If I own a floating rate bond (indexed to LIBOR) and I want to hedge it, what is correct:
A. Taking a short position in a Eurodollar future
B. Go Long a Eurodollar future
C. Go long a treasury bill future
Answer is B, take a long position in the Eurodllar contract. If interest rates decrease, yield on the LIBOR based security will all, but the decrease will be offset by gains on a long position in a Eurodollar futures contract.
This answer makes no sense to me. If interest rates fall, don’t we want to be short eurodollar futures in order to hedge it?
I am also confused. But i figured Eurodollar futures have an inverse relationship with interest rates. So you’d want to go long the Eurodollar when rates fall.
Eurodollar futures are priced using discount rates, not add-on rates; their price increases when interest rates decline and decreases when interest rates rise.
They’re priced essentially identically to T-bill futures; the only reason that B is correct and C is not is that Eurodollar futures are based on LIBOR while T-bill futures are not.
When LIBOR falls you would never want to be short ED Futures. Remember how ED Futures are quoted: 100 - LIBOR or IMM quote. As rates fall, the quote becomes bigger and thus the ED Futures increases in value which shows that rates and ED Futures are inversely related just like the Price-yield relationship of an option-free bond.
Thus, taking a long position in an ED Futures will offset the decrease in yield due to a reducing coupon and reinvestment rate, not a short ED Futures position.