Derivatives - Options Contract to Hedge - Essay Example

Therefore, I would be able to enable the loss in one market to be compensated, either completely or partially, by the gains received in the other (TMXGroup, 2012).

In hedging, there are a number of risks but the main risk involved is the basis risk. This comes about as a result of futures contracts not being perfectly tracked by the bond that is being hedged. In most cases, it is usually greater for bonds as the actual price is usually lower than the theoretical value. However, the loss due to the basis risk is the same as the profit gained from arbitrage transactions thus recoverable (TMXGroup, 2012).

Question Two:

Explain how you could use an options contract to hedge your $10m portfolio of 5-year US BBB-corporate bonds over the next year. State what different types of options you might use to implement this strategy

I could use the open swap position to hedge the $10m by following the strategy of hedging a fixed-rate portion of the swap against a rise in interest rates by selling a specific number of contracts. In most cases, receiving a fixed rate on a swap is the same as buying a bond with the corresponding hedge consisting of selling bond futures contracts. The method is slightly different from the one described in question one above as in question one I would concentrate on buy positions and sell positions and hedge when the correlation is greater to make the process more efficient (TMXGroup, 2012).

Question Three:

You are an investor and hold a $10m portfolio of US, BBB-corporate bonds and £20m in UK, AA-rated corporate bonds. The current spot rate is 1.5$/£. Over the next year, you want to reduce your exposure to UK bonds by £10m and gain £10m exposure to the UK economy by taking a position such that you earn the return on the FTSE in terms of US dollars.

Actually, it is possible to achieve this cost-efficiently using interest-rate futures instead of cash bonds. Furthermore, it is also possible to use Rho as this is the change in the price of an option with respect to the risk-free rate of borrowing. In breaking rho into financial risk and the cross currency, exposure of their reporting versus home currency is reduced and risks avoided (TMXGroup, 2012).