giants2010

Here was my thought logic on C -

If I am "short" a floating rate bond, that means i am PAYING, not receiving, a floating rate of interest. So as interest rates go up, i must pay more interest. Therefore, my problem would be rates going up, so i need an instrument where i will be the winner when rates go up:

(a) - sell a cap - no good - i receive a premium and must make payments when rates go above a strike rate - doesn't offset my risk, as "i win" when rates stay low.

(b) buy a floor - also no good - i pay a premium and receive payments when interest rates go down - doesn't offset my risk, because "i win" when rates decline

(c) - buy a cap - i pay a premium and receive payments when interest rates go up - this is what i need. On my initial instrument, i "lose" when rates go up, because i'm paying a floating rate. Therefore, I need this instrument because it pays me when rates go up.

So if rates go up, i'm screwed on my floating rate bond due to increased coupon payments, but my cap kicks in and acts like "insurance' because i now receive payments from the person that sold me the cap.

I find that sometimes thinking of it in terms of coupon payments, as opposed to value of the actual bond itself, can help.