What does it mean to short something?

What does it mean to short something?

For instance, the phrase:

>'shorting treasury bond future to hedge against interest rate risk'.

I haven't a clue what that means

short: selling cuz u think its guna crash
long: buying cuz u think its guna go up

futures*

shorting is borrowing stock from your broker, selling it and then buying at a lower price netting you the difference

you borrow something someone else has it, then later to close the trade, you buy it to pay the person back. leaving you with the difference in the price since you borrowed it.

But how do you short a bond 'future' and how does that hedge interest rate risk?

Might search for 'turbo's' Very interesting product.

Here's what it means to short something.

When you short something, you complete a procedure which I will describe below:

Step 1: Borrow the thing you wish you to short from somebody else (perhaps through an exchange).

Step 2: Sell the thing you have just borrowed for whatever the current market price is for it.

Step 3: Wait however long you would like to short.

Step 4: Buy back the thing you sold previously to the market at whatever the current market price is now. Hopefully, the value of the thing you have decided to short has gone down so you can buy it back at a lower price.

Step 5: Give back the thing you just bought to the person you originally borrowed it from and give him interest as well for loaning it.

Some other complications may apply. If the lender lending to you believes the item is particularly scarce and that you may not be able to return it to him after you are done with it, he may require you to give him something (cash) as a collateral. He will have to pay you interest on this collateral. Also, if you happen to be borrowing a stock which pays dividends, you will have to pay the dividends back to the person you are borrowing from as well.

Lots of other things can happen too but that is the general idea of shorting. It all comes down to borrowing from someone, selling at the current market price, waiting, re-buying the thing you previously sold, and then returning it back to the person you borrowed it from. Hopefully when you rebuy, it is significantly cheaper than when you originally sold it so you can keep the difference in profit.

In regards to your comment
>shorting treasury bond future to hedge against interest rate risk
"Interest rate risk" means the risk that interest rates, which are the rates of interest one would receive if they owned a treasury bond, might go down. If you "short treasury bonds," then you are essentially doing the process I described above because you believe the interest rates will go down.

Bonds have value. This value is determined essentially by what their interest rate is (how much interest they pay the holder) in comparison to whatever the current market's interest rates are.

Thus you can think of a bond as an asset with a market price which can go up or down, just like a stock. Understand?

Now apply the steps here: To say he is hedging interest risk implies somewhat that the investor owns some kind of asset which relies on interest rate risk in some way. To protect himself from significant loss if interest rates should decline, he is shorting the bonds so that the maximum amount of money he will lose if interest rates go down is not so big. The downside is that by hedging, and thus limiting how much money he can lose, he is also somewhat limiting the amount of money he could make. So he is managing his risk.

Got it?

I see, I see. But is there a difference between hedging a bond and futures contract with the underlying asset being the bond (i.e. a contract stipulating x many treasury bonds at x date etc.)?

Derivatives are a major pain in the a$$.

long: buy now and hope price rises for profit on sale
short: sell now with the promise of buying back in the future. price dip = profit

shorting is betting against the asset

as far as bonds... are we talking yield or price?

Futures contracts apply only to certain assets and have specified terms, and are liquid.

From what I can tell, it's possible that futures contracts with bonds as the underlying assets are the only way to short treasury bonds.

I'm not sure of the details of shorting bonds, to be honest. From a mathematical perspective, they're essentially the same thing.

>>shorting treasury bond future to hedge against interest rate risk
>"Interest rate risk" means the risk that interest rates, which are the rates of interest one would receive if they owned a treasury bond, might go down. If you "short treasury bonds," then you are essentially doing the process I described above because you believe the interest rates will go down.

This is if you assume the coupon is floating, which is usually the case. He may be tho trying to hedge the price of the bond too as IR have direct impact on it. Depending on what your position and intention is, but usually market makers - trader in the bank - would be hedging against prices. But again, depends on what you want to hedge.

and forgot to mention. IR Risk measures how much the price of a security changes when interest rate change.

You have to take into account that when you do P/L of a hedging position, big changes in price are more important than the floating coupon - which again can be fixed or not.

Not yield, my question is all to do with price risk and hedging.

Imagine this scenario. Institution A owns a shitload of bonds (CDO 'shares', other ABS's, fixed-rate bonds) and anticipate an increase in interest rates and thus a decrease in bond prices. Institution A wants to keep these bonds however, instead of selling them.

Instead they decide to short treasury bond futures to hedge against this risk that bond prices might fall. Essentially mitigating their portfolio's decrease in value.

I'm stuck on how this works exactly (shorting a futures contract) because now i know how bonds are shorted but its the whole issue with the bond as the underlying asset. From my perspective they seem to be the same thing.

Futures contracts are exchange traded so they can be shorted just like any other exchange-traded asset. And the futures themselves would behave similarly to forwards based on the bond yields, I think.

This guy: could probably provide a better, more detailed explanation and answer your question better.

You know what a future contract is? A future contract is an obligation to buy or sell something for a given price at a certain time in the future.

Now hedging with futures works like this (options is kind of similar):

A. You own an asset (are long on it). So you sell a future or forward contract. If Prices increases you make profit from your asset, however you make losses with the future contract --> You lock-in a price. Same if prices decrease: Profit future - loss asset

B. You short asset and long future (You will buy an asset in the future - so you lock in the price for the future).

When it comes to bonds and IR, it's tricky because to hedge the risk of one set of securities with another set of securities, traders have to know how sensitive the price of each security is to interest rate changes (there is a whooooole theory behind it for bond hedging - DV01, Duration, Delta Hedging, etc).

Which basically means, maybe your long asset (CDO in this case) decreases by 10bps however the forward you sold only increases 5bps. So it's not a full hedge, which is usually the case.

Cool. So basically the value of the futures contract is derived from the value of the underlying asset and in this case Financial Institution A is going for Option A. You may as well treat the contract like a bond/share for all intents and purposes.

Option B is more the hedging I'm used to.

There's also ETF's Like TLT that deal with bonds at the long end of the curve, like 20+ years and its inverse, TBT

It has liquid options so you can them as well.

It's just not that simple where the future contracts prices come from (I'm not talking about their pricing). Fixed Income is not an easy topic.

In general: By no arbitrage law the forward price is usually settled so that the initial value of the contract is zero.

its when you take out an insurance plan on a building you think might get hit by two jihadis in airliners a short period before you think it might happen

But consider it like this. You bought 100$ share and want to sell it in the future. So you are afraid of changes in price, therefore you sell a future contract to sell your share at 100$ in exactly on year. One years passes and the price of the share is now 110$. You make a profit of +10$ in the long position, but you will have a loss of -10$ in the future, you sell the share share which now is worth 110$ for 100$ (that’s the future agreement you signed).

What I meant with Option A and B is that it depends on your position of the sahre. In the above case you own it and are long on it. If you are short on it and are supposed to buy and not sell a share in one year you would long a future contract.

Whatever happens you lock-in a fixed price.This is very straight forward with shares, same with commodities, but when it comes to bonds it’s difficult. Because there are different kind of bonds, with different convexities, durations and term structures. So let’s say when Interest Rate increases by +10bps maybe Bond 1 increases by +10bps, Bond 2 by +2bps and Bond 3 by +6bps. Thus increasing the difficulty of hedging perfectly a bond (aka having the P/L at 0$) when prices go up or down.

For more detail information for real, grab a Fixed Income or Derivatives book. It’s a very technical, intense and interesting topic in finance.

Finally. When I wrote everything in one message it didnt sent it.

>But how do you short a bond 'future' and how does that hedge interest rate risk?

well you type in 'ZN' Which is the symbol for the 10-year treasury future contract, choose which expiration date you want, then sell it to someone, hoping it goes down, so you can buy it back and pocket the difference.