In CFAI volume 4 page 251 the author discusses equitizing cash and altering duration to generate return. “One simple approach could be to vary the duration between 90 day bills (cash) and 3 year notes based on yield curve slope.” They go on to state that when the curve steepens to go long duration and when yield curve is flat stay short. Can someone help me understand the transaction necessary? What are you short? What is the initial investment? Do you use cash generated from shorting T-bills to buy futures and if the curve steepens you buy the 3 year note? Or are you not short T-bills at all? Any help would be greatly appreciated. Thanks guys!
short = short-term, not that you sell anything
You don’t have to sell anything and as Pfcfaataf pointed out, in the context of the reading, when the yield curve is flat, there is no extra gain to be made by exposing your portfolio to higher interest rate risk by buying the 3 year note. It is better to just stick to 90-day t-bills because when you roll over periodically, you will end up with the same yield as investing in the 3-year note (because the yield curve is flat). However, then the yield curve is steep, you can take on the interest rate risk by going long, buying the 3-year note, which will trump the 90-day bills.
“Equitize” cash means use cash as collateral , implying you don’t pony up all the notional immediately . The natural way of thinking: buy forwards or futures implying the delivery is sometime later and you let the profit be generated over time. Not sure if I’m connecting everything above i.e. meaning of equitize cash , be long 3 month or be longer the 3 yr note
Ok short means short duration…duh. So is this the portfolio/transaction that would result: You are long T-bills (i.e, long cash) and at the same time you buy futures to equitize this cash which requires no upfront amount. You will profit if the market goes up plus you will earn the yield on the T-bills. If the yield curve steepens you will want to sell your T-bills get your cash back and invest the proceeds into 3 year notes to earn the higher yield (I assume that the intention is to hold to maturity and capture yield only, as your price will fluctuate more with the higher duration) while at the same time rolling your futures. By doing so you will earn the higher yield from the 3 year cash position and at the same continue to earn the return on the equity market from your future position. Is that how it works? Can anyone confirm? Thanks so much…
yes, the idea is to earn higher yield (from cash investment - T-bills and T-notes) than interest cost included in the price of the equity futures that you buy (for margin) and roll.
Thanks a ton guys…big help.