Interest rate caps/floors2 following, interest, will, reduce, shorts

mamuka12

Another curveball that threw me off.

Bower shorts the floating rate bond given in Table 2. Which of the following will best reduce Bower's interest rate risk?

A) Buying an interest rate floor.
B) Shorting an interest rate floor.
C) Shorting Eurodollar futures.

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!

giorgio10

Skies Wrote:
-------------------------------------------------------
> long a eurodollar future contract protects you
> from rising prices...what's the falling rates in
> this scenario? is it like the relationship between
> bond price and interest rates?
>

Well a Eurodollar future will protect you from falling rates or lower prices. Since Eurodollar contracts move inversely to interest rate changes, the two are equivalent.

Otabek

Thanks all for your responses on this and the previous post I had. Very helpful!

MiniMe7

long a eurodollar future contract protects you from rising prices...what's the falling rates in this scenario? is it like the relationship between bond price and interest rates?

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.

iteracom

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.

defour44

the Q says reduce interest rate risk not " Hedge"..



Edited 2 time(s). Last edit at Thursday, April 29, 2010 at 02:10AM by simi.

hassan

CFABLACKBELT Wrote:
-------------------------------------------------------
> A was my original reasoning based on my initial
> thoughts on how this works.
>
> Since reading the responses to the other post, B
> makes sense... but I hate to be the bearer of bad
> news b/c the answer is C...
>
> "If he adds a short position in Eurodollar futures
> to the existing liability in the correct amount,
> he is able to 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."

Damn, I was torn between B and C and went with B since it mentioned interest rate risk.

NO EXCUSES

ap0258

I also chose B and think that this is a poorly worded question...although I can see the logic of why C may be correct. Perhaps a case of C being the 'best' answer, even though B is not necessarily wrong?

lucasg85

A was my original reasoning based on my initial thoughts on how this works.

Since reading the responses to the other post, B makes sense... but I hate to be the bearer of bad news b/c the answer is C...

"If he adds a short position in Eurodollar futures to the existing liability in the correct amount, he is able to 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."