Reference no: EM131787189

You are the senior portfolio manager of an institutional account. You are reviewing the response of a junior member of your portfolio management team to a client who inquired about the use of options and futures. Four paragraphs in the letter to the client are reproduced below.

a. "The substantial interest-rate volatility is forcing many of our clients to grant us authorization to employ options to hedge their bond portfolios." Explain why such movements in interest rates would motivate clients to authorize their portfolio managers to use options.

b. "We believe options are a prudent choice because should the market move against us if we purchase an option for your account, the only negative is that the option expires worthless, and all we have only lost for your account is the option price paid." Comment on the accuracy of this statement.

c. "As an alternative, we could use another type of derivative to hedge a bond portfolio: futures contracts. We are reluctant to use this type of derivative because futures cost more, and there is tremendous downside risk; that is there is no limit on the amount of losses that might be realized for your account before we get out of the futures position." Comment on the accuracy of this statement.

d. "The overall strategy involved in using options is straightforward. If we are concerned about interest rates rising but do not want to do a major rebalancing of your portfolio, we simply take a position in put options." Why might put options be a preferable means of altering the a bond portfolio rather than rebalancing the portfolio?