Another derivatives questions

Walex

Table 2
Interest Rate Instruments

Dollar Amount of Floating Rate Bond
$42,000,000

Floating Rate Bond paying LIBOR +
0.25%

Time to Maturity (years)
8

Cap Strike Rate
7.00%

Floor Strike Rate
6.00%

Interest Payments
quarterly



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


A) Shorting Eurodollar futures.

B) Buying an interest rate floor.

C) Shorting an interest rate floor.


Your answer: B was incorrect. The correct answer was A) Shorting Eurodollar futures.

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. (Study Session 17, LOS 62.a)


My reasoning was

Here is Shorting a bond, that means interest rates rises, he likes it. If interest rates fall, he will be losing. Shouldn't he buy a interest rate floor then?

hassan

I think B is still correct but the question asks which option will BEST reduce their i risk. Shorting Eurodollar futures would probably better hedge his position that the interest rate floor. With the floor he will lose money until rates hit the 6.00% floor.

19831985

Ok. Since he sold a floating rate bond. His risk is going rates up. How is this equivalent to Short Euro Dollar?

tianxin

he issued a floater , his risk is rates up

no floor will help here only the future

tarunajwani

^^long eurodollar future=right to BORROW at X not lend.

Am I right?

5566

bhans2 Wrote:
-------------------------------------------------------
> It is kind of counter-intuitive, going long a
> Eurodollar future gives you the right to lend USD
> at X and going short allows you to borrow USD at
> X. So as interest rates rise (eurodollars are
> based on libor) the short makes money and offsets
> the money you lose on having to pay more interest
> on the floating rate bond.

Good explanation. Thanks

SpyAli

Good Explanation