When to use futures Vs options to hedge

If you have a bond portfolio and would like to protect the value of the bonds against the risk of changes in the future interest rates: Use futures : A or B and why? Use options : A or B ? A) when the interest rates are expected to go up B) No opinon on the future interest rate changes

Use futures when interest rates expected go up. Use options when you have no opinion on the future changes. In general, use futures when you want to hedge a specific interest rate. Use options when you have no clue which way it goes. The reason is because the option is like buying insurance, it has an asymmetric payoff. If it goes in your favor, you dont exercise and make a gain. If not, exercise the option which will offset the capital loss. For futures, its a zero-sum game. If it goes the wrong way on you, you’re screwed, which is why you use it when you believe in a certain direction.

Thats what I thought but CFAI thinks the other way… Vol4 Reading 30 Q3 If one has no clear opinion about the interest rate outlook but would like to avoid risk, selling interest rate futures would be a good strategy. If a bond holder believes that interest rates are going to increase buying the puts would not be a bad idea.

Hmmm…I’m not too sure now. Anyone else chime in?

When we hedge with futures, we are not gaining anything in our position… we are eliminating any interest rate movements… because if interest rates go up, your portfolio value goes down, but your futures position will gain because you are short the instrument… The same situation will be if interest rates go down… However, if you think interest rates are going to increase, you want to only hedge against that direction… hence, use put options… that way, you are only protected from increase in interest rates, and you will gain if interest rates decline…

Care to explain why it made sense to you? Thanks,

^ That’s what I thought…but the examples seem counter-intuitive.

So if you are not sure which direction the interest rates are headed: you have two possibilies(50-50): 1) rate increase : 2) rate decrease In this case, you want protection from rate increase but keep the upside potential intact. Then you want to buy options (right?) But if you expect that interest rates are going to go up: There is an high probability that 1) rate increase only… Why do you want to pay premium on options when you have high probability of increase in interest rates? kurmanal Wrote: ------------------------------------------------------- > When we hedge with futures, we are not gaining > anything in our position… we are eliminating any > interest rate movements… because if interest > rates go up, your portfolio value goes down, but > your futures position will gain because you are > short the instrument… The same situation will be > if interest rates go down… > > However, if you think interest rates are going to > increase, you want to only hedge against that > direction… hence, use put options… that way, you > are only protected from increase in interest > rates, and you will gain if interest rates > decline…

if rates are going up, buying a put will be advantageous as you are able to sell your bond at a higher pricer compared to when rates go up and bond price decreases.

mp2438, Not sure if I understand your logic. When there is going to be increase in the interest rates: Yes, you can get the protection using puts. But why you need to pay premium on put option when you can hedge using futures with no cost?

In response to Vegas. Options can be a good play in this situation because of the increase in value with volatility. If you’re not sure which way they are going, up or down but it’s going to be volatile you can profit. So if you are not sure which direction the interest rates are headed: you have two possibilies(50-50): 1) rate increase : 2) rate decrease In this case, you want protection from rate increase but keep the upside potential intact. Then you want to buy options (right?) But if you expect that interest rates are going to go up: There is an high probability that 1) rate increase only… Why do you want to pay premium on options when you have high probability of increase in interest rates?

GMofDen: They are talking about the protection not to gain profits. Also question does not say anything about future volatility wrt the current volatility. Anyway, I think I need to move on… GMofDen Wrote: ------------------------------------------------------- > In response to Vegas. > Options can be a good play in this situation > because of the increase in value with volatility. > If you’re not sure which way they are going, up or > down but it’s going to be volatile you can > profit. > > > So if you are not sure which direction the > interest rates are headed: > you have two possibilies(50-50): > 1) rate increase : > 2) rate decrease > In this case, you want protection from rate > increase but keep the upside potential intact. > Then you want to buy options (right?) > > But if you expect that interest rates are going to > go up: > There is an high probability that > 1) rate increase only… > > Why do you want to pay premium on options when you > have high probability of increase in interest > rates?

Vegas Wrote: ------------------------------------------------------- > So if you are not sure which direction the > interest rates are headed: > you have two possibilies(50-50): > 1) rate increase : > 2) rate decrease > In this case, you want protection from rate > increase but keep the upside potential intact. > Then you want to buy options (right?) > > But if you expect that interest rates are going to > go up: > There is an high probability that > 1) rate increase only… > > Why do you want to pay premium on options when you > have high probability of increase in interest > rates? > > you are right that you can use put options if you think there is 50-50 chance interest rates go up or down… the disadvantage here is that you have to pay the option premium upfront. If you don’t know what’s going on in the market, why pay anything upfront? Just enjoy your life and let your futures to protect you without any obligation to pay anything… If you sell futures where you are pretty confident that the interest rates will go up, than you will forego the gain if interest rates in fact went down… Remember, you are simply trying to protect yourself…

I am with mp here

guys you are all forgetting that one of the choices was that it was a costless collar (in fact i think you actually made $)

^ a costless collar would not be a good idea. limited upside and only a small amount of downside protection? not exactly protection. i don’t even remember the q, but a collar doesn’t sound like it does what the OP is wanting it to do here at all. if you just wanted protection against any change in interest rates up or down, you sell the futures. plain and simple, lock in a rate, take risk out of the equation.

iregula Wrote: ------------------------------------------------------- > guys you are all forgetting that one of the > choices was that it was a costless collar (in fact > i think you actually made $) +1. More than paid for itself.

i am with banni… a zero cost collar still allows for some risk when the rates go up or down. This OP is trying to protect against risk.