Question

Suppose that at the end of the year you have a capital gain on a T-Bond. You would like to lock in your profits now but rather wait for the year to end to delay the capital gain tax until next year. How would you use the futures markets to achieve your objective? What are the risks of your strategy?

Answer 1

Assume-Calender Year January 2019 to December 2019

CASE :Therefore at end of the year Investor has a capital gain on T BOND

Investor would like to lock gain now but wishes to delay the capital gain tax next year.This mean investor wants to lock the profits in December but delay the capital gain TAXnext year.

NOW LETS UNDERSTAND HOW CAN THE INVESTOR HEDGE HIS POSITION BY T BOND FUTURE,

Position –short (selling)

Security –T BOND FUTURE

Hence if he Decides to take a selling position in December 2019 for march 2020 he can lock his profits arising from capital gain.This way T BOND FUTURE WILL help him to retain his profits.

HOW:
Risk=lets understand what is the risk

Risk for the Investor is RISE IN INTEREST RATE which can lead to FALL IN VALUE OF T BOND therefore to offset any losses A future position will help.Now even if interest rate rises the gain due to future position will offset any losses this is called hedging of losses.

HENCE WE CAN USE FUTURE MARKETS TO OFFSET ARE LOSSES TO ACHIEVE OUR OBJECTIVE OF LOCKING CAPITAL GAIN.

What will happen if For tax purposes bond is sold before march2020

Eg. January2020

If bonds are sold in January 2020 hedge is removed. Therefore short position is closed, now the investor can buy back the T BOND Future so that he can save himself from any additional risks.

Hence the risk is of RISE in interest rate which can cause the value of bond to fall and hence decreasing capital gain.

WE can Conculde Future markets can be used to offset the position of losses in this case by taking a short position of T Bond to save Investor from falling prices. The risk in this situation is of rising interest rates leading to fall in prices . Basis Risk(Spot price -future price) is also associated in this strategy.