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I'm currently paying a 1.25% margin rate. This rate is based on the Fed Funds rate plus a margin. I would like to hedge against the possibility of this margin rate increasing. What is the best/cheapest way to do that? I have access to the futures market but not the market for swaps.

Some hedging ideas:

  • Short 2-year Treasury futures. Roll the futures every quarter and eat the cost of rolling since treasury futures are in backwardation. Also, I have to pay margin costs on the $2000 I borrow to put up as collateral for every contract I short.

  • Short Fed Fund futures. However, these don't go out very far. Also, I still have to pay margin costs on the money I borrow for collateral.

Any other ideas? Pros/cons/costs of the above?

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Those are both reasonable ideas. The pros of the Treasury futures : a) very liquid b) works well assuming you are pretty certain you will pay margin for a 2yr timeframe. The pros of the Fed funds futures : a) you can vary your hedge maturity depending on the timeframe you anticipate b) they precisely hedge your liability , whereas 2yr Treasury doesn’t have to reflect Fed funds exactly (price can be at least a +/- 10bp spread to the equivalent strip of Fed Funds futures).

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  • $\begingroup$ Thanks. Actually, I'm looking to lock in my margin rate for much more than 2 years. Specifically, I own on margin uncallable Bank of America and Wells Fargo preferred stock that yields about 5% and I want to own it for decades. I want to lock in the spread vs. my margin rate of 1.25%. Would simply rolling the contract for decades accomplish that at a reasonable cost? Also, how do I go about calculating my cost of hedging to see if it's worth it? $\endgroup$ – Landlord Investor Feb 15 at 18:00
  • $\begingroup$ "I want to lock in the spread vs. my margin rate of 1.25%. Would simply rolling the contract for decades accomplish that at a reasonable cost?" --- you can answer this easily enough yourself by looking at the total return on rolling UST futures. Spoiler: no. Carry + rolldown would eliminate much of your return. $\endgroup$ – user42108 Feb 16 at 18:43
  • $\begingroup$ Thanks. What I really want to do is synthetically replicate an interest rate swap. An IRS would accomplish the hedging against rising floating rate margin costs that I'm looking for. But alas, I don't have access to the swaps market so want to synthetically replicate as close as possible using futures. What's the best hedge against rising floating rates available in the treasury futures market (no access to Libor futures either). $\endgroup$ – Landlord Investor Feb 17 at 20:18
  • $\begingroup$ No access to Eurodollar futures? Might sound dumb but I am surprised you have access to UST futs but not Eurodollars. $\endgroup$ – user42108 Mar 17 at 22:37
  • $\begingroup$ It's worth noting that your margin could increase for reasons other than the underlying RFR/benchmark rate increasing, e.g. increased volatility, policy changes at your broker... $\endgroup$ – user42108 Mar 18 at 15:40

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