The following content is from OPTIONS, FUTURES,AND OTHER DERIVATIVES 9th by John C. Hull P90-P91
Note: The "forward interest rate contracts" mentioned below is first FRA + The second FRA
See the red underline in the screenshot below. Does The portfolio mean the first FRA + The second FRA?
If The portfolio refers to the first FRA + The second FRA, I think the risk of the portfolio is not zero。Because the first FRA+ The second FRA=[imath]L(R_K-R_F)(T_2-T_1)e^{-R_2T_2}[/imath] .[imath]R_k[/imath] is fixed, while [imath]R_F[/imath] is floating. Because [imath]R_F[/imath] is floating, MTM can be implemented. Since [imath]R_F[/imath] is floating, the bank will recalculate the forward interest rate contract margin every day. If you do not have sufficient margin, you will be exposed to risk.
But if you think of forward interest rate contracts and future deposits (or loans) as an investment portfolio. Then this investment portfolio is theoretically risk-free! Because this is a hedging! But this is not risk-free in real trading. Because deposits initiated in the future cannot serve as margin for forward interest rate contracts. (When futures hedging, the warehouse receipt can be offset against the margin).And judging from the content of the original article, the investment portfolio mentioned by the author does not look like a hedging investment portfolio.
So what does the author mean by "The portfolio is therefore a risk-free investment"?
Note: The "forward interest rate contracts" mentioned below is first FRA + The second FRA
See the red underline in the screenshot below. Does The portfolio mean the first FRA + The second FRA?
If The portfolio refers to the first FRA + The second FRA, I think the risk of the portfolio is not zero。Because the first FRA+ The second FRA=[imath]L(R_K-R_F)(T_2-T_1)e^{-R_2T_2}[/imath] .[imath]R_k[/imath] is fixed, while [imath]R_F[/imath] is floating. Because [imath]R_F[/imath] is floating, MTM can be implemented. Since [imath]R_F[/imath] is floating, the bank will recalculate the forward interest rate contract margin every day. If you do not have sufficient margin, you will be exposed to risk.
But if you think of forward interest rate contracts and future deposits (or loans) as an investment portfolio. Then this investment portfolio is theoretically risk-free! Because this is a hedging! But this is not risk-free in real trading. Because deposits initiated in the future cannot serve as margin for forward interest rate contracts. (When futures hedging, the warehouse receipt can be offset against the margin).And judging from the content of the original article, the investment portfolio mentioned by the author does not look like a hedging investment portfolio.
So what does the author mean by "The portfolio is therefore a risk-free investment"?