In the schweser AM exam 1, I came across this question#31. I am assuming the portfolio bond in the question is libor-addon instrument and eurodollarsfuture is a discount instrument. I want to know how does this combination effectively hedge with disparity in the type of instruments. Can you please help? here it goes… “Riechmann would like to hedge the interest rate risk of one of his bonds, floating rate bond(indexed to LIBOR). O’Shea recommends to take a short position in Eurodollar futures contract because Eurodollar contract is a more effective hedging instrument than a T-Bill futures contract”. Qn:To most effectively hedge his long position in the floating bond against declining rates, Reichmann should: 1) go per OShea 2) go long in Eurodollar futures contract 3) go long in a T-Bill futures contract
you’d want to take a position also based on eurodollars that will increse when rates go down to offset the decreased value of the floating rate position. go long the eurodollar futures since it will incresae in value when rates go up since they’re quoted on price basis, inverse relationship.
jgradits, I think this qn is more about interest rate risk than price risk. I understand to the point that when portfolio intrest falls, the long future is going to help as we have purchased the option. However, this moght not be a perfect hedge. As the portfolio bond is an add-on instrument vs the eurodollar futures contract – a discount instrument. Also note that the qn conpares between the T-bill and Euro dollar. In this case, Euro is preferred as it is attached to LIBOR the same reference as in the case of the portfolio. I guess the among the choices, as taking a short position does not help at all to hedge the declining rates, the only choice remains 2). However is not a perfect hedge. Am I missing something?
the question asks to choose between eurodollar contract and tbill futures. so hence euro dollar is better choice. from practical stand point, it is not “A PERFECT HEDGE” like you indicated. There are other products out there that you can use to hedge paying/recving cashflow. However, these might not be feasible since the transaction cost/operational risk might outweight the benefit. eurodollar contracts happens to be one of the most liquid libor based instrument out there. you can easily buy/sell to express your views on the front part of the libor curve. hence, people choose eurodollar contracts over other libor based instruments. this liquidity disappears if you go further out the curve, say, more than 5 yr (gold pack). in that case, most will use swap. good example would be swap spd. when a trader wants to take exposure in swap spd and he wants to express his view that yield on 2yr note will decrease vs 2yr libor rate (swap spread widener). he will most likely be buying 2yr tsy note (spot settling) vs selling eurodollar contracts (fwd settling). the reason for his choice is to mitigate the transaction cost of his trade and take advantage of liquidity.
wow! thanks a lot gangsta… guess continuing on the same note, another qn in the same vignette offers choices on constructing a collar. My problem is that I don’t understand the motivation of one against the other Reichmann finds that interest rate volatility increases. so wants to hedge using a collar Here goes the qn. What would be the most appropriate way to construct an interest rate collar to hedge against the fixed rate portion of the portfolio using 2-yr 6% floor and a 2-yr 12% cap? 1)Buy the floor buy the cap 2)Buy the floor sell the cap 3)Sell the floor buy the cap Any help here too is much appreciated
Ok here is my attempt. Its from memory so please let me know if I got it backwards. I try to remember that an interest rate cap “caps” my loss on a long bond so it caps the most rates can rise and hurt my portfolio by paying me more when rates go above my cap. I try to remember a floor as I have a floating rate bond and the floor is the most my interest rate can decrease before my floor offsets my lost income. So we: Buy Cap - if rates exceed cap, you get paid money. So if you are hedging an investment that loses money as rates increase (a fixed rate bond) then you want to long the cap which pays you when rates go above 12% Sell Floor - The long floor gets paid when rates are below the floor. Essentially, if you are long a floor you would be hedging a floating rate bond. In the case we have a fixed rate bond that will gain when rates drop. So we are going to “lock in our rate” by selling a floor where our losses on the floor are offset by the gains on the long bond we are hedging.