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DV01 Option-Bond hedge explained in Market B2 RSS

Atin

Posted: 18 October 2008 02:28 PM   [ Ignore ]
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Hi David

I got confused with the explanation of DV01 hedge by
1. Writing call option
2. Long on zero coupon bond

If rates decline, value of call option would decline. It should not affect the option writer adversly.
Infact it might be better for the writer as that chances of option getting exercised is less.
And rates decline would raise price of the bond.

So effectively this combination does not produce a good hedge.

Am I missing something here

Thanks
Atin

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Atin

Posted: 18 October 2008 02:35 PM   [ Ignore ]   [ # 1 ]
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Ah I know what I missed.

I was considering this option as option on a stock. But it is actually option on another fixed income instrument.
so by writing, market maker stands to lose money if rates fall

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David Harper, CFA, FRM, CIPM

Posted: 27 October 2008 07:14 PM   [ Ignore ]   [ # 2 ]
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Atin,

Actually, that is my mistake. I had incorrectly been thinking about the call option as an option on a stock; but you are right, Tuckman’s example is about a hedging a written call option on a bond. Thanks for noticing this.

David

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