Question

In each of the following cases, discuss how you, as a portfolio manager, could use financial futures to protect a portfolio.

a. You own a large position in a relatively illiquid bond that you want to sell.

b. You have a large gain on one of your long Treasuries and want to sell it, but you would like to defer the gain until the next accounting period, which begins in four weeks.

c. You will receive a large contribution next month that you hope to invest in long-term corporate bonds on a yield basis as favorable as is now available.

Short answer

a. Take a short position in T-bond futures

b. Take a short position in T bond futures

c. The extra cash would be available to purchase the bond with anticipated contribution

Step-by-step solution

Explanation on situation ‘a’

To offset interest rate risk, take a short position in T-bond futures. In case of increase in rates, the loss would be offset by the futures gain.

Explanation on situation ‘b’

To offset the bond price risk, take a short position in T bond futures.

Explanation on situation ‘c’

In case of increase in bond prices, the extra cash would be available to purchase the bond with anticipated contribution. In other words, a price increase will generate a profit.