best protection?
agree C. you short a floating rate bond, interest rates up hurt you. you short eurodollar, rates go up, eurodollar goes down, helps you.
Niblita - you have got this stuff down pat… I guess D works like Lance explained, but it appears that C would be best. Here’s the explanation: A short position in Eurodollar futures in the correct amount will lock in a specific interest rate. A short Eurodollar position will increase in value if interest rates rise because the contract is quoted as a discount instrument so increases in rates reduce the futures price. I’m getting killed on this stuff…
If you sell the floor you are hurt as well. Rates go down to 1%, so you are pretty happy, but you shorted a floor at 3% so you still end up paying 3%. I can see it as shorting the floor to help pay for a cap which is more important. That makes sense to me so I think your right.
Right, just like a covered call does not completely eliminate downside risk, but you can pocket that premium which gives you a little cushion.
C. When you are SHORT an floating interest rate bond, you will have to pay the rate specified in the bond (borrowing at floating rate). -To hedge this position, you want an instrument that will increase in value when interest rates rise. A EuroDollar future is like a future contract on a bond. The HOLDER of a EuroDollar future makes money when interest rates fall. The SHORT position makes money when interest rates RISE. So, when interest rates rise you will have to pay higher interest on the Floater and you will receive money from the short EuroDollar Futures contract. --A long position in a floor will be worthless when interest rates rise. --Short Cap will lose money when interest rates rise --Short floor will not provide a hedge because it is like selling a put on interest rates (only gain premiums)
Good question. Very testable I think.
mwvt9 Wrote: ------------------------------------------------------- > Good question. Very testable I think. Of course they’ll change a few details on the real exam and I’ll get it wrong anyway…
Very good indeed.
sterling76 Wrote: ------------------------------------------------------- > mwvt9 Wrote: > -------------------------------------------------- > ----- > > Good question. Very testable I think. > > Of course they’ll change a few details on the real > exam and I’ll get it wrong anyway… Nah, you will nail it. If they give a question like this 3 of the 4 selections will benefit you in one why and the fourth will be the opposite. Just have to think through each option.
assume i have issued floating and want to limit my interest cost with an interest rate collar. i am short floating rate bond. interest rate collar consists of: short floor and long cap. so if rate increase the cap provides a hedge… sets a maximum. if rates decrease (CFA, book 6, page 309): the sale of the floor sets a minimum. What? the floor is in the money if the reference rate is below the floor rate. if i’m short i have to pay the long the difference. the problem is why not long floor and short floor?
barthezz Wrote: ------------------------------------------------------- > assume i have issued floating and want to limit my > interest cost with an interest rate collar. > > i am short floating rate bond. If you are short the floating rate bond then you lose if rates go up becaues you are paying the coupon. > > interest rate collar consists of: > short floor and long cap. > > so if rate increase the cap provides a hedge… > sets a maximum. > > if rates decrease (CFA, book 6, page 309): the > sale of the floor sets a minimum. What? the floor > is in the money if the reference rate is below the > floor rate. if i’m short i have to pay the long > the difference. > > the problem is why not long floor and short floor? We aren’t talking about a collar here just a floor. The floor is valuable to the long when interest rates drop, but that wouldn’t hedge our short bond because when rates drop we win. If we are short the floor then we get a premium and if intrest rates rise we will pocket the premium but that is all.
C… but doesn’t the material expressly say that eurodollar doesn’t hedge well…
I know I’ve stressed out about this questions before… This wasnt one of the options but wouldn’t a buying a Cap be a good option to hedge interest rate risk?
AFJunkie Wrote: ------------------------------------------------------- > I know I’ve stressed out about this questions > before… > > This wasnt one of the options but wouldn’t a > buying a Cap be a good option to hedge interest > rate risk? yes, i believe so… this area absolutely killed me on a mock and it shouldn’t have. (combo of poor reading, some poor wording and my not know long/short and necessarily price/yield on options well enough.