Using a Replicating portfolio for Floater what is Shorting Floater and selling treasury is equivalent to?
The correct answer and explanation is:
In the context of a replicating portfolio, shorting a floater and selling treasury securities is equivalent to creating a portfolio that has an exposure to the floating rate and the underlying treasury bond but in reverse positions. This approach is used to hedge against or replicate the exposure to interest rate movements.
A “floater” is a type of bond whose coupon payments are tied to a reference interest rate, such as LIBOR or SOFR, with periodic adjustments. These bonds are sensitive to changes in interest rates since their coupon payments change based on the reference rate. When an investor takes a short position in the floater, they are betting that the floating rate will decrease, causing the floater’s price to rise. Conversely, selling treasuries involves taking a short position on government securities that generally offer fixed interest payments.
By combining these two positions, the investor is constructing a replicating portfolio that seeks to benefit from changes in interest rates in a way that mimics the behavior of holding a floater. The short position in the floater is essentially a negative exposure to the floating rate, while selling the treasury securities provides a positive exposure to the fixed-rate interest environment. Together, this portfolio is structured to behave similarly to a floater in terms of price sensitivity to interest rates.
The strategy of shorting a floater while selling treasuries is commonly employed by sophisticated investors to replicate the returns of a floating-rate bond using a combination of fixed-rate securities. This technique allows for more precise management of the risks associated with floating-rate instruments and interest rate fluctuations. The effectiveness of this strategy depends on the investor’s ability to manage and predict interest rate movements and market conditions.