L2 CFA Mock 2019 A Q39

CFA Level II Derivatives
#1

Hi all,

I am a bit confused about the following case. Why is the correct answer B? Franco correctly described the 2 components (future and bond) and using the call to hedge against rising interest rates. So therefore I think the correct answer should be A.

Any thoughts?

Case: Franco replies: “The Black model can be used to value options on the Eurodollar future. In this model, futures options have two components: a futures component and a bond component. When hedging against rising interest rates, according to the Black model, the Eurodollar futures option used can be viewed as the futures component minus the bond component.”

Questions: Franco’s description of the Black model’s approach to valuation of Eurodollar futures options used for hedging is:

A correct.

B incorrect, because he is describing a call option.

C incorrect, because he is describing a put option.

Solution: B is correct. Franco is incorrect because he describes a long call option, which according to the Black model can be viewed as the futures component minus the bond component. Long put options hedge against rising interest rates. The Black model evaluates put options as the bond component minus the futures component.

A is incorrect. The statement is incorrect. C is incorrect. The Black model evaluates put options as the bond component minus the futures component.

#2

Franco is planning to borrow, and thus is trying to hedge against rising interest rates. Hedging against rising interest rates requires you to long put, not long call. The description given in the vignette correctly describes a call option, which is not what Franco should be doing.

#3

This question threw me for a loop as well.

The key is a technicality: Eurodollar futures (i.e., the underlying for this problem) are quoted as 100 - r, where r is the interest rate.

Franco is worried about rising interest rates, because it would result in a decrease in the underlying: since the underlying is 100 - r --> as r goes up, the Eurodollar goes down. So when it comes to options on the Eurodollar (i.e., not options on interest rates), we want to protect against downside which is achieved by buying a put on the Eurodollar.

(FWIW, it’s true that a call option on interest rates can also be valued using the Black Model and that a call option on interest rates could also protect Franco against rising interest rates - this same line of thinking led me to choose A when I took the exam.)

#4

Many thanks for your help!