scarecrow

sbmarti2 Wrote:
-------------------------------------------------------
> Shorting an floating rate bond means how much you
> pay each coupon is directly related to interest
> rates- higher interest rates, higher payments.
>
> A) Buying an interest rate floor will not help as
> you're receiving money when rates are low- right
> when you're paying the least in interest. This
> effectively makes you win twice when rates are
> low.
> B) Selling a floor sounds correct, but don't
> forget about the unipayment structure of options.
> In this case you'll receive a payment for option
> from the buyer regardless, but you'll end up
> paying them off when rates are low- i.e. hedging
> away the profit side of shorting the bond. When
> rates are high and you're paying more interest,
> you're not paying or receiving anything from the
> counterparty to the floor, except for the intial
> option premium. That makes this a poor hedge
> (does not reduce the downside risk of the
> position).
> C) This is the correct answer. Eurodollar futures
> lock in a set price in the future. If you long a
> contract, it protects you from falling rates,
> therefore shorting a contract protects you from
> rising rates. Futures do not have a unipayment
> structure, so you can lose or gain on them,
> depending on the rate. Therefore you lose on the
> floating bond when rates increase, but you gain on
> the Eurodollar future.
>
> In terms of caps/floors, the answer would be
> buying an interest rate cap. The key is that
> buying a cap and shorting a floor are NOT
> equivalent, just like buying a call/selling a put
> are not equivalent.


great answer!