An FI has a $100 million portfolio of six-year Eurodollar bonds that have an 8 percent coupon. The bonds are trading at par and have a duration of five years. The FI wishes to hedge the portfolio with T-bond options that have a delta of –0.625. The underlying long-term Treasury bonds for the option have a duration of 10.1 years and trade at a market value of $96,157 per $100,000 of par value. Each put option has a premium of 3.25 (percent of $100,000). Bonds put options are necessary to hedge the bond 824How far must interest rates move before the payoff on the hedge will exactly offset the cost of placing the hedge?How far must interest rates move before the gain on the bond portfolio will exactly offset the cost of placing the hedge?If interest rates increase 100 basis points, what is the expected gain or loss on the put option hedge?

An Overview of the Hedge's Functions Taking out an insurance policy is a lot like hedging, in a sense. If you own a house in a flood-prone area, you should get flood insurance to safeguard your investment from the possibility of flooding. There is no way to prevent a flood, but you may plan to minimize the risks if one does occur. This trade-off is inherent in the hedging process, which can minimize risk while also limiting gains. Hedging costs money. In the flood insurance example, the monthly premiums mount up, and if the flood never occurs, the policyholder does not receive any compensation from the insurer. Nonetheless, most people would prefer to incur a predetermined and limited loss than lose their home suddenly and unexpectedly. Hedging works in the same way in the investment world. They utilize hedging techniques to limit or mitigate the risks they face as investors or money managers. As an investor, one must employ a variety of instruments to hedge against the risk of price volatility in the market. To accomplish this, it is best to make a targeted and managed investment. Even if there are some similarities to the insurance example above, the policyholder will receive total compensation for her loss, perhaps with a deductible in the case of flood insurance. When it comes to hedging in the financial sector, it is both more complicated and less precise. There is no risk in a position or portfolio if it has a perfect hedge to offset it entirely. Because the wall is completely uncorrelated to its target asset, it is described as an "inverse correlation." This is more ideal than a practical reality, and even the ideal hedge has a price tag. When an asset and a wall do not move in opposite directions as planned, "basis" refers to the discrepancy; The Threat of Rising Interest Rates Cannot Be Ignored. With any risk assessment, there is the option to do nothing, and many people do. However, in situations of uncertainty, not hedging might have disastrous consequences. Hedging costs money, but what if you make a big mistake and end up losing a lot of money? In 1994, Orange County, California, served as a cautionary tale about the dangers of neglecting interest rate risk. Simple: Robert Citron, Orange County Treasurer, borrowed money at cheaper short-term rates and lent money at higher long-term rates. Short-term rates plummeted, and the regular yield curve was preserved, which made the plan great at first. However, things started to change when the yield curve began to shift and approach inverted yield curve status. It is believed that roughly $1.7 billion in losses were incurred by Orange County and the nearly 200 governmental agencies for which Citron was responsible. For neglecting interest rate risk, this is a heavy price. The Bottom Line Different products are better suited for different scenarios, but they give a mechanism to protect against the danger of rising interest rates. However, nothing in life comes for free. You have to give up something when using any of these options, whether it's money (like premiums paid for options) or opportunity cost (the profit you would have made without hedging).PART A The underlying asset is a bond in a bond option, and a contract is an option contract. Bond call and put options are conventional option contracts that allow investors to adopt a variety of speculative positions. Derivative products such as options, especially bond options, allow investors to make speculative bets on the direction of the underlying asset prices or to hedge specific asset risks in a portfolio. PART B PART C PART D