Why would I buy an interest rate cap to hedge shorting floating rate bond? If I short a FRB, then I lose if rates go down. If I buy a cap, I win if rates go up / lose if rates go down. David
Dave, I think when interest rate goes down, price of the bond goes up. When you buy interest rate cap, you are putting a limit to its down price. So when rate crosses your cap rate (for example from 5 to 7%), price will go down to 900 (from 1000). In this case, you want to put limit on 900. If it goes below 900 you want that party to pay you the losses. Not sure am I right here…I need morning coffee to think more on this.
If you short and FloatRB, it means you need to pay a floating rate, so u are worried that interest rates might go up and you might end paying more, so you buy an Interest rate cap which means that it pays you when interest rates go beyond the cap rate. I think so, not sure, but lets hear form others too
Dax, you say, if I’m short a bond, I’m worried rates might go up. If I’m long a bond, I’m worried rights might go up - right? I mastered all this stuff now having a brain freeze!
Maybe this example helps you: If a company issues a floating rate bond it is short the bond. Now they worry that rates could go up, so they will have to pay more interest for the bond. With an interest rate cap they can set an upper limit for there interest payment.
McHigi Wrote: ------------------------------------------------------- > Maybe this example helps you: > > If a company issues a floating rate bond it is > short the bond. Now they worry that rates could go > up, so they will have to pay more interest for the > bond. With an interest rate cap they can set an > upper limit for there interest payment. exactly - from a bond’s issuers’ perspective
I agree with Dax. Important to note that this is a floating rate bond. You are trying to hedge the payout of the coupon payment. You don’t have to worry about hedging fluctuations in the market value of the bond (it will reset to 100 after each coupon).
Agreed.