Question

The trustees of a pension fund would like to examine the issue of protecting the bonds

in the fund’s portfolio against an increase in interest rates using options and futures.

Before discussing this with their external bond fund manager, they decide to ask four

consultants about their recommendations as to what should be done at this time. It turns

out that each of them has a different recommendation. Consultant A suggests selling

covered calls, Consultant B suggests doing nothing at all, Consultant C suggests selling

interest rate futures, and Consultant D suggests buying puts. The reason for their different

recommendations is that although all consultants understand the pension fund’s objective

of minimizing risk, they differ with one another in regards to their outlook on future

interest rates. One of the consultants believes interest rates are headed downward, one has

no opinion, one believes that the interest rates would not change much in either direction,

and one believes that the interest rates are headed upward. Based on the consultants’

recommendations, could you identify the outlook of each consultant?

Answer 1

A covered call is when a call option is sold on an asset that is owned. It is a strategy used when one believes there is not much probability of an upward move or a downward move in the asset price. A downmove will be protected to some extent by the premium received on the call option, and losses on the call option will be protected by the bonds owned. Hence, within a certain range, selling a covered call option will be profitable if bond prices are not expected to move much. This is the view of Consultant A.

Since one of the consultants has no option, it is Consultant B since he suggests doing nothing

Selling interest rate futures will be profitable if the interest rate fall. Prices of interest rate futures are directly related to interest rates. If interest rates fall, price of interest rate futures will fall. Since Consultant C suggests selling interest rate futures, he is expecting interest rates to fall

Bond prices are inversely related to interest rates. If interest rates rise, bond prices will fall. If bond prices fall, the prices of put options on bonds will rise. Buying put options is a strategy used to protect against the fall in bond prices. Since Consultant D suggests buying put options, he is expecting interest rates to rise.