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Hedging

Hedging

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#1 shsh1340

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Posted 06 June 2013 - 08:18 PM

I have a question and need a help

 

Strobel Company has a large amount of variable rate financing due in one year. Management is concerned about the possibility of increases in short-term rates. Which of the following would be an effective way of hedging this risk?

a. Buy Treasury notes in the futures market.

b. Sell Treasury notes in the futures market. 

c. Buy an option to purchase Treasury bonds.

d. Sell an option to purchase Treasury bonds

 

The answer is B

 

Can anybody here explain to me why?? I wouldn't understand this. Thanks a lot .

 

 

 



#2 markdog

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Posted 13 June 2013 - 07:47 AM

If interests rates rise, the value of today's treasury note will drop. However, you didn't buy a treasury note, you actually sold short in the futures market (Answer B).

 

If rates do indeed rise, your position in the futures market will now be profitable

At the same time, the debt obligation tied to the company's variable rate financing has also increased, resulting in a loss.

 

The hedge: The profit from the sale of treasury notes is designed to hedge the loss taken on the variable rate financing side.

 

Vice-versa: if interest rates DROP, your position in the futures market would be negative and result in a loss. The resulting loss would be hedged though by the decrease in debt on the variable rate financing side (assuming the debt's variable interest was tied to a correlated index).

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A (Wrong): Buying Treasury notes in the face of rising of interest rates actually increases your exposure to fluctuations in short-term rates. Bad hedge.

B (Right)

C (Wrong) same reason as A. Why would you want to buy an option to increase your exposure? You will lose your option money if your bet on rising interest rates is correct.

D (Wrong) You will earn money by selling the option, but this is not an effective hedge considering the company's short-term variable financing.

    - If your bet was temporarily correct, your position would be profitable (on paper).

    - But what if the interest rate reverses, and the option is put to you at a later date? You could sustain a big loss from the naked short, combined with the option buyer's willingness to let the option ride against you before closing out big.

 

Selling directly in the futures market provides liquidity to close your position should your hedge be incorrect, the option does not.