[ 2009 FRM Sample Exam ] Quantitative Analysis Q17

lalamei

 

17. Your firm is holding a short position in an Argentinean bond with a notional value of ARS 5,000,000 and a coupon yield of 5.5%. Your model predicts the bond's yield will decrease over the coming year. You are asked to hedge the position. Your recommendation is to:

A. Buy a credit default swap

B. Sell a credit-spread put option

C. Short a credit-spread forward

D. Buy a total rate of return swap

lalamei

 

Correct answer is Bfficeffice" />

A is incorrect: CDS is insurance against default of the underlying asset, here it is explicitly noted that the probably of default is expected to reduce over the coming year

B is correct: you are looking to hedge against a price increase in the underlying as you're currently short the bond

C is incorrect: your are not sure the underlying will decrease in value and the bond price decreases you will not be able to participate in the revalue as you have paid for the forward up front and if traded at mid market requires no premium

D is incorrect: Total rate of return swaps create non-funded positions in the total return of the referenced bond, effectively a default swap plus market risk. We are not concerned about credit risk or default, we're concerned about the underlying bond's asset value (credit quality) and hedging against that possibility