CFA Institute CFA-Level-II Exam - Topic 2 Question 28 Discussion

Erich Reichmann, CFA, is a fixed-income portfolio manager with Global Investment Management. A recent increase in interest rate volatility has caused Reichmann and his assistant, Mel O'Shea, to begin investigating methods of hedging interest rate risk in his fixed income portfolio.

Reichmann would like to hedge the interest rate risk of one of his bonds, a floating-rate bond (indexed to LIBOR). O'Shea recommends taking a short position in a Eurodollar futures contract because the Eurodollar contract is a more effective hedging instrument than a Treasury bill futures contract.

Reichmann is also analyzing the possibility of using interest rate caps and floors, as well as interest rate options and options on fixed income securities, to hedge the interest rate risk of his overall portfolio.

Reichmann uses a binomial interest rate model to value 1-year and 2-year 6% floors on 1-year LIBOR, both based on $30 million principal value with annual payments. He values the 1-year floor at $90,000 and the 2-year floor at $285,000.

Reichmann has also heard about using interest rate collars to hedge interest rate risk, but is unsure how to construct a collar.

Finally, Reichmann is interested in using swaptions to hedge certain investments. He evaluates the following comments about swaptions.

* If a firm anticipates floating rate exposure from issuing floating rate bonds at some future date, a payer swaption would lock in a fixed rate and provide floating-rate payments for the loan. It would be exercised if the yield curve shifted down.

* Swaptions can be used to speculate on changes in interest rates. The investor would buy a receiver swaption if he expects rates to fall.

If 1-year LIBOR at the end of year 2 is 5.8%, the absolute value of a position (long or short) in the 2-year, 6%, $30 million interest rate floor at the end of year 2 is closest to: