hedge LIBOR add-on with Eurodollar futures? like, instrument, discount, interest

bcp901

In the schweser AM exam 1, I came across this question#31. I am assuming the portfolio bond in the question is libor-addon instrument and eurodollarsfuture is a discount instrument.

I want to know how does this combination effectively hedge with disparity in the type of instruments. Can you please help?

here it goes....
"Riechmann would like to hedge the interest rate risk of one of his bonds, floating rate bond(indexed to LIBOR). O'Shea recommends to take a short position in Eurodollar futures contract because Eurodollar contract is a more effective hedging instrument than a T-Bill futures contract".

Qn:To most effectively hedge his long position in the floating bond against declining rates, Reichmann should:
1) go per OShea
2) go long in Eurodollar futures contract
3) go long in a T-Bill futures contract



Edited 1 time(s). Last edit at Monday, May 23, 2011 at 03:38PM by ov25.

bingbingliang

jgradits,

I think this qn is more about interest rate risk than price risk.

I understand to the point that when portfolio intrest falls, the long future is going to help as we have purchased the option.

However, this moght not be a perfect hedge. As the portfolio bond is an add-on instrument vs the eurodollar futures contract -- a discount instrument.

Also note that the qn conpares between the T-bill and Euro dollar. In this case, Euro is preferred as it is attached to LIBOR the same reference as in the case of the portfolio.

I guess the among the choices, as taking a short position does not help at all to hedge the declining rates, the only choice remains 2). However is not a perfect hedge.

Am I missing something?

Otabek

the question asks to choose between eurodollar contract and tbill futures. so hence euro dollar is better choice.

from practical stand point, it is not "A PERFECT HEDGE" like you indicated. There are other products out there that you can use to hedge paying/recving cashflow. However, these might not be feasible since the transaction cost/operational risk might outweight the benefit.

eurodollar contracts happens to be one of the most liquid libor based instrument out there. you can easily buy/sell to express your views on the front part of the libor curve. hence, people choose eurodollar contracts over other libor based instruments. this liquidity disappears if you go further out the curve, say, more than 5 yr (gold pack). in that case, most will use swap.

good example would be swap spd. when a trader wants to take exposure in swap spd and he wants to express his view that yield on 2yr note will decrease vs 2yr libor rate (swap spread widener). he will most likely be buying 2yr tsy note (spot settling) vs selling eurodollar contracts (fwd settling). the reason for his choice is to mitigate the transaction cost of his trade and take advantage of liquidity.

iteracom

wow! thanks a lot gangsta...

guess continuing on the same note, another qn in the same vignette offers choices on constructing a collar.

My problem is that I don't understand the motivation of one against the other

Reichmann finds that interest rate volatility increases. so wants to hedge using a collar

Here goes the qn.
What would be the most appropriate way to construct an interest rate collar to hedge against the fixed rate portion of the portfolio using 2-yr 6% floor and a 2-yr 12% cap?
1)Buy the floor buy the cap
2)Buy the floor sell the cap
3)Sell the floor buy the cap

Any help here too is much appreciated