An active fund trader seeks to capitalize on an expected steepening of the current upward-sloping yield curve using option-based fixed-income instruments.
Which of the following portfolio positioning strategies best positions her to gain if her interest rate view is realized?
A Sell a 30-year receiver swaption and a 2-year bond put option.
B Purchase a 30-year receiver swaption and a 2-year bond put option.
C Purchase a 30-year payer swaption and a 2-year bond call option.
I understand that as YC steepens upward, we want to receive float pay fixed. (first part of answer C)
I don’t understand why having a 2 year bond call option is valuable (with an upward sloping YC - increasing interest rates, don’t we expect S/T bond prices to drop so I wouldn’t exercise the call option?)
I had the same question too. We don’t know whats happening to the short-term rates.
What are we expecting? or what do we assume when it is not specified
I think this is to create a duration neutral position so if the curve moves in a parallel manner, then the steepener trade will still work. 30y pay fixed position would have a significant negative duration so this is balanced with a long call position.
Thanks simon. On this point, what is the usage of having a duration neutral position? Can you explain a bit more on how the steepener trade will work if it is duration neutral?
Perhaps am confusing it with the fact that steepener trade with no change in level would be best positiond if Portfolio duration is zero. Not sure why this is too, if you can give a bit of enlightenment
You don’t assume anything; i.e., you want a strategy that works irrespective of what happens to short-term rates (consistent with the steepening stipulation).
Most curve trades work on the principle of removing broad market risks and only aiming to profit from a specific change. Same approach applies when trading skew, we would undertake the trade such that we had a delta neutral position. With a steepener - where the 2s10s spread will increase, to create a duration neutral trade we can go long 2s (+ D) and short 10s (-D). This will create a profit whether short term rates fall and/or long term rates rise regardless of any parallel changes in the curve. That said in some instances such as a bull steepener we want a positive D but think of this as more of a positive bias rather than an outright and large + position. For a bull steepener we would still go long, short term and short, long term but would have slightly higher BPV at the short end compared with the long end.