CFA 2015 PM q21

[pokhim]

We hold a bond portfolio and we’re concerned about a rise in rates. Do we:

1. enter into a reciever
2. buy a protective put
3. buy a covered call

I would have thought it was buy a covered call. But the answer is a protective put..which would pay off when rates decline..not increase?… Why is the answer protective put?

 

[cpk123]

you normally sell a covered call and buy a protective put, don’t you?
since it talks of buying a covered call - that option would be wrong here.

 

[pokhim]

Hi Cpk123
Appreciate your response. The question actually states ‘write a covered call’…
Anyways, I think I figured it out. A PP is the same as a payer swaption, so when rates rise we would exercise and recieve the floating rate…i.e. there is payoff to us when rates rise.

 

[Que Sera]

When interest rates rise, value of the bond portfolio falls
Protective put limits the downside fall in value
Covered call does not protect a fall in value, covered calls are mainly used when you expect the rates to stay the same as it most effective then