Question

Suppose that the pension you are managing is expecting an inflow of funds of $1 billion next year and you want to make sure you will earn the current interest rate of 5% when you invest the incoming funds in long-term bonds.

A. How would you use the options market to do this?

B. How would you use the futures market to do this?

C.What are the advantages and disadvantages of using a futures contract rather than an option contract?

Answer 1

A)"Buy call option on long-term bonds with a delivery date of one year from now and at a strike price which would result in 8% interest.

B)"Buy long-term bond futures contract with one year expiry worth $100 millions.
No of contracts = $100,000,000/$100,000=1000
After one year we would be entitled to get a delivery of the long-term bonds at the price agreed today. This would ensure that we will get the desired current interest rate of 8%."

C)Advantage of using options: We are protected against the downside but if there is an opportunity for upside, with a call option we can enjoy that. Thus, we an earn an interest rate of more than 8% if interest rates go up. But we are protected if interest rates go down. With futures, we are locked at 8%. So neither a downside nor an upside.

Disadvantage The investor may end up being incorrect as to the direction and timing of a stock\'s price, rendering the attempt at enhanced portfolio return worthless.
Thanks