Help! I am having a hard time understanding this question…
An investor with an extensive bond portfolio is concerned about interest rate risk and wants to utilize yield-based options to hedge herself. Which of the following options should you recommend?
Answer: Long TYX call. WHY?? I thought if I owned bonds I would want to go LONG the PUT. Why are bonds different than stocks? HELP!!! I’m confused.
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Hi, are you referring to the question in the text from this chapter?
An investor with an extensive bond portfolio is concerned about interest rate risk and wants to utilize yield-based options to hedge herself. Which of the following options should you recommend?
A) Long TYX calls
B) Short TYX calls
C) Long TYX puts
D) Short TYX puts
The answer is discussed below in the spoiler section:
Answer: A) Long TYX calls
First, eliminate the short options as answers. Long options are almost always the better choice when identifying a hedging position. Best case scenario, writing (going short) options results in a gain equal to the premium (nothing more). If the investor’s portfolio faces significant risk, the premium will only offset that risk on a limited basis.
The investor is concerned about interest rate risk, which occurs when interest rates rise, forcing bond market prices downward. Her portfolio will experience losses if this happens.
The investor should purchase the option that will profit in case interest rates rise. Interest rates and yields are correlated, meaning they go in the same direction. When interest rates rise, so do yields (because bond prices are falling). Therefore, she should invest in the bullish long TYX call yield-based option.
Please let me know if there is anything specific I can clarify!