Interest rate caps/floors position, interest, following, best

bleach

Miller asks Johnson to hedge a hypothetical short position in the floating rate bond in Table 2. Which of the following is the best hedge for this position?

A) Sell an interest rate cap.
B) Buy an interest rate floor.
C) Buy an interest rate cap.

I thought I had this but not sure whey my answer is wrong. Will follow up when you guys have the chance to answer the question.

Thanks.

hassan

buy a floor?

CP

Swanand

If you are short a floating rate bond, that means you want the interest rate to go down.

If you want to hedge the position, that means you are afraid the interest rate will go up.

So I think you would buy an interest rate cap. This way, there is a cap as to how high rates can go after which point you won't lose any more money. All you have to give up for this comfort is a premium fee.

jarobi04

Agree with NY, exact same reasoning.

OmarAdnan

If you are long a bond, that means you have lent it out and want the rates to go up. So think in terms of interest rates, not bond prices.

There was actually as similar very tricky Q like this on last year's exam. They told you you had a long gold position and asked what you would do if you wanted to hedge the position, and then what your payoff would be. Key was to understand that if you are long an asset you go short to hedge.

economicz

sbmarti2 Wrote:
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> I'm having a hard time interpreting what the
> underlying instrument is. If the underlying is an
> actual interest rate (such as LIBOR), then I agree
> with NY, you want to protect against rising
> interest rates, which means you purchase an
> interest rate cap. However if the underlying
> instrument is a bond, then you want to buy an
> interest rate floor. This is because bond prices
> move inversely to interest rates.

The answer was buy an interest rate cap. I also am confused about the underlying instrument. I assumed it was a bond. Since we are short the bond, it would make sense to buy a floor since we are already "winning" if interest rates increase since we are short. The floor would hedge our position if interest rates were to decrease.

So the question is asking as if it is a floating rate bond based of actual interest rates such as LIBOR??? I'm still kinda confused here on why we would call the floating rate bond LIBOR.

I understand that if we were short on LIBOR interest rates, we would need to get something that protects against increases in rates... an interest rate cap.


I have more questions coming as I just did a couple V's on interest rate caps and floors.

busterbluth

the show NY Wrote:
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> If you are long a bond, that means you have lent
> it out and want the rates to go up. So think in
> terms of interest rates, not bond prices.
>
> There was actually as similar very tricky Q like
> this on last year's exam. They told you you had a
> long gold position and asked what you would do if
> you wanted to hedge the position, and then what
> your payoff would be. Key was to understand that
> if you are long an asset you go short to hedge.


Huh? Not sure I understand what you mean. If your long the bond you want interest rates to go up???

mengxu

that is right.
bond price is inversely related to rates. rate goes up, price goes down. If you are long the bond, that is good for you.

that is what messed me up too, when I wrote the answer initially.

in this question - you are short the bond. so you want rates to go down. It would be bad if rates went up, since you sold the bond. If rates went up, you want them to go up only very little. so you need to buy an Interest rate CAP!...

CP

lucasg85

cpk123 Wrote:
-------------------------------------------------------
> that is right.
> bond price is inversely related to rates. rate
> goes up, price goes down. If you are long the
> bond, that is good for you.
>
> that is what messed me up too, when I wrote the
> answer initially.
>
> in this question - you are short the bond. so you
> want rates to go down. It would be bad if rates
> went up, since you sold the bond. If rates went
> up, you want them to go up only very little. so
> you need to buy an Interest rate CAP!...

Sorry I still am not catching you on this. If I own the bond, why would I want rates to go up since my bond will go down in value...???

brainsX

If you are trying to buy the bond, you want to pay as low as possible for it, so you want rates to go up then.

if you own the bond, you want to sell it (short position -- as in the problem) you want price to go up. You want to then hedge against price going down. (which means rates go up)

does that make sense?

CP