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.

ayaz_mahmud369

smileygladhands Wrote:
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> 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.

Just to add one thing: The above is correct if the cap has an interest rate as the underlying- i.e. LIBOR. So if the cap is LIBOR + 200 bp, then yes, you want to purchase this to hedge your short floating bond risk.

However, you can also have interest rate caps/floors when the underlying instrument is a bond. If the underlying is a different floating rate bond, then you want to do the opposite, because interest rates and bond prices move in opposite directions.

Just be aware of the underlying when looking at these. Chances are it'll be LIBOR, but there is potential for a curve ball here.

llxx

Answer is C.

The effective duration on a floating rate bond is not the same as a traditional bond, therefore an increase in interest rates will not have as much impact on bond price.

NO EXCUSES

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.

senlinlang

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.


I guess what you said makes sense. Its a Floating Rate bond.. rates will not have as much effect on Bond Price as a reg bond
is that why you are considering in terms of Interest rates and not price?

Long - You will rec Libor + X
Short - You will pay LIbor + X...
so you want rates to go down...
& you want to hedge against them going up

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

busterbluth

the show NY Wrote:
-------------------------------------------------------
> 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...???

economicz

sbmarti2 Wrote:
-------------------------------------------------------
> 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.