What are derivative positions in bond markets?

Question

What are derivative positions in bond markets?

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Answer 1

A derivative is basically a contract where money is exchanged based on the value of something else. In short, it is two investors making a bet with each other about something. These are commonly used to help manage investment risk or business risk.

Consider an airline company. They need to buy loads of jet fuel. In a way, they are gambling on the price of oil – if oil goes up, they lose. If oil goes down, they win. The opposite is true for an oil driller – if oil goes up, they win, if oil goes down, they lose. It would be nice for both businesses if they could control their risk, so that they aren’t gambling quite so much. The problem is that the airline needs jet fuel not crude oil, and the oil driller only has crude oil. An easy solution is that the airline makes a bet with the driller – the airline bets that oil will go up, and the driller bets that oil will go down. If oil actually goes up, the airline loses money on their fuel bill, but the driller pays them winning from the bet – so the airline is even. The driller gets a massive bonus from high oil prices, but pays up on losing their bet – so they come out even.

A similar thing happens in bond markets. A bond is basically a loan, typically a long-term fixed interest loan. An investor who wants a steady return, like a pension fund, may like the fixed interest rates on bonds. The problem is that if you have a 30 year bond paying 2%, and suddenly interest rates go up to 10% – then your 2% bond looks like a real bad deal. If you needed to cash it out, then you could be looking at massive losses (getting back only pennies for each dollar you paid in). Derivatives based on interest rates are a common way to manage this type of risk.

If an investor has a lot of money tied up in 30 year 2% bonds, and interest rates start rising, they may be looking at a big loss. So they may use a derivative to bet that interest rates will go up. This way, if interest rates go up, they win back some of their losses on the bond.