Raj holds a 5-year bond that pays a fixed coupon of 8%. Raj feels that interest rates will rise for the next 3 years and hence he wants to hedge his investments in bonds. The best way to hedge is: a. Buy a Future contract. b. Buy an Option c. Enter in to a swap. Ans C. Shouldn’t the answer be B? How is he hedged in case of C? Earn fixed (he is already earning fixed). If you enter into a swap how do you nullify your position so that you earn a fixed rate of 8%? Did I understand the question correctly? If fixed was to be earned why hedge in the first place? Fixed is going to be earned any how.
As rates rise the value of the bond you hold decreases. So to hedge that fixed risk he will enter into the swap to mitigate some of that interest rate risk to another party who wants exposure to fixed rates. He will trade fixed and receive variable; as the differential increases between variable and fixed rates, the more valuable the swap will become but at the same time the bond decreases in value as well, up to a certain point assuming no embedded options like a put option is available on the bond.
Here Raj is getting fixed coupon payments and he needs to enter in swap agreement.
Where he will recieve market rate and pay only 8% coupon payments.