Bond futures - hedgers with long positions

[Sheen]

The futures markets' original role was to provide a means to manage risk. For instance, a farmer growing wheat on his farm is satisfied with the price the futures market says he can get in 3 months for his crop, so he decides to take some risk off his chest by establishing a short position in the wheat futures contract. Similarly, a bakery claims they can make a decent profit in a couple of months using wheat at a price suggested by the futures market, so they decide to lock in this profit by opening a long position in the wheat futures contract.

As easy as it is to understand it using a commodity futures as an example, the same thing cannot be said about financial futures. Let us consider T-Note futures. If you own a bond portfolio and are concerned about the loss of its value due to interest rate rise, you can hedge this risk by opening a short position in the T-Note futures market. Having said that, how can there ever be a hedging LONG position? Who can be a hedger opening a LONG position in this contract? Nothing really comes to my mind in this respect. Can anyone be so kind to share their thoughts on this, or give a practical example of a hedger with LONG positions in T-Note market?

 

[Martinghoul]

A lender is an example...

 

[Sheen]

A lender is an example...

Could you explain a bit more, please? Long hedging positions will obviously be opened by someone predicting a rise in T-Note prices, for instance, because of falling interest rates. However, how does this apply to a lender issuing loans which are not in any way linked to T-Notes yield?

Another example that has come to my mind is a fixed-income investment fund looking to close a round of financing in a few months. If the fund manager is worried about the possible rise in T-Note prices, which will reduce the yield, he can hedge this risk by establishing a long position in the relevant futures contract until the subscriptions to the fund are complete and the underlying instrument can be bough in the spot market.

 

[Martinghoul]

Anyone who is exposed adversely to falling yields will potentially want to hedge by being long. An example of this is a bank or a specialised company which happens to be in the lending business. Another very common example, which is rather different, is a pension fund. You can imagine that a pension fund owns a large portfolio of equities and has liabilities. The PV of these liabilities increases when rates fall, which means that pension funds would need to buy bonds and/or bond futures.

 

[Sheen]

Would these entities not use interest rate futures instead? If their liabilities are not related directly to bonds?

 

[Martinghoul]

Would these entities not use interest rate futures instead? If their liabilities are not related directly to bonds?

Depends on the duration of their liabilities... Bond futures offer the only way to hedge across the entire curve, which would imply that even people whose liabilities are not related to bonds directly would use them. To be fair, most of these people would simply use bonds, but there are significant trade offs involved which can make futures more or less suitable, depending on the institution and its constraints.