A company has a $3M position in fixed-rate Treasury bonds and it will like to hedge the position using out-of-the money call (each cover $100,000) on Treasury bonds with delta of 0.3. How this can be implemented ? The solution said it shall SELL 100 Treasury bond calls. Why ? Can anyone explain ? Please note it does not mention that this is a dynamic hedge.
My question point is : Why Treasury bond call can be used to hedge the position of Treasury bonds, not the number of the calls used here.
when rate increases -> call will gain position, the bond will lose value. both will offset each other (not exactly, but to the extent there will not be so much of a loss). when rate decreases - call is out the money - you only lose to the extent of the premium paid to buy the call - but bond gains in position. why a t-bond call - any other kind of call your movement on the call will not be a 1:1 move.
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CP, Please note that the calls are sold rather than bought.
ignore my earlier answer. missed that…
it is a case of selling a covered call. you own the bond, you sell an out the money call. you gained a premium. Now say rates in the market fall sufficiently so as to increase the price of the bonds. in that case you have to sell the bonds - but you still gain the price difference + you gained the premium. when the price remains below the strike - bond call will not be exercised, you gained the premium, + a gain or loss depending on what the bond does in the premium. since it is a covered call - you need to be match the characteristics of the underlying.
CP, I agree with you that this is a covered call & matching the characteristics of the underlying is required. I think the solution is not correct and this is why I raised this question here. Thanks a lot !
If you own the bond, why would you want to purchase a call as a hedge? That would increase your exposure, so you sell them. Or, you can purchase puts to limit your downside.
I think this is a dynamic (delta) hedging, as stated on p.456~464 of cfai text vol 5. The stock position is replaced by bond position here. Bond price rises => Bond position : Gain, Call : Loss Bond price falls => Bond position : Loss, Call : Gain Gain/Loss will offset only for a SMALL change in underlying (bond) price. So, a large change in bond’s price can not be hedged away by this hedge due to gamma effect.
Explain this more please.
Ive been considering doing exactly this but i find conflicting information on this.
I thought being long a treasury and long a interest rate cap would hedge out the risk (more or less)…
But ive read conflicting statements that since rates increase, bond value decreases and call doesnt work. This has me ??? Becsuse thats the point of the call/cap to engage as the rate increases and capture as close to a 1:1 delta as possible.
Is a call options the best hedge? Probably not but that is the instrument the question gives so. So that is what we work with.
You are long the bond.
Gain prices up lose prices down
We are using a call we need a position that will have opposite pay off (even if not symetric)
Short call
Prices below strike = premium = gain
Prices above stike = loss
We have given up some upside to protect some of downside
Long call would have increased out long exposure not offset it.